Payroll Compliance Auditing By Beth L. Ashcroft, CIA First published in TransMISsion Online, Internal Audit Edition, Volume 4, Issue 3. Reprinted with permission from the MIS Training Institute. The Department of Labor's Wage and Hour Division recovered more than $212 million in back wages from employers in fiscal year 2003. This represents a 21% increase over fiscal year 2002, when the DOL's recovery of back wages hit a ten-year high. In addition to back wages, civil money penalties assessed against employers in FY 2003 hit almost $10 million. Eighty-seven percent of the agency's enforcement work involves the Fair Labor Standards Act. This most basic of all payroll and employment laws is also known as the Federal Wage-Hour Law and governs minimum wages, overtime pay, child labor and equal pay for equal work. According to Rick Speier, acting deputy chief of the Internal Revenue Service's Criminal Investigation Division, the IRS is increasing enforcement of employment taxes in 2004. Speaking at a recent American Bar Association Tax Fraud Conference, Speier said that for years the IRS was not terribly active in employment tax enforcement but "at this point, we are probably at a high water mark in terms of our attentiveness to employment tax cases." The government is trying to find all tax loss, and violations of the employment tax regulations in the Internal Revenue Code provide fertile ground for investigation. Staying Out of Trouble with the Law Given the increasing enforcement activity, regulatory compliance in the payroll function is a risk area that all internal audit departments should have on their radar screen. However, because the payroll function is governed by numerous and complex laws and regulations at both federal and state levels, traditional annual financial cycle reviews do not even come close to covering the major risks in this fundamental and vital area. Noncompliance with requirements, however, can have far-reaching implications under the Federal Sentencing Guidelines and Sarbanes-Oxley Act as well as significant financial consequences from penalties, back-pay awards and additional tax assessments. Conversely, extreme efforts to comply may result in reduced productivity or costly processes that cause administrative headaches. Even organizations that intend to be in compliance are at risk because of the sheer complexity of some of the requirements, changing regulations, and "gray areas" in the laws and regulations that are subject to interpretation. Ignorance of the law, however, is never an excuse. Here are just some of the critical areas that internal audit should consider reviewing for compliance: Exempt vs. Non-Exempt - This distinction refers to an employee's status under the Fair Labor Standards Act. Exempt employees do not have to be paid the required minimum wage or overtime payments and employers do not have to keep certain records detailing their work. One such exemption is the "white collar exemption" for executive, administrative, and professional employees. Tests for determining exempt status measure the actual duties and responsibilities of the employee, not the job title. In addition, policies and practices that result in paying exempt employees on an hourly basis or that dock the pay of an exempt employee can put an employee's exempt status in jeopardy - thus making the employee eligible for overtime pay. While the "white collar" exemption is the best known, there are also narrower exemptions that apply to retail and service establishment employees, hotel and restaurant employees and others. Compensable Time and Overtime Pay - The general rule under the Fair Labor Standards Act is that all covered employees must be paid at least 1 ½ times their "regular rate of pay" for all hours physically worked over 40 in a workweek. For tipped employees, the employer cannot take an increased tip credit for overtime hours worked. Calculating the overtime pay rate, however, is not 1 Source: www.misti.com Reprinted with permission.
as simple as taking 1.5 times the number of hours over 40. According to the FLSA, several determinations enter into picture. First, what is the established workweek for the employee? Second, what constitutes the hours physically worked? The time employees take to don and doff required clothing, for example, can be considered time they should be paid for. Lastly, what payments made to the employee are considered wages for the purposes of determining overtime, thus affecting the "regular rate of pay"? In addition to hourly or contract wages, the following payments must be considered when calculating an employee's "regular rate of pay" for any given week: shift differentials, nondiscretionary bonuses, payments in a form other than cash, retroactive pay, on-call pay, and supplemental disability payments. Employee vs. Independent Contractor - Under the Internal Revenue Code, an employer must withhold income, social security and Medicare taxes from an employee's wages. It must also match any withheld social security and Medicare taxes with employer funds. Employers are also required to pay federal and state unemployment insurance taxes on employees' wages and most companies have certain benefits that they provide to employees as well. None of this is required for independent contractors and, thus, many businesses find it less expensive to hire independent contractors rather than put more employees on the payroll. However, companies should be careful to assure that independent contractors actually meet the tests for that status as set out in the Internal Revenue Code and other laws and regulations. The IRC, for example, has a "common law test" which basically focuses on the employer's right to control what work will be performed and how that work will be done. Evidence of the degree of control and independence are grouped into three general categories: behavioral control; financial control; and the type of relationship between the parties. The IRC also has a "reasonable basis test." In addition, there are situations in which the IRC mandates the employment status regardless of whether or not the "common law test" or "reasonable basis test" are met. Taxable vs. Non-Taxable Compensation - In general, the Internal Revenue Code provides that all compensation an employee receives, no matter what form it takes, constitutes wages that are subject to federal income and employment taxes. The compensation is excluded from wages and exempt from taxation only where the IRC provides a specific exclusion. What this means is that wages and benefits, whether they are called fringe benefits or "perks" or something else, are considered taxable compensation unless the IRC says otherwise. In reviewing this area, some of the items internal auditors should be concerned about include personal use of employer-provided vehicles and aircraft; discounts on property or services; health and welfare benefits; educational assistance; employee business travel expense reimbursements; employer-provided meals and lodging; awards and prizes; back pay awards; advances and overpayments; bonuses; commissions; dependent care assistance programs; employer-paid taxes (grossing-up); uniform and equipment allowances; gifts; stock and stock options; tips; and wages paid after the death of an employee. The exclusions that do exist in the IRC often require a certain amount of documentation to show that the payment or benefit to the employee did meet the exclusion criteria. Therefore, internal auditors also need to be concerned with whether there is enough supporting documentation for excluded items to prevail in an IRS review. Withholding and Depositing Taxes - Federal regulations prescribe not only the tax rates that must be used when withholding taxes from employees' pay, but also the timing of when the taxes must be withheld and when they must be deposited with the government. Penalties for improper withholding or underpayment of taxes can be substantial, especially if the IRS can show that any portion of an underpayment is due to the employer's negligence or disregard of IRS regulations. And it's even worse yet, if the IRS can show that any portion of the tax is not paid because of fraud. Internal auditors should be checking the completeness, accuracy and timing of employment taxes withheld, deposited and reported to the federal government.
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About the Author: Beth L. Ashcroft, CIA is a Senior Instructor for MIS Training Institute. She developed and presents MIS' two-day seminar, Auditing Your Payroll Function for Regulatory Compliance, (http://www.misti.com/08/troa0804oap221inf.html). Ms. Ashcroft is the former Manager of Accounts Payable and Payroll and former Manager of Audit Services for Central Maine Power Company. She currently has her own business specializing in audit and management training and consulting.
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