Payroll Fraud: What Every Small Business Owner Needs to Know

Payroll fraud can silently drain resources for months before anyone notices. When Joel Popoff, CEO of Axwell, discovered payroll fraud in his company, it came as a shock. "The deception was subtle, occurring in little increments," he explains. Only a quarterly audit revealed the extent of timesheet fraud that had been eating away at his bottom line.

The numbers back this anecdote. The Association of Certified Fraud Examiners (ACFE) found that small businesses with fewer than 100 employees are actually the most common targets, with nearly a third falling victim to fraud. But once you know what to look for, you can spot the warning signs early and protect your business. 

Let's walk through everything you need to know about payroll fraud and how to prevent it.

{{banner-cta}}

What is payroll fraud?

Payroll fraud happens when someone manipulates a company's payroll system to steal money, with small businesses being particularly vulnerable. While some cases involve complex payroll tax fraud schemes, many of them start with simple timesheet manipulation that can go unnoticed for months.

Edward White, Head of Growth at beehiiv, discovered this the hard way: "Since the sums were small when examined separately, the fraud remained undiscovered for months." For businesses with fewer than 50 employees, where every dollar counts, these small deceptions can quickly add up to pretty big losses.

If you've ever noticed discrepancies in your timesheets or suspected an employee was clocking in for an absent coworker, you were probably dealing with signs of payroll fraud. While catching these issues on your own can be challenging, technology has made detection much easier. Modern tools like Homebase can help protect your business by automatically flagging suspicious patterns—like unusual overtime claims or mismatched clock-ins—before they impact your bottom line.

How payroll fraud can hurt your small business

Payroll fraud wreaks havoc on small businesses in ways that go far beyond missing money. When fraudulent overtime entries at Bright Force Electrical added up to thousands of dollars, owner Daniel Vasilevski discovered just how deep the damage could go. When you're operating on tight margins, these losses often mean the difference between growing or dying out.

The true cost of payroll fraud includes:

• Loss of money. It starts small—maybe a few extra hours on a timesheet—but it adds up fast. Those "minor" losses can eat away at your profits and kill your growth plans before you even notice something's wrong.

• Damaged team morale and broken trust. Nothing damages workplace culture like discovering fraud. "After discovering fraud, we spent months rebuilding trust within our team," one retail manager told us. When employees learn about payroll fraud, productivity drops and good people start looking for other jobs.

• Legal headaches and expensive fines. The IRS takes payroll fraud seriously. Since it's often classified as a felony, you're looking at potential criminal charges on top of hefty fines. They can demand up to 100% of unpaid taxes, plus you might need to hire lawyers to handle audits and investigations. And fraudulent tax returns filed as a result of payroll fraud can lead to more penalties and further legal complications.

• Your time and peace of mind. For small businesses, investigating payroll fraud means hours spent reviewing timesheets, interviewing employees, and implementing new prevention systems. 

The worst part of dealing with payroll fraud is never the money. Small business owners often describe discovering payroll fraud as feeling like a personal betrayal. As Brian Alexis Prado from Coastline Gutter Pros puts it, "Employee fraud in a small business is deeply hurtful as we all know and work closely with each other." When you're running a small business where everyone knows each other, the emotional toll can be just as devastating as the financial one.

5 types of payroll fraud in small businesses

Small businesses face several common payroll fraud schemes that can drain thousands from your bottom line. Here's what to watch for:

1. Timesheet fraud and manipulation

Time theft happens when employees deliberately lie about their work hours, committing payroll fraud using methods like:

• Timesheet manipulation (falsifying start/end times)
• Buddy punching (clocking in for absent coworkers)
• Break time manipulation (misreporting break durations)
• Remote work time fraud (logging hours without working)

This type of payroll fraud often begins with minor adjustments that compound over time, making it particularly difficult to detect.

Red flags to watch for:

• Overtime hours that don't match business activity levels
• Multiple employees with identical clock-in/out times
• Time entries that don't align with security footage or door access logs
• Breaks recorded during peak business hours
• Consistent 40-hour weeks with no variation over a long period of time

🏠Homebase tip: Our system uses photo verification, GPS-enabled clock-ins, and automated monitoring to prevent all forms of time theft, sending real-time alerts for suspicious patterns.

