IRS Payroll Tax Audit:
What to Expect and How to Respond

The IRS can audit any return you file with the agency, including payroll returns. Your payroll returns may be selected randomly or due to Federal Tax Deposit (FTD) alerts related to late or inconsistent payments. In either case, you must be ready to back up the details on your return, and you may need to appeal if the auditor doesn’t agree. 

Receiving an IRS payroll tax audit notice can be a stressful and overwhelming experience for any employer. To get through the process as painlessly as possible, consider hiring a tax attorney for payroll audit representation. To get help now, contact us at Damien’s Law today.

Key takeaways

• IRS payroll tax audits – require you to back up the information reported on your payroll tax returns.
• What to expect – you must provide the auditor with time cards, pay rates, bank records, and other details related to your payroll returns.
• Audit process – the audit may be through the mail or in person at your business or an IRS office.
• Additional audit considerations – the auditor may also check that you have correctly classified your employees.
• Audit results – the auditor may accept your returns as filed, or make changes leading to tax assessments and penalties.

What Is a Payroll Tax Audit?

A payroll tax audit is when the IRS audits your payroll tax returns. For most employers, this means an audit of their 941 (Employer’s Quarterly Federal Tax Return) forms and a look at their federal tax deposits. However, the IRS may also audit:

• Form 944 (Employer’s Annual Federal Tax Return)
• Form 940 (Annual Federal Unemployment Tax Act (FUTA) Tax)
• Form 943 (Employer’s Annual Federal Tax Return for Agricultural Employees)
• Schedule H (Form 1040) if you paid payroll tax on household employees

Additionally, the auditor may compare the wages and taxes reported on your payroll tax returns to the wage deductions noted on your business income tax return.

Why Were You Selected for Audit? Payroll Tax Audit Triggers

The IRS selects some returns randomly for audits, but your payroll returns may also be selected due to:

• Late 941/940 filings
• Late payroll tax deposits
• Discrepancies between reported wages and tax deposits
• FTD alerts after multiple missed deposits or inconsistent deposits
• Claiming the employee retention credit (on payroll returns from 2020 or 2021)

Note that there are audits that look at specific credits – the most common example right now is the ERC audit. The IRS audits returns with these credits at relatively high rates.

What to Do If You Receive a Payroll Audit Notice

The IRS will typically send an audit notice indicating the type of audit, the scope of the audit, and the documentation required to support your payroll tax filings. Review the notice and make sure you understand what is being requested so that you can provide the right information and documents. Then, start gathering your documents or reach out to a tax attorney with audit experience for representation. 

A professional tax advisor or lawyer can provide guidance on the types of records and documentation required by the IRS, help prepare and organize the necessary records, and ensure that all responses to the audit are accurate and timely.

What to Expect During the Audit

During an audit, the auditor’s role is to examine the payroll tax records and financial statements of a business to perform a compliance check. The auditor’s primary responsibility is to ensure that the business has accurately reported all wages, tips, and other compensation paid to its employees, as well as the correct amount of taxes withheld and paid to the government.

The auditor will also examine other payroll-related expenses, such as benefits, bonuses, and reimbursement payments, to ensure that they are properly reported and recorded. This process may vary depending on the type of audit:

• Correspondence audit – conducted through the mail.
• Office audit – conducted at an IRS office; involves a face-to-face meeting with the auditor in their office.
• Field audit – the most comprehensive type of audit; involves an on-site visit to your place of business. 

The type of audit determines the extent of the audit and the amount of preparation required. Initially, the auditor will give you a list of the documents they want to see, but they may ask for additional documents during the audit process.

It is important for businesses to cooperate with the auditor and provide all requested information in a timely and accurate manner to ensure the smooth and efficient resolution of the audit. While the auditor is not necessarily against you, they are not on your team—all the more reason you should seek professional help.

How to Prepare for a Payroll Tax Audit

As soon as you receive the audit notice, get ready by following these steps.

• Review the notice – Look over the notice carefully to see which documents the auditor wants to see and make special note of the deadline.
• Gather the documents – Get the listed documents ready. If you don’t have everything, consult with a tax professional about recreating documents.
• Consult with representation – A tax attorney can help you prepare for the audit, ensuring that you are compliant with the IRS, but not sharing anything unnecessary.

Which Documents Do Auditors Need During Payroll Tax Audits?

The IRS will request specific financial and payroll records that are relevant to the audit. That may include:

• Payroll records
• Tax returns
• Bank account statements
• Pay stubs
• Payroll reports
• Any other financial records that pertain to the audit

What to Expect at the Conclusion of the Payroll Tax Audit

There are essentially three ways for an audit to conclude:

• No change – the auditor has not made changes to your payroll tax return.
• Change and you agree – the auditor has made changes to your return and you agree with the changes.
• Change and you disagree – the auditor has made changes to your return and you disagree with the changes.

