Reimbursements: Income to an employee or not?

Sarah J. Fischer
Sarah J. Fischer

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

Under Internal Revenue Service regulations, amounts paid under an accountable plan are excluded from income and exempt from income and payroll taxes. However, amounts paid under a nonaccountable plan — or an improperly maintained accountable plan — impose additional income taxes to the employee and employment taxes to the employer. If, for instance, a company improperly provides an employee with a vehicle allowance of $500 a month — $6,000 a year — that could cost the employee and employer and employee almost $3,000 in additional income and payroll taxes. Clearly, the savings from properly structured reimbursement arrangements constitute a valuable benefit for businesses and their employees.

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

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

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

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 subject to income and payroll taxes.

The excess allowance or reimbursement is the amount paid that is 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 of the facts and 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. An employee receives 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, excess reimbursements are returned within 120 days after the expense was paid or incurred or a periodic statement is given to the employee at least quarterly that asks them to either return or adequately account for outstanding advances and the employee complies within 120 days of that statement.

The rules require an adequate accounting for 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, employees must provide employers with the same type of supporting information they would have to provide to the IRS if the agency were to question the deduction. Any expense not accounted for appropriately or in excess of the actual amount must 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 conditions are met:

The employer limits payments of such expenses to only those incurred in the 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, apply the standard mileage rate or fixed and variable rate.

The employee proves the times, dates, places and business purposes of 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 with 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.