What is a payroll audit?
A payroll audit is a comprehensive review of your company’s payroll processes, records, and systems to verify that employees are being paid correctly and all payroll-related taxes and filings are accurate. It checks for compliance with employment laws, verifies financial accuracy, and helps identify potential errors before they become costly.
Payroll audits can be conducted internally by an employer or externally by a third party, such as a CPA or a government agency like the IRS or state labor department. For small business owners, conducting regular internal payroll audits is one of the best ways to maintain compliance, avoid penalties, and protect your team’s trust.
How a payroll audit works
During a payroll audit, your payroll records are evaluated line by line to ensure accuracy and compliance. Key elements reviewed include:
- Employee classifications: Are your workers correctly classified as employees or independent contractors?
- Exempt vs. non-exempt status: Are employees eligible for overtime to be paid accordingly?
- Pay rates and hours worked: Do the pay rates match employment agreements, and are time records accurate?
- Payroll taxes: Are you withholding and remitting the correct amounts for federal, state, and local taxes?
- Benefit deductions: Are voluntary deductions (e.g., health insurance or retirement contributions) correct and authorized?
- Wage garnishments: Are court-ordered withholdings being processed correctly?
- Tax filings: Have all required filings (Forms 941, 940, W-2, etc.) been submitted on time?
A payroll audit typically compares payroll reports, timekeeping records, pay stubs, tax documents, and bank statements to ensure consistency across all sources.
Why payroll audits matter for employers
Payroll mistakes aren’t just clerical issues—they can lead to fines, lawsuits, or back pay owed to employees. Common consequences of payroll errors include:
- Failing to pay minimum wage or overtime
- Misclassifying workers to avoid taxes or benefits
- Late or inaccurate tax filings
- Incorrect benefit or garnishment deductions
- Missing or incomplete employee documentation
Conducting a payroll audit helps small business owners:
- Catch errors early: Fix issues before they impact employees or regulators
- Avoid penalties: Stay ahead of IRS, DOL, and state agency requirements
- Improve accuracy: Strengthen your payroll process and financial reporting
- Build trust: Employees expect accurate and timely compensation
- Prepare for growth: Clean payroll records lay the groundwork for smooth scaling
Internal vs. external payroll audits
An internal payroll audit is a self-conducted review, often done annually or quarterly by the business owner, HR manager, or payroll administrator. It’s proactive and meant to identify and correct issues before they escalate.
An external payroll audit is performed by a third party. It might be scheduled voluntarily (such as by a CPA) or required as part of a government investigation, insurance review, or legal dispute.
Even if your business isn’t being audited by an outside agency, performing regular internal audits shows due diligence and helps protect your company.
What triggers a payroll audit from the IRS or labor authorities?
External audits can be triggered by:
- Employee complaints about pay or working conditions
- Mismatched or missing tax filings
- Large changes in payroll size or classification
- Independent contractor vs. employee disputes
- Random compliance checks from the IRS, Department of Labor, or state agencies
If your records are clean and organized, an audit is easier to navigate and less disruptive to your business.
How to prepare for a payroll audit
Being prepared means having all payroll documentation organized and easily accessible. Here's what to focus on:
- Timekeeping records: Accurate logs of hours worked, breaks, and PTO
- Payroll summaries: Reports showing gross pay, withholdings, and net pay
- Employee documents: W-4s, I-9s, job titles, offer letters, classification forms
- Tax filings and payment receipts: Form 941, W-2s, W-3s, state filings
- Benefit enrollment and deduction authorizations
- Direct deposit authorizations and pay stubs
- Garnishment documentation, if applicable
Keeping these records in one place—preferably within your small business payroll software—can save hours if you’re ever audited.
Best practices for conducting a payroll audit
While payroll audits are inevitable sooner or later, there are ways you can make one as painless as possible. Follow these steps to ensure your audit is effective:
- Audit quarterly or annually: Catch small mistakes before they become big problems.
- Compare time tracking and payroll data: Make sure hours and pay match.
- Check tax calculations: Ensure federal, state, and local taxes are accurate and submitted on time.
- Verify employee classifications: Especially if job roles or duties have changed.
- Document all changes: Raises, promotions, and schedule changes should be clearly logged.
How Homebase helps with payroll audits
Homebase Payroll simplifies payroll audits by keeping everything in one place. Our platform automatically tracks hours worked, calculates wages, files taxes, and stores payroll reports—so when it’s time for an audit, you’re ready.
With Homebase, you can:
- Track employee hours and pay history in real time
- Generate payroll summaries and tax reports
- Store digital copies of pay stubs, W-2s, and tax filings
- Automate compliance with tax deadlines and deductions
Running payroll shouldn’t feel like a liability. With the right tools and regular audits, it becomes a predictable, compliant process that supports your team and protects your business.
Try Homebase today to automate payroll, simplify audits, and stay compliant from day one.