2. Ghost employee fraud

Ghost employee fraud is exactly what it sounds like: paying "ghost" employees who don't actually exist. It typically happens in two ways. Either someone creates completely fictional employees on the payroll, or they keep collecting paychecks for employees who've left the company.

Julia Yurchak, Senior Recruitment Consultant at Keller Executive Search, shared that one manufacturing client lost $400,000 through a complex ghost employee scheme that went undetected until a thorough payroll audit was conducted.

Red flags to watch for:

• Multiple employees sharing the same bank account or address
• Employee records missing crucial documentation
• Paychecks that are never claimed or direct deposits to unfamiliar accounts
• Social Security numbers that don't match employee names
• Employees with no benefits deductions

🏠Homebase tip: Our system requires complete employee documentation and photo verification during onboarding, making it difficult to create ghost employees.

3. Payroll processing manipulation

This type of payroll fraud is particularly tricky because it's committed by the very people trusted to manage payroll. This type of fraud happens when employees with payroll system access secretly adjust pay rates, hours worked, or other data for their own benefit. Since these employees understand the system inside and out, they know exactly how to hide their tracks.

Loris Petro, Marketing Manager at Kratom Earth, discovered this firsthand when their payroll manager had been inflating their own hours for months. "It only came to light during a routine financial review, where we noticed payroll expenses were unusually high compared to prior periods, even though the workload hadn't changed," Petro explains.

Red flags to watch for:

• Unusual adjustments to payroll processor's own records
• Changes to pay rates without proper documentation
• Payroll totals exceeding forecasted amounts
• Adjustments made outside normal processing times
• Missing approval documentation for changes

🏠Homebase tip: Our system requires dual approval for sensitive changes and maintains detailed audit trails of all payroll adjustments.

4. Commission fraud

Commission fraud involves deliberately manipulating sales data, customer accounts, or transaction records to inflate commission payments. This sophisticated form of payroll fraud particularly affects retail and sales-based businesses. Commission fraud can also lead to discrepancies in payroll taxes, further complicating the financial records of your business.

Red flags to watch for:

• Commission earnings inconsistent with historical patterns
• Unusual spikes in individual sales numbers
• High volume of voided or adjusted transactions
• Customer complaints about unauthorized accounts
• Sales recorded outside normal business hours

🏠Homebase tip: Our integrated POS and time tracking helps verify sales activities against employee work hours, automatically flagging suspicious patterns.

5. Unauthorized pay rate changes

Think of this type of payroll fraud as salary sleight-of-hand. It happens when someone quietly changes employee pay rates, bonuses, or deductions without proper approval. While it might sound similar to payroll processing manipulation, there's a key difference: these fraudsters specifically target compensation structures. 

Pay rate fraudsters often make their moves during hectic periods like year-end or major company transitions when these kinds of changes are more likely to slip through the cracks. On top of unauthorized pay rate changes, they may also use payroll diversion schemes to redirect wages to fraudulent accounts.

Red flags to watch for:

• Unexplained changes to base pay rates
• Unauthorized bonus payments
• Unusual patterns in overtime pay rates
• Changes made during peak business periods
• Missing authorization for pay adjustments

🏠Homebase tip: Our system logs all pay rate changes and requires multi-level approval for any modifications to employee compensation.

How to prevent payroll fraud

No business owner wants to think about payroll fraud happening in their company. But here's the good news: preventing it doesn't require complex security systems or expensive solutions. In fact, the most effective prevention strategies are surprisingly straightforward.

We've gathered battle-tested advice from business owners who've successfully prevented fraud, combined it with official recommendations from the IRS and legal experts, and distilled it all into seven practical steps you can implement today.

1. Implement automated time tracking systems.

Modern time tracking systems, like Homebase, combine biometric verification, GPS tracking, and automated monitoring to create a strong defense against time theft. These integrated solutions prevent common fraud tactics like buddy punching and timesheet manipulation by creating an undeniable digital record of when and where employees work.

