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How Small Businesses Can Fight Payroll Fraud Schemes

Thirty percent of fraud cases take place in small businesses with less than 100 employees.

Fraudulent activity can be difficult to detect. On average, instances of payroll fraud last approximately 36 months, wrecking complete havoc on the organization. The longer fraudulent activity continues, the more financial fallout it causes for the business.

What systems do you have in place to protect your company against payroll fraud? Arm your business against payroll fraud cases by understanding common scams and how to defend your business appropriately.

What is payroll fraud?

Payroll fraud is when someone steals money from a business through the payroll system. Perpetrators of payroll fraud can be employees, managers, or business owners.

Fraud affects businesses of any size but might be particularly detrimental to small businesses. According to the Association of Certified Fraud Examiners, the average organization loses 5% of its annual revenue to fraud.

Understand the financial risk associated with payroll fraud and identify common types of payroll fraud.

Payroll Fraud

Common payroll scams

Secure payroll and keep an eye out for fraudulent behavior at your business. Payroll fraud can take on many different forms, including the following common schemes.

Employees might claim they worked more hours than they actually did. They might enter overtime hours they did not work or clock in for a co-worker who is late or doesn’t show up for their shift.

If employees have access to your payroll system, they might alter their hourly rate so they get paid more wages. In severe fraud cases, employees might commit payroll check fraud by creating ghost employees. Ghost employees are fake workers on the payroll who don’t work for the company. Instead, funds are funneled to the fraudulent employee. Generally, ghost employee cases are rare and easy to catch in small businesses.

Another common payroll scheme is employees receiving a salary advance and not paying it back. If you offer payroll advances without instituting an organized system, you leave the door open for employees to commit this type of payroll fraud.

Do you reimburse employees for expenses? Employees can easily claim they had more expenses than they actually did if you don’t require proof.

Employees who run payroll can also commit fraud by withholding taxes from wages and pocketing the amounts. If the employee running payroll isn’t remitting taxes to the government, you will lose the money the employee is pocketing, plus the amount you will end up paying the government in back taxes, penalties, and interest.

Not all payroll fraud is committed by employees. In fact, when owners commit fraud, the damage is 10 times worse than when employees do.

In addition to things like using company money to pay for personal expenses or embezzling money out of escrow accounts for business, owners can commit payroll fraud by misclassifying employees as independent contractors. When you misclassify, you don’t pay employment taxes or workers’ compensation insurance for the worker. And, you might also be violating overtime and minimum wage laws.

How to avoid fraud in business

Although there’s no way to guarantee that employees won’t commit payroll fraud, you can take measures to prevent it or catch it quickly.

Set up controls to protect your company from payroll fraud and other kinds of small business fraud cases. Here are some things you should do to secure payroll at your business.

1. Establish checks and balances

If you pass along responsibilities to employees, you need to make sure you don’t entrust everything with one employee. You should have different employees set up new hires, process payroll, and handle accounting duties. And, you should have more than one employee doing each task to make sure they are honest.

Keep an eye on employees who have access to account numbers and payroll checks, too. These employees could fabricate ghost employees and falsify wages. You especially need to pay attention if you only have one employee who handles payroll at your small business.

Don’t allow payroll department employees to generate their own paychecks. They might add overtime wages when processing payroll. Run payroll for them or rotate responsibilities within a department.

2. Ask employees to report suspicious behavior

The ACFE’s Fraud in Small Business study found that action by whistleblowers is the most common and effective way that employers discover fraud in the workplace. The report found that 30% of small businesses detect fraud by receiving tips.

Establishing a special phone number for tips and a clear procedure for reporting suspected fraud is a good investment in fraud protection. Employees who report suspicious behavior may mitigate losses more quickly than if the fraud goes on undetected for years.

As a business owner, you might not be able to see every detail that goes on in your business. But employees are most likely in a better position to spot payroll fraud red flags.

3. Conduct internal audits

An internal audit is when someone working within your company checks your business’s finances, operations, or management. You can conduct internal audits at random times to catch employees off guard. This can help you determine if anyone is committing payroll fraud.

An internal audit is a common way small businesses can catch payroll schemes. Twelve percent of small businesses detect fraud by conducting internal audits, according to the ACFE report.

When you conduct audits, you review your financial records to find where money is going. You can find gaps in records when you conduct regular audits, which can help you determine if employees are committing payroll fraud.

4. Create a separate payroll account

Keeping all your business funds in one bank account might be an invitation for fraud. A payroll account lets you separate your payroll funds from your general business funds. This way, you will only put enough money into the payroll account to cover employee wages and taxes.

With a separate payroll account, you can count on additional security. You limit the amount of money that might be compromised in the case of payroll fraud, keeping the rest of your funds secure.

Using a payroll account makes it easier to reconcile your bank statement and maintain accurate records. The more accurate your records, the easier it will be to catch payroll fraud.

5. Make sure payroll tax deposits are being made

Because an employee running payroll might be pocketing taxes, it’s important that you verify tax deposits are being made.

Keep a separate copy of your PIN and password for the Electronic Federal Tax Payment System (EFTPS). EFTPS is the system used to pay taxes. When you are enrolled in EFTPS, the IRS will automatically send you an EFTPS Inquiry Pin so you can monitor tax deposits.

Log into the system periodically to make sure that accurate, timely deposits are being made for the company. You can also regularly review tax filings to make sure your deposits add up.

Knowing whether your taxes are being deposited correctly can help you avoid IRS penalties that result from not depositing taxes. And, it can help you catch payroll schemes before your business loses too much money.

6. Do your due diligence before you hire

Obviously, no business owner intentionally hires employees with fraudulent behavior. Most candidates put their best foot forward during the hiring process, making it difficult to spot certain behaviors. But, you need to do your due diligence before you extend a job offer.

Take your time during the hiring process. Conduct multiple rounds of interviews and administer job-fit tests to get to know candidates. Make sure you do reference checks. Talk with the candidate’s previous employers. Find out about any suspicious behavior or even past instances of payroll fraud.

Do a thorough background check to see if the candidate has a criminal record. Require drug and alcohol screenings as well.

The more thorough you are in the hiring process, the more you will be able to avoid negligent claim cases. And hopefully, you will avoid future cases of payroll fraud or other types of small business fraud.

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This article has been updated from its original publication date of 05/30/2014.

This is not intended as legal advice; for more information, please click here.

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