How do you distinguish expense reimbursements from disguised compensation? Establish an accountable plan!
Accountable vs. Nonaccountable
If a company’s arrangement meets the accountable plan requirements, expense reimbursements to employees are 100% deductible by the company (50% for most meals and entertainment). Also, the reimbursements are excluded from the employees’ taxable income and are not subject to withholding.
However, if the company’s reimbursement plan is nonaccountable, the company must deduct the reimbursements as compensation, and the reimbursements are subject to payroll taxes. The reimbursements are included in the employees’ gross income and are subject to withholding. The employees may deduct the expenses as a miscellaneous itemized deduction, subject to 2% of adjusted gross income.
Nonaccountable plans force employees to pay more tax, because the reimbursements are included in their gross wages, and only a portion of the reimbursement is deductible. Employers may lose the benefit of deducting 100% of the reimbursements as compensation, due to the increased payroll taxes.
Accountable Plan Requirements (IRC Sec. 162(c))
- Business Connection
The plan must stipulate that expenses may only be reimbursed when incurred by employees in connection with their duties as an employee of the company. Payments must be clearly identified, i.e. using separate checks for reimbursements or identifying the reimbursement on the check stub, if the payment is combined with wages
The plan must require substantiation of the expenses through a log, expense report or detailed receipt. This allows the employer to identify the nature of the expense and make sure that it is attributable to business purposes. The documentation must show 1)the amount and business purpose of the expense 2)the time and place of travel and/or entertainment 3) the date and description of any gift and 4)the business relationship of any person entertained or receiving a gift.
- Return of Excess Advances
The plan must require employees to return any advance that exceeds the substantiated business expenses. If the employees does not return the advance, then the employer must treat the excess as compensation and subject it to payroll taxes.
- Reasonable Time Period
Both the Substantiation and Return of Excess Advances requirements must be completed within a reasonable period of time. Regulation 1.62-2(g) offers 2 safe harbors for meeting this requirement.
a. Fixed Date Safe Harbor – The plan’s timeliness requirement is met if:
- An advance to be made no more than 30 days before the employee pays or incurs the expense
- An expense must be substantiated within 60 days after it’s paid or incurred.
- Excess advances must be returned to the employer within 120 days after the expense is paid or incurred.
b. Periodic Statement Safe Harbor – The timeliness requirement is met if the company, no less than quarterly, provides employees with detail of advances not yet substantiated, and requests that the advances be substantiated or returned to the company within 120 days
See our Resources page for a template of an accountable plan for your business. Please don’t hesitate to contact our McMurray Tax Practice if you have any questions about expense reimbursement.