What Is a Payroll Audit and What Does It Entail?
Demystify the payroll audit process. Gain insight into its objectives, what's reviewed, and how to effectively navigate an audit.
A payroll audit involves a systematic review of an employer’s payroll records and practices. This process helps ensure a business adheres to compliance requirements and maintains accurate financial records. It verifies correct employee compensation, proper tax withholding and remittance, and alignment with applicable laws and regulations. A payroll audit supports financial integrity and helps prevent potential legal and monetary issues.
What a Payroll Audit Entails
A payroll audit comprehensively examines a company’s payroll processes and documentation. Its core objectives include verifying compliance with federal and state tax laws, labor regulations, and benefit plan rules. This review aims to identify discrepancies, errors, or non-compliance in how employees are paid and how payroll-related finances are managed.
The scope of a payroll audit typically involves scrutinizing wage calculations, tax withholdings, and deductions for benefits. It also reviews the accuracy of payroll reporting and record-keeping practices. The primary parties involved are the employer and an auditing entity, which could be a government agency, an insurance provider, or an independent third-party auditor.
Reasons for a Payroll Audit
Payroll audits are conducted by various entities for distinct reasons. Government tax agencies, such as the Internal Revenue Service (IRS) and state tax departments, perform audits to ensure accurate withholding and reporting of income tax, FICA, FUTA, and SUTA. Triggers for these audits can include discrepancies in reported wages, late tax filings or deposits, or random selection. Changes in employee classifications or a high ratio of independent contractors versus employees can also raise flags.
State labor departments focus on compliance with wage and hour laws, including minimum wage, overtime pay, and break requirements. Employee complaints regarding unpaid wages or misclassification often trigger these audits. Inconsistent or incomplete record-keeping, as well as high turnover rates, can also lead to scrutiny.
Workers’ compensation insurance carriers conduct audits, typically annually at the end of a policy term, to verify payroll figures used for premium calculations. These audits ensure the estimated payroll aligns with actual payroll, influencing the premium. Changes in payroll or employee classifications during the policy period can also trigger an audit.
Benefit plan administrators, such as those for 401(k) plans, conduct audits to ensure compliance with the Employee Retirement Income Security Act (ERISA) and plan documents. A 401(k) plan audit is required when it has 100 or more participants with account balances at the plan year’s beginning. They verify contributions, eligibility, and overall plan operation.
Some businesses also conduct internal audits or hire third-party auditors for proactive compliance checks or due diligence. These internal reviews help identify and correct errors before they lead to external scrutiny, potential penalties, or employee dissatisfaction.
Key Areas of Examination
Auditors scrutinize specific information and documents during a payroll audit. Employee information includes hiring documents, employment contracts, and federal W-4 forms, which dictate income tax withholding. Form I-9, verifying employment eligibility, is also reviewed.
Payroll records are examined in detail, covering timecards or timesheets to confirm hours worked, and payroll registers showing gross wages, net pay, and various deductions. This includes pre-tax deductions for benefits like health insurance premiums and post-tax deductions such as wage garnishments. Pay frequency and the calculation of overtime, bonuses, and commissions are also verified.
Tax filings are a primary focus, with auditors reviewing federal and state payroll tax returns like IRS Form 941 and Form 940. Annual wage and tax statements, such as Forms W-2 and 1099, are also checked for consistency with reported payroll.
Benefit documentation is also reviewed, including health insurance enrollment forms, records of 401(k) contributions, and documentation related to paid time off (PTO) accrual and usage. This ensures deductions and contributions align with employee elections and plan rules. Compliance documentation, such as records supporting minimum wage adherence, overtime calculations, and independent contractor classifications, is critical.
Steps in a Payroll Audit
A payroll audit typically commences with employer notification, often a letter or phone call from the auditing entity. This initial contact usually includes a request for specific documents and data, defining the audit’s scope and timeframe.
Following the information request, the employer submits the necessary documentation via mail, secure online portals, or in-person delivery. Providing accurate, readily available records helps facilitate a smoother process.
The auditor then reviews and analyzes the submitted records. This involves cross-referencing data, checking calculations, and identifying inconsistencies or non-compliance. In some instances, auditors may conduct interviews with payroll staff or management to clarify information.
Upon completion of their examination, the auditor communicates findings to the employer. This discussion highlights discrepancies, errors, or non-compliance discovered. The resolution phase involves addressing these findings, which may include making adjustments to payroll records, remitting additional taxes or penalties, or agreeing on a corrective action plan. Employers may also appeal findings if they disagree with the auditor’s conclusions.