7 Payroll Red Flags That Can Lead to an IRS Audit

Payroll accuracy isn’t just about making sure your team gets paid on time—it’s also key to keeping your business in line with IRS rules. In this blog, we’ll break down the top payroll mistakes that can trigger an IRS audit, how to prepare if one happens, and how partnering with a compliance-focused PEO like TBM can make your life a whole lot easier.  

Don’t risk expensive mistakes—learn how to stay compliant and protect your business. 

Understanding the IRS Audit Surge  

Thanks to an increase in IRS funding under the Inflation Reduction Act, enforcement is undergoing a major overhaul. Audits, specifically, are expected to rise, and the focus has shifted to areas where noncompliance risks are highest.  

While this does mean that large corporations and wealthy individuals will be the primary targets, it doesn’t mean that small and medium-sized businesses are off the hook. Staying on top of payroll compliance is critical for business owners to avoid being flagged. 

7 Payroll Red Flags That Could Trigger IRS Audits

Misclassification of Employees 

One big mistake businesses often make is misclassifying employees as independent contractors to save on payroll taxes. While it might seem like a smart way to cut costs, it can actually lead to serious financial and legal trouble if not done correctly.  

The IRS pays close attention to the relationship between the worker and the employer. They evaluate how much control the employer has over the worker's tasks, schedule, and methods for getting the job done. If you’re setting hours, providing tools, or requiring specific training, chances are the worker should be classified as an employee, not a contractor. Misclassifying can lead to hefty back taxes, fines, and legal action. 

High Volume of Cash Transactions 

Cash-heavy businesses like restaurants, salons, and retail stores often find themselves under the IRS microscope because they rely on cash transactions. These industries are more likely to have unreported income, making them a common target for audits. This can be a headache for business owners who might not have the right systems in place. 

If cash transactions aren’t documented well, it can raise IRS red flags about unreported income. For instance, if your reported income doesn’t match up with your actual cash sales, it can look suspicious—like tax evasion or errors in reporting. This is especially true when financial statements don’t line up or vital records are missing. 

Inaccurate Payroll Reporting 

Incorrectly reporting wages, tips, or withholdings is a quick way to catch the IRS’s attention, which could lead to audits or penalties. This usually happens when payroll filings don’t match up with tax deposits, raising red flags.  

The IRS closely monitors mismatches between payroll filings (Form 941) and the tax deposits you’ve made. Even minor errors can draw attention, suggesting possible mistakes or issues with your payroll process. 

Excessive Deduction Claims 

Claiming significant deductions for fringe benefits or employee expenses can catch the IRS’s attention and lead to unwanted scrutiny. These deductions, especially if they’re unusually high or don’t match what’s typical for your industry, tend to stand out during reviews.  

The IRS closely monitors deductions that seem "off" or don’t fit with your business operations. If your claims look inflated or out of line with industry norms, it could trigger an investigation, audits, or even penalties. 

Non-compliance with Employee Benefits Regulations 

Improperly managing employee benefits, like not depositing withheld funds into 401(k) plans on time, can cause significant trouble for businesses. It can lead to penalties, damage employee trust, and even attract unwanted attention from regulators—not to mention the hit your company's reputation might take.  

Payroll providers that miss federal deadlines for benefit contributions put businesses at serious risk. Late deposits or mistakes in handling benefits can lead to costly fines and strain relationships with employees. 

Frequent Changes in Payroll Providers 

Switching payroll providers repeatedly can raise concerns about the stability and transparency of your payroll practices. Frequent changes disrupt your operations and raise red flags with regulatory bodies, such as the IRS, which closely monitor payroll consistency.  

Frequent changes could signal sloppy record-keeping, disorganized payroll processes, or even attempts to obscure errors and non-compliance. Such patterns may invite additional scrutiny, audits, or penalties.

Unreported Foreign Bank Accounts 

If your payroll involves international transactions or paying foreign contractors, keeping up with your reporting requirements is crucial. Failing to disclose foreign bank accounts can lead to hefty penalties and unnecessary legal headaches.  

Under the Foreign Account Tax Compliance Act (FATCA), U.S. taxpayers must report any foreign financial accounts that exceed $10,000 at any point during the year. This includes accounts used for payroll, contractor payments, or business operations overseas. Ignoring this can result in major fines and increased IRS scrutiny.  

Why TBM is Your Best Compliance Ally  

Navigating payroll compliance on your own can be difficult, especially in states where regulations are complex and constantly evolving. That’s where TBM comes in to simplify the process and let you focus on what matters—growing your business.  

What TBM Offers  

• Expert PEO Services: We specialize in payroll and HR solutions tailored to meet New York's unique and stringent compliance standards. Whether you’re a small or growing business, we help ensure you stay on top of the latest regulations.  

• Custom Guidance: You’ll receive personalized, one-on-one advice from your dedicated account manager, who works closely with you to ensure no detail is overlooked. From payroll processing to filing deadlines, we’ve got you covered.  

• Proactive Risk Management: Our team conducts regular compliance checks, staying ahead of potential pitfalls and reducing the risk of errors, penalties, or surprise audits. We take a proactive approach so you can rest easy.  

• Seamless Integration: We provide end-to-end solutions, from handling payroll and tax filings to managing employee benefits and onboarding. Our seamless integration ensures your business operations run smoothly, freeing your time to focus on strategy and growth.  

With TBM, you gain a reliable partner who understands the complexities of compliance and is committed to simplifying the process for you. Contact us to learn how we can help you drive your business forward confidently.