Shu Saito, founder and CEO of All Filters, implemented a comprehensive solution after discovering fraud in his company: "I switched to a payroll software solution with built-in fraud detection features, such as alerts for unusual logged-hour patterns or salary changes." The automation reduced both fraud attempts and human error at his company, effectively preventing payroll fraud.

2. Set up a dual approval system.

Dividing payroll responsibilities among multiple team members creates a crucial system of checks and balances. When different people handle processing, approval, and reconciliation, it becomes nearly impossible for any single person to manipulate the system without detection, effectively preventing payroll fraud scheme and potential opportunities for fraud.

Julia Yurchak, Senior Recruitment Consultant at Keller Executive Search, shares how her manufacturing client implemented what they call a "three-person checkpoint" system after discovering the $400,000 ghost employee scheme we mentioned earlier: one person processes payroll, another approves it, and a third reconciles the accounts.

3. Conduct regular payroll audits.

Regular audits of payroll records serve as both a detection and prevention tool. By reconciling timesheets with bank statements and payroll records monthly, businesses can catch discrepancies early while creating a culture of accountability. Random timing of these reviews adds an element of surprise that can help deter potential attempts at fraud, including the ability for fraudsters to file fraudulent tax returns using manipulated payroll data.

Catherine Schwartz, Chief Marketing Officer at EssayService, emphasizes the importance of consistent monitoring: "Only after an annual audit, when disparities between documented hours and project results were discovered, did the fraud become apparent." This experience led her team to implement both planned and ad hoc audits to prevent future occurrences.

4. Create an anonymous reporting system.

An anonymous reporting system empowers employees to flag suspicious activities without fear of retaliation. This creates an additional layer of protection against fraud by leveraging the eyes and ears of your entire workforce, often catching issues that might slip past other controls. For example, it can help identify workers compensation fraud, where employees falsely claim work-related injuries to receive benefits.

5. Maintain detailed documentation.

Comprehensive record-keeping is a fundamental defense against payroll fraud. By maintaining detailed documentation of all payroll transactions, employee files, pay rate changes, and overtime approvals, businesses can create an audit trail that makes it difficult to manipulate records and easier to spot irregularities. Detailed documentation is also important for accurately recording workplace injuries, which can help prevent fraudulent claims.

The IRS emphasizes that thorough documentation isn't just good practice; it's essential for compliance and fraud prevention. Their guidelines recommend keeping complete employee files, documenting all pay rate changes, and maintaining detailed records of approvals for overtime or bonuses.

6. Use automated monitoring systems.

Modern payroll systems can automatically detect and prevent payroll fraud schemes through built-in safeguards. These systems continuously monitor for suspicious patterns, flag unusual activities, and require multi-level approvals for sensitive changes, creating a proactive defense against common types of payroll fraud.

Joseph Passalacqua, Owner/CEO of Maid Sailors Cleaning Service, implemented a digital verification system that helped prevent $45,000 in potential losses. His company uses a three-part verification system where employees check in through an app, clients confirm service completion, and GPS tracking verifies location—reducing time padding incidents by 95%.

7. Report suspected payroll fraud.

Quick action is essential when you suspect payroll fraud in your business. Having clear reporting procedures and knowing which authorities to contact can help minimize losses and prevent even more fraud from occurring. The sooner you report suspected fraud, the better chance you have of recovering losses and protecting your business.

The IRS provides Form 3949-A for reporting suspected tax fraud, and they take these reports seriously, often classifying payroll fraud as a felony. Beyond federal reporting, businesses should also contact their state's labor department and local law enforcement for cases involving potential criminal activity.

Protect your business from payroll fraud: Practical steps you can take today.

Protecting your business from payroll fraud doesn't require complex systems or expensive solutions. Start with these immediate steps:

1. Review your current payroll processes for vulnerabilities
2. Implement at least two levels of approval for all payroll changes
3. Set up a system for documenting and verifying all time entries
4. Create clear policies around overtime and break time reporting
5. Schedule regular audits of your payroll records

Implementing these preventive measures doesn't have to be complicated. While manual processes are a good start, the right tools can help automate and strengthen your fraud prevention efforts. Homebase helps small businesses protect their payroll with features like photo verification, real-time alerts, and automated monitoring, making it easier to focus on growing your business instead of worrying about fraud.

{{banner-cta}}