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Reimbursing employees for expenses: income or not?

Sarah J. Fischer

When an employer advances or reimburses an employee for business expenses, appropriate documentation must support the deduction as a business expense. Otherwise, these types of payments are considered additional wages paid to the employee subject to payroll and income taxes.

Under Internal Revenue Service regulations, amounts paid under an “accountable plan” are excluded from employee  income and therefore exempt from payroll and income taxes.

Amounts paid under a nonaccountable plan — or under an improperly maintained accountable plan — constitute additional income subject to income taxes to the employee and employment taxes to the employer.

Savings from properly structured reimbursement arrangements can have a valuable effect on businesses and their employees. If, for example, a company provides an employee with a vehicle allowance of $500 a month ($6,000 a year) and that allowance is considered income, it could cost the employer and employee a total of almost $3,000 in additional income and payroll taxes.

So what is an accountable plan? For an employer to take advantage of favorable IRS rules, a reimbursement or allowance arrangement must include all of the following:

The expense must have a business connection, meaning you must have paid or incurred deductible expenses while performing services as an employee for your employer.

The employee must adequately account — the amount, time, place and business purpose — to the employer for these expenses within a reasonable period of time.

The employee must return any excess reimbursement, allowance or advance within a reasonable period of time.

If all three rules aren’t met, the payment will be considered to have been made under a nonaccountable plan and therefore a payroll expense, making it employee income and subject to income and payroll taxes.

The excess allowance or reimbursement is the amount paid greater than the actual business-related expense the employee has adequately accounted for to the employer.

The definition of a reasonable period of time depends on the circumstances of the situation. However, the regulations allow the following safe harbors — and if met will automatically be treated as made in a reasonable period of time.

To meet regulations, an employee must receive an advance within 30 days of the time of the expense, the employee adequately accounts for expenses within 60 days after they were paid or incurred and excess reimbursements are returned within 120 days after an expense is paid or incurred. If a periodic statement is furnished to an employee (at least quarterly) that asks him or her to either return or adequately account for outstanding advances, the employee must comply within 120 days of receiving the statement.

One of the rules is to adequately account for the business expenses by proving the amount, time, place and business purpose of the expense.

This is achieved by the employee giving the employer some sort of statement of expense, along with a record that proves the expense was actually incurred and when — such as a receipt.

Essentially, the employee must give the employer the same type of supporting information that would have to be provided if the IRS were to question the deduction. Any advance or allowance that’s not accounted for appropriately or exceeds actual expenses must then be paid back to the employer.

Employee business travel expenses paid through car allowances and per diem automatically satisfy the adequate accounting rules as they relate to the amount of the expense — meaning receipts aren’t required — only if all of the following are met:

  • The employer limits payments of such expenses to only those incurred in ordinary course of business.
  • The allowance doesn’t exceed federal rates. This means one of the following — the regular federal per diem amount, standard meal allowance or high-low rate. For car expenses, the standard mileage rate or fixed and variable rate must be used.
  • The employee proves the times, dates, places and business purposes of the expenses to the employer within a reasonable period of time.
  • The employee is not related to the employer.  If related, the employee must prove expenses through supporting documentation and receipts.

In summary, a properly managed accountable plan offers an ideal way for employers to save payroll tax on business expenses paid by employees.

Sarah J. Fischer, CPA, specializes in Tax planning and preparation services for individuals, and private companies for clients in several industries including auto dealerships, construction, manufacturing and medical practices. She is a member of American Institute of Certified Public Accountants and the Colorado Society of Certified Public Accountants.
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