If there are no changes, the audit is over, and you can move on with your life. If you agree with the changes, the IRS will assess the tax liability. Make payment arrangements or talk with a tax attorney about how to deal with delinquent payroll taxes. If you disagree with the changes, you can appeal, but you must do so by the deadline on the audit conclusion letter.

Why Audits Lead to Changes on Payroll Tax Returns

Auditors often make changes to payroll tax returns because they unearth the following types of issues:

• Inaccurate or missing employee information
• Improper classification of employees as independent contractors
• Incorrect calculation of taxes
• Failure to report all employee wages or tips
• Failure to deposit or remit payroll taxes to the government
• Improper reporting of taxable benefits
• Failure to file payroll tax returns promptly
• Mismatched employer and employee Social Security numbers
• Unreported fringe benefits
• Improperly paying employees in cash

All of these concerns can lead to an additional payroll tax liability, and you may also incur penalties on top of the tax due.

Penalties for Failing Payroll Tax Audits

If you fail a payroll tax audit, you may see the following types of penalties added to your account:

• Failure to pay penalties – Ranging from 0.5 to 1% of the tax due per month, this penalty can be backdated to the original due date.
• Failure to file penalties – If you didn’t file a return, these penalties are 5% of the tax due, up to 25% of the tax liability.
• Failure to deposit – If you deposited payroll taxes late, you can face penalties ranging from 2 to 15% of the deposit amount. 
• Accuracy-related penalties – These penalties are applied in cases where an audited return shows significant errors, and they’re generally 20% of the unreported tax.
• Civil fraud penalties – In cases of civil fraud, the penalties are 75% of the unpaid tax.

Additionally, if the payroll taxes continue to go unpaid, the IRS may assess a Trust Fund Recovery Penalty (TFRP). The TRFP is 100% of the unpaid taxes that were withheld from an employee’s pay, and it’s assessed on individuals (owners, shareholders, employees, or anyone else responsible for depositing payroll taxes).

Understanding Your Rights and Options for Appeal

If you disagree with the audit findings, you have the right to appeal the decision. This process starts with filing a protest within the timeframe specified by the IRS. The protest should include a detailed explanation of the disagreements and any supporting documentation.

Alternatively, you can participate in the appeals conference with a representative of the IRS Office of Appeals. During the appeals conference, both parties will have an opportunity to present their case and come to a resolution. In case of a final decision, you can file a lawsuit in the U.S. Tax Court or seek relief in a federal district court.

Moving Forward: How to Avoid Future Tax Audits

Once an IRS payroll tax audit is completed, it is important to take steps to ensure that future IRS tax audits are avoided.

This may include a review of internal processes and procedures to identify and correct any issues that may have led to the original audit. It may also be necessary to implement new systems or controls to prevent similar issues from arising in the future.

If I’m Being Audited, Am I in Legal Trouble?

Being audited by the IRS does not necessarily mean that you are in legal trouble. However, if the audit uncovers evidence of intentional tax evasion or fraud, legal consequences may ensue. It is important to understand the difference between a routine audit and a criminal investigation. If you are unsure about the nature of your audit, it is recommended to seek the advice of a tax attorney who can help guide you through the process and protect your rights.

How Far Back Can a Payroll Tax Audit Go?

The IRS generally has three years to audit most tax returns – that’s because there’s a three-year limit on assessing new taxes. But the timeline is slightly longer for payroll tax returns. Quarterly payroll returns are due April 15th, July 15th, October 15th, and January 15th for wages paid the previous quarters. The statute of limitations for these returns starts on the following April 15th and runs for three years. 

For example, payroll tax returns for the four quarters of 2025 are due April 15th, 2025, July 15th, 2025, October 15th, 2025, and January 15th, 2026. The statute of limitations time clock starts running on April 15th, 2026, and the IRS can audit these returns until April 15th, 2029. But if you don’t file the returns, the timer never starts, and the IRS can go back any amount of time. 

Get Help With IRS Audits and Tax Filing

An IRS payroll tax audit is a complex process that can be stressful and time-consuming for business owners. However, understanding the steps involved in the process and seeking professional help can greatly reduce the burden.

If you are facing an IRS payroll tax audit in Mississippi, Tennessee or surrounding states, call Damiens Law Firm, PLLC at (601) 202-4745 and talk to an experienced tax professional to help with your tax matters. A knowledgeable and experienced tax attorney can help ensure that you are well-prepared and confident throughout the audit process and help you prepare employment tax returns for the next tax year.