What is a payroll audit? How to do one

No matter your size, payroll audits are worth the effort. Catching an error early can save you thousands in fines or missed payments—costs that small businesses often can't absorb as easily. A simple audit could be the difference between a smooth payroll run and a cash flow crisis. 

But what happens if you don’t catch the mistake—and the IRS does?

What is an IRS payroll audit?

An IRS payroll audit is when the government steps in to check whether you're properly withholding and paying payroll taxes. They’ll look at employee classifications, tax filings, and payment records. If something’s off, they’ll let you know, and they may not be gentle about it.

What happens if you fail an IRS payroll audit?

If your business fails an IRS payroll audit, the consequences can add up fast. You might owe back taxes and face stiff penalties or interest. In more serious cases, it could trigger legal battles or investigations. 

Beyond the financial hit, it can also hurt your business’s reputation with customers and employees. That’s why it’s smart to catch and fix issues before the IRS does.

How to conduct a payroll audit

Running an audit might sound complex, but it’s simply about making sure everything adds up. Your employee records, tax forms, and bank statements should all tell the same story. 

We’ve broken the process into four clear steps to help you audit your payroll with confidence.

Step 1: Review employee payroll data

The first step in a payroll audit is to review employee payroll data. This helps you catch inconsistencies, prevent fraud, and make sure you pay everyone accurately and legally. Focus on the following areas:

Worker’s employment status:

• Make sure you have a completed Form W-4 for each employee and Form W-9 for any independent contractors.
• Confirm that each person on payroll is an active, legitimate worker with the correct Social Security number or Employer Identification Number (EIN).

Pay rate and job details:

• Check hourly or salaried pay rates, including any overtime or bonuses.
• Verify job titles and classification—mistakes here can lead to tax or labor law issues.
• Cross-reference time cards or schedules with actual hours paid.

Calculate periodic pay:

• For salaried workers, divide the annual salary by the number of pay periods.
• For hourly workers, multiply hours worked by their pay rate. Don’t forget to include any approved overtime or PTO.

Step 2: Check tax forms and deposits

Now it’s time to make sure your tax forms and deposits are accurate and filed on time. This step helps you stay on the IRS’s good side and avoid costly penalties.

Forms to check:

• Form 941: Confirms that federal income taxes, Social Security, and Medicare were withheld and reported correctly.
• W-2: For employees, make sure all info is correct and matches your records.
• 1099: For contractors, verify that payment totals and contractor Tax Identification Numbers (TINs) are accurate and reported properly.

Review tax withholdings:

• Match each worker’s withholdings to their most recent W-4.
• Double-check the gross wages and how you calculated withholdings.

Confirm tax deposits and deadlines:

• Make sure you paid the IRS and state agencies on time and for the correct amounts.
• Review each deposit to confirm it lines up with what you withheld from the employee’s wages.

Step 3: Examine banking activity

Bank records are a great way to make sure your payroll system is doing its job—paying people the right amount at the right time.

Match payroll with bank statements:

• Cross-check every payroll disbursement with your accounting software and bank statements.
• Look for payments made to the wrong person, in the wrong amount, or on the wrong date.

Double-check contractor payments:

• Even if you use a payroll provider, you’re still responsible. Confirm the right people received payment, especially if you issued 1099s.

Step 4: Reconcile with accounting records

Finally, you’ll want to properly record all your payroll in your accounting software. Your books, payroll system, and bank account should all match up.

Reconcile payroll with the books:

• Make sure payroll costs—like wages, taxes, and benefits—are recorded in the right general ledger accounts.
• Match recorded payments against your payroll reports and bank statements.

Investigate discrepancies:

• If something’s off, like a missing transaction or a mismatched total, dig into it.
• Common culprits include manual adjustments, rounding errors, or fees not recorded in payroll software.

What’s an example of a payroll audit report?

A payroll audit report summarizes your findings—what you checked, what matched, and what needs fixing. It typically includes employee data, payment records, as well as tax forms that the auditor reviewed and any discrepancies they noted. 

Keeping a clear report not only helps with internal transparency, but it’s also a lifesaver if you’re ever audited by the IRS. Plus, it gives you a roadmap to tighten up your payroll process going forward.

When and how often to conduct a payroll audit

How often you should conduct a payroll audit depends on how your business runs. If you have a small team and straightforward payroll, an annual audit is usually enough to stay on track. 

But if you’re growing fast, hiring often, or have more complex pay structures—like bonuses, commissions, or a mix of contractors and employees—you’ll want to run quarterly or biannual audits instead.

You should also schedule an audit any time there’s a big change, like switching payroll providers, updating your accounting software, or if you suspect fraud or payroll errors. 

To stay consistent, set a recurring calendar reminder or use your payroll software’s automation tools (if available) to prompt regular reviews. A simple habit here can save you from costly headaches later.

How long does a payroll audit take?

The length of a payroll audit depends on your business size and how complex your payroll is. For small businesses with just a few employees, it might only take a couple of days to review everything. 

If your business has more detailed employee compensation structures, audits can take a week or more. Either way, building payroll audits into your schedule makes the process easier and less time-consuming each time you do it.

