A payroll audit reviews a business’s payroll records to ensure compliance with California labor laws and tax regulations. Agencies such as the IRS, California Employment Development Department (EDD), and the U.S. Department of Labor (DOL) conduct audits to verify wage payments, tax withholdings, and worker classification. Errors in payroll taxes, employee classification, and wage compliance can lead to fines, back payments, and legal action.

Proper preparation reduces risks and streamlines the process. This guide explains how California businesses can organize payroll records, correct errors, and respond to auditors effectively.

What Is a Payroll Audit?

A payroll audit examines employee wages, tax withholdings, overtime pay, and benefit deductions to ensure they align with state and federal laws. Audits may be scheduled randomly but often occur due to payroll discrepancies, late tax payments, or employee complaints.

In California, the EDD audits payroll tax compliance, worker classification, and unemployment insurance contributions. The IRS checks federal tax withholdings, while the DOL enforces wage and hour laws under the Fair Labor Standards Act (FLSA).

Common reasons for audits include misclassifying workers as independent contractors, failing to pay overtime correctly, missing payroll tax filings, or delaying tax payments. A company flagged for one issue may face a broader review of its payroll processes.

Steps to Prepare for a Payroll Audit

Gather Payroll Records

Auditors typically request payroll records covering the past three to four years. Businesses should compile payroll reports, W-2 and 1099 forms, IRS tax filings (Forms 941 and 940), California state payroll tax filings (DE 9, DE 9C, DE 88), employee timesheets, and tax payment confirmations. Keeping these records organized allows for a faster and smoother audit process.

Verify Employee Classification

Misclassifying employees as independent contractors is a leading cause of payroll audits in California. Under California’s AB5 law, a worker is an employee unless they meet the ABC test:

  1. A) They are free from company control.
  2. B) They perform work outside the business’s main service.
  3. C) They have an independent business doing similar work.

Failing the ABC test means the worker is an employee. If a business has misclassified workers, it may owe unpaid payroll taxes, back wages, and penalties.

Check Payroll Tax Compliance

California businesses must comply with both state and federal payroll tax requirements. Employers must file DE 9 and DE 9C with the EDD to report state income tax and unemployment insurance contributions. Federal payroll taxes must be reported through Forms 941 and 940.

Tax filing errors or late payments can lead to penalties. Businesses should review their payroll tax submissions to ensure they match employee earnings and tax withholdings. If discrepancies exist, correcting them before the audit can reduce the risk of fines.

Review Overtime and Wage Payments

California has some of the nation’s strictest wage and hour laws. Employees must receive 1.5 times their hourly rate for work exceeding eight hours in a day or 40 hours in a week. Double-time pay applies after 12 hours in a day. Employers must also provide meal breaks for shifts over five hours and paid rest breaks every four hours.

Underpaying employees or failing to provide breaks can lead to claims with the California Labor Commissioner. Reviewing payroll records ensures employees are compensated correctly for all hours worked. The 2025 California minimum wage is $16.50 per hour statewide, but some cities require higher wages. Any errors should be addressed before an audit to avoid back payments and penalties.

Audit Benefits and Deductions

Payroll audits also examine benefit deductions. Errors in health insurance, retirement contributions, and wage garnishments can lead to compliance issues. Employers should verify that health plan contributions, 401(k) deductions, and wage garnishments match employee elections and legal requirements.

Mistakes in benefit deductions can result in additional payments owed to employees or tax agencies. A careful review ensures accuracy and reduces the risk of penalties.

Conduct an Internal Payroll Audit

Before an auditor arrives, perform an internal audit review using this checklist:

  1. Are all employee classifications correct?
  2. Do tax forms match reported earnings?
  3. Were all employees paid according to California wage laws?
  4. Are payroll deductions accurate?
  5. Are records complete and properly stored?

If mistakes are found, correct them and keep documentation showing the adjustments.

What to Expect During a Payroll Audit

  • Once an audit begins, the auditor will:
  • Request payroll records for a specific period.
  • Review wage payments, tax filings, and benefits deductions.
  • Check employee classification compliance (W-2 vs. 1099).
  • Interview HR or payroll staff to clarify records.

The business may need to pay back taxes, penalties, or wages if issues are found. Keeping organized records speeds up the process and minimizes risk.

Penalties for Payroll Non-Compliance in California

Failing a payroll audit can result in serious financial penalties. The EDD imposes fines for late payroll tax payments, while the IRS may issue penalties for incorrect tax filings. Businesses that violate California wage and hour laws may face claims from employees, leading to legal action or settlements.

Regular payroll audits and compliance checks help businesses avoid fines and meet all payroll obligations.

How Smith Marion & Co. Can Help

Payroll audits can be complex, especially with California’s strict labor laws and tax regulations. Smith Marion & Co. provides expert payroll tax and accounting services to help businesses prepare for audits, correct classification errors, and ensure compliance.