Legacy Law Blog

IRS employment tax audits are reviews conducted by the Internal Revenue Service (IRS) to verify that employers and self-employed individuals have correctly reported and paid all required employment taxes such as Social Security, Medicare, federal income tax withholding, and federal unemployment on behalf of their employees.

These audits can be intimidating, especially for those unfamiliar with IRS procedures, but understanding how they work and what triggers them can make the process less stressful and help businesses avoid serious problems down the line.​

What Is an IRS Employment Tax Audit?

An employment tax audit focuses on whether a business or self-employed individual has properly complied with their payroll tax responsibilities.

During this process, IRS examiners review payroll tax returns, including Form 941 (Employer’s Quarterly Federal Tax Return), Form 940 (Annual Federal Unemployment Tax Act Return), and any related filings to ensure accurate wage reporting, proper federal tax deposits and compliance with all employment tax laws.

The audit may also review how workers are classified—either as employees or independent contractors—because these classifications determine whether specific taxes are required.​

Who Can Be Audited?

Both individuals and businesses can be subject to employment tax audits. Small business owners, self-employed individuals, household employers (such as those who hire nannies or caregivers) and large corporations may face IRS scrutiny for their payroll tax practices.

Audits often occur in the context of a routine income tax examination where the agent notices discrepancies in wage reporting or payroll deposits and refers the taxpayer to a specialist for further review.​

What Triggers an IRS Employment Tax Audit?

Audits may be triggered by several factors, including:

• Late filing or late deposits of payroll tax returns (Form 940/941)​
• Discrepancies between reported wages and payroll tax deposits​
• Excessive or inconsistent payroll tax credits such as the Employee Retention Credit (ERC)​
• Worker misclassification issues (whether a worker is designated as an employee or contractor)​
• Random selection as part of routine IRS reviews​

What Happens During an Audit?

An audit typically begins with a notice from the IRS specifying the tax years and employment tax returns under investigation.

The IRS will request records, including payroll journals, wage payment summaries, W-2s, 1099s, time sheets and any other documentation supporting the payroll tax returns filed. The examiner may conduct interviews and examine how workers are classified, wage amounts, payroll procedures and whether all required taxes were properly deposited and reported.​

The process may be conducted:

• By mail, where documents are sent to the IRS for review​
• In person, at the business or accountant’s office, allowing for more detailed examination of books and records​
• By email where documents and correspondence are exchanged electronically

Common Issues Found in Employment Tax Audits

At the conclusion of the audit process, the auditor will provide the taxpayer with a copy of the results of the audit and any proposed adjustments. Some of the most frequent adjustments uncovered during an employment tax audit include:

• Failure to collect employee FICA (Social Security and Medicare) taxes​
• Not properly remitting withheld taxes to the IRS​
• Misclassification of employees as independent contractors, resulting in missing payroll tax payments and other compliance failures​
• Unreported or underreported taxable fringe benefits​
• Unreasonable compensation for corporate officers or owner-employees in S-corporations, leading to underpaid employment taxes on wages​
• Incorrect or fraudulent claims for employment tax credits (ERC, etc.)​

Penalties for Non-Compliance

Penalties for failing an IRS employment tax audit can be severe. They may include any of the following:

• Late deposit penalty (2-10% of taxes owed for missing required payroll tax deposits)​
• Failure-to-pay penalty (0.5% per month, up to 25% of unpaid tax)​
• Accuracy-related penalty (20% of any understated tax due to negligence)​
• 100% Trust Fund Recovery Penalty (TFRP)—responsible persons can be personally liable for taxes withheld from employees’ wages but not remitted to the government​
• Fraud-related penalties (up to 75% of understated tax if fraud is found)​
• Interest on any unpaid balance from the due date of the return, compounding the cost until payment is made​
• Criminal prosecution and even prison time in cases of willful tax evasion, repeated failures or deliberate fraud​

How to Prepare for and Respond to an Audit

If selected for an audit, careful preparation and cooperation are critical. Taxpayers should do the following when they are selected for an audit:

• Gather all payroll and employment tax records for the periods in question, including wage summaries, W-2s, 1099s, paystubs, time sheets, payroll tax returns and records showing federal tax deposits.​
• Be ready to explain worker classifications (employee vs. independent contractor) and the justification for any fringe benefit treatment.​
• Review officer compensation for reasonableness in S-corporations and ensure that wages match payroll reporting.​
• If claiming employment tax credits, have clear supporting documentation and justification for entitlement.​
• Cooperate with the IRS examiner by responding to requests and attending interviews as needed.​
• Seek the assistance of a knowledgeable tax professional, especially one with audit experience, or guidance and advocacy.​ This is especially important to do prior to providing any documents to the auditor to prevent exposure to unnecessary risk.

If the IRS proposes adjustments, taxpayers have a right to appeal within the IRS or, in some cases, challenge the findings in federal court.​

Steps to Prevent Future Employment Tax Audits

While there is no foolproof way to make your business immune from a payroll audit, there are meaningful steps that you can take to lower the risk of an employment tax audit in the future. These steps include the following:

• File all payroll tax returns on time and make timely federal tax deposits every quarter.​
• Accurately classify workers and follow IRS guidelines for employee vs. contractor status.​
• Properly report all taxable wages, fringe benefits and payroll expenses.​
• Review compensation for owners and officers to ensure it reflects a reasonable salary for services performed.​
• Double-check claims for employment tax credits, such as the ERC, and maintain all supporting documentation.​
• Consult with a payroll specialist or tax adviser to ensure compliance with all applicable laws and regulations.​

Final Thoughts

IRS employment tax audits can be complex and stressful, especially for those unfamiliar with the rules. By understanding what triggers these audits, what happens during the process and the serious consequences of non-compliance, businesses and individuals can better protect themselves. Staying organized, keeping accurate payroll records and complying with tax laws are the surest ways to avoid audit headaches and costly penalties down the road.