Benefits of doing a payroll audit

Think of a payroll audit like a health check for your business. It’s not just about catching mistakes—audits help make you feel confident that you’re running your business well.

Whether you have five employees or 50, regular payroll audits give you a clearer picture of where your money’s going, help you stay compliant, and make sure no one slips through the cracks. Here’s how a well-run audit pays off.

Ensures payroll compliance

Staying current with federal, state, and industry-specific employment laws isn’t optional. A payroll audit helps you verify that you’re classifying workers correctly, withholding the right taxes, and following wage laws. It also reduces your risk of legal issues, like penalties or labor disputes.

Prevents and detects payroll fraud

Payroll fraud can fly under the radar without regular checks. Audits help you spot red flags like ghost employees, falsified time cards, or unauthorized pay rate changes. Catching these early saves you money and protects your company’s integrity.

Improves financial accuracy and reporting

Payroll is often one of your biggest expenses, so it’s important to get it right. Audits help ensure you're not overpaying or underpaying employees and that your payroll costs match your accounting records. Cleaner data leads to better reporting and smarter business decisions.

Boosts employee trust and satisfaction

When your team knows they’re being paid accurately and on time, it builds trust. Regular audits reduce payroll mistakes and tax-time headaches, which means fewer complaints and a smoother employee experience. A reliable payroll process shows your team that you’ve got their back.

What to include in a payroll audit report

A payroll audit report is your official record of what the auditor reviewed, what they found, and what actions you need to take. It’s a valuable tool for accountability, whether you're sharing it with your bookkeeper, an internal team, or just keeping it on file for future reference.

Start with a brief executive summary that outlines the audit’s scope, who conducted it, and when. Then move into the details, including any discrepancies the auditor discovered, such as misclassified employees, incorrect withholdings, or late tax filings. Be sure to include a payroll compliance check that covers labor laws, IRS deadlines, and state regulations. This part shows whether you're in good standing or where you might be falling short.

Your report should also include the following:

• List of errors or inconsistencies, with dates and employee details if applicable
• Payroll tax and filing review, including any missed or late payments
• Recommendations for improvement, like updating employee records, adjusting payroll schedules, or setting up internal controls
• Corrective actions taken (if any), or a plan to fix issues going forward
• Sign-off from responsible parties, whether it’s an internal payroll manager or an external auditor

A clear and well-organized report makes it easy to track improvements over time and gives you a solid foundation for smoother audits in the future.

Payroll audit best practices

A good payroll audit is about building smarter systems that prevent mistakes. Following a few key best practices can make your audits faster, more accurate, and more useful for your business in the long run.

Here’s how to strengthen your audit process and protect your payroll from costly errors.

Separate roles for HR and accounting

Dividing responsibilities between HR and payroll accounting helps prevent internal fraud. When one person has too much access, mistakes—or intentional tampering—can slip through the cracks. Segregating duties adds a layer of accountability and transparency.

Use consistent reporting formats

Standardizing your audit reports makes life easier. It allows you to track progress over time, compare audits year to year, and spot trends faster. A clear, repeatable format also keeps your team on the same page.

Document procedures in a manual

Create a step-by-step guide on how to do payroll audits for your business. Include what to review, who’s responsible, and how to handle discrepancies. This keeps the process consistent, even if team members change.

Consider an external audit periodically

Bringing in a hired accountant or third-party auditor every few years offers a fresh perspective. They can catch things you might miss and ensure your process holds up under outside scrutiny. It’s a smart way to boost confidence in your payroll system.

Common payroll audit mistakes

Even with the right tools, payroll audits can go off track if you're not careful. Avoid these common missteps that can lead to compliance issues, costly corrections, or unhappy employees.

Watch out for these mistakes:

• Missing or outdated tax forms for employees or contractors
• Misclassifying workers as employees or independent contractors
• Overlooking overtime, PTO, or bonus discrepancies
• Failing to match payroll records with bank or accounting data

These issues are easy to miss but hard to fix later. Catching them early keeps your payroll accurate and protects your business from penalties.

Tools and software that simplify payroll audits

The right tools can take a lot of stress out of payroll audits. Payroll software with built-in reports and compliance checks makes it easy to track wages, taxes, and deadlines in one place. Many platforms also alert you to errors before they become bigger issues.

Look for payroll tools that integrate with your accounting software and HR systems so data flows automatically between platforms. This reduces manual entry and the risk of mistakes.

Automation is a game-changer, especially for reconciliation. Instead of matching records by hand, software can instantly compare payroll totals with your accounting books and bank statements. Tools like QuickBooks Payroll simplify the process and help you stay audit-ready year-round.

Next steps for streamlining your payroll process

Payroll audits aren’t just a best practice; they’re a smart way to protect your business. Regular reviews help you stay compliant, fix issues early, and ensure your team is paid fairly and on time. And when you automate the process, it’s even easier to stay audit-ready year-round.

The right payroll software can do more than just run payroll—it can flag issues, sync with accounting tools, and provide detailed reports with just a few clicks. Explore our payroll resources for more tips, or try QuickBooks Payroll to simplify your payroll audits from the start.