When an employer pays an expense reimbursement or advance to an employee — regardless of whether the employee incurs or is reasonably expected to incur the expense — the IRS considers the arrangement to be disguised taxable compensation. In other words, the purported expense reimbursement is treated as additional taxable compensation.
But when these payments are made under a so-called “accountable plan,” they’re free from federal income and employment taxes for recipient employees. Additionally, the employer benefits because the reimbursements aren’t subject to the employer’s portion of federal employment taxes.
Accountable plan basics
Accountable plans are required to meet four requirements in order for payments to recipient employees to qualify as tax-favored expense reimbursements, rather than taxable compensation:
- Business connection. Reimbursements or allowances can be paid only for expenses incurred by employees in connection with performing services for the employer. A common example is business-related travel expenses.
- Substantiation. Expenses must be substantiated by an expense report or similar record. Receipts should be required for expenses over $75. For lodging expenses, receipts are required regardless of the amount.
Rather than reimbursing employees for actual expenses, an accountable plan can instead pay predetermined mileage or per-diem travel allowances up to the amounts paid to federal employees. Companies that opt for this simplified method don’t need their employees to substantiate actual expense amounts.
- Return of excess payments. Within a reasonable period of time, employees must be required to return reimbursements or advances that exceed actual substantiated expenses. Under an exception, employees aren’t required to return excess mileage or per-diem travel allowances based on the amounts allowed to federal employees.
- Reasonable time. Substantiation of expenses and the return of excess payments must occur within a reasonable period of time.
In a 2009 private letter ruling, the IRS concluded that a company plan that reimbursed employees for the cost of providing their own job-related tools and equipment qualified as an accountable plan. The employer required that managers approve the expenditures and that the tools be kept on company premises and used exclusively for work performed for the company.
Other reimbursement arrangements
Unless your company’s expense reimbursement or allowance arrangement qualifies as an accountable plan, the IRS will treat payments as additional taxable compensation. Examples of arrangements that won’t qualify as include: 1) designating part of an employee’s salary as a travel allowance, and 2) reimbursing expenses out of the employee’s salary by reducing his or her paychecks by the reimbursed amounts.
To illustrate: Suppose ABC Manufacturing Co. operates expense reimbursement plans for its warranty repair technicians and salespersons. On any day a repair technician travels away from home on business, ABC designates $50 of that day’s pay as an allowance for travel expenses. The technician receives the $50, but his or her salary is reduced by that amount. The technicians aren’t required to substantiate actual travel expenses.
ABC also designates $500 of each salesperson’s monthly salary as an allowance for monthly business-related entertainment expenses. The salesperson receives the $500, but his or her monthly salary is reduced by that amount. Salespeople aren’t required to substantiate actual entertainment expenses.
These arrangements do not qualify as accountable plans because the allowances are paid regardless of whether the recipient employees actually incur business-related expenses and because the allowances are actually just part of the employees’ salaries. Therefore, ABC must report the allowances as taxable wages on the recipient employee’s W-2 forms.
The allowances are subject to federal income and employment taxes. ABC must withhold for federal income tax and the employee’s portion of federal employment taxes on the allowances. ABC also must pay the employer portion of federal employment taxes on the allowances.
Creating your accountable plan
Setting up an accountable plan for employees’ business-related expenses can save taxes for both the employees and the employer. Consult your tax advisor for more details.