To save yourself and your employees some payroll tax expenses, the Internal Revenue Code and the IRS regulations allow expenses to be deductible for a business and not income to the employee who is being reimbursed for his business expenses if, and only if, the reimbursements are made under an accountable expense reimbursement plan.
To be an “accountable plan”, the reimbursement program must have these characteristics:
- Business connection of expenses;
- Proper substantiation of expenses;
- Written plan requiring that employees return to the employer reimbursed amounts in excess of actual expenses incurred;
- The actual return by employees, within a reasonable time, of reimbursed amounts in excess of actual expenses incurred; and
- Any advance made by an employer to an employee must be reasonably calculated and must not be expected to exceed the amount of reasonably anticipated expenditures to which such advance relates.
|The Accountable Plan requirements are located at Internal Revenue Code Sec. 62(c) and IRS regulations 1.62-2.|
The result of not meeting the requirements of an accountable plan is that the money that is paid to the employee is taxable compensation to the employee. The employee can then deduct his business expenses on his Individual Income Tax Return.
Each of the five accountable plan requirements is highlighted in detail below.
I. Business Connection
A reimbursement arrangement has a business connection if through it the employer in good faith provides advances, allowances or reimbursements for deductible business expenses incurred by the employee in connection with the performance of services as an employee. A reimbursement arrangement will fail the “business connection” requirement if the employer does not reasonably believe that the employee will use the reimbursement to pay for deductible expenses.
II. Proper Substantiation
There are two categories of expenses to which the substantiation rules apply:
Code Sec. 274 Expense items. Basically, the written substantiation required relating to a specific expenditure is that the “who, what, where, when, why and how much” information related to the expenditure must be documented in writing. For example, for listed property such as business cars, actual substantiation must meet the following four requirements:
- the amount of the expense (repairs, gas, depreciation, etc.);
- business use (number of business miles);
- time (date) of use; and
- business purpose of business use (name of customer will do).
Other Expense Items. For employee business expenses that do not fall within Code Sec. 274 (such as professional journals, professional dues, etc.) an employee is considered to have substantiated expenses for this purpose if information submitted is sufficient to enable the person providing the reimbursement to identify the specific nature and amount of each expense and to conclude that the expense is attributable to the employer’s business activities.
It is not sufficient if an employee merely aggregates into broad categories (such as “travel”) or reports individual expenses through the use of vague, non descriptive items (such as “miscellaneous business expenses”).
III. Written Plan
The determination of whether an expense reimbursement plan requires an employee to return amounts received from the employer to the employer in excess of substantiated expenses will depend on the facts-and-circumstances. The easiest and perhaps the only way to prove that the “arrangement requires an employee to return amounts in excess of substantiated expenses” is to have a written expense reimbursement plan (which is incorporated by reference into the worker’s employment contract), which clearly so provides.
IV. Actual Return by Employees of Excess Reimbursed Amounts.
A plan must require the employee to pay back any reimbursements in excess of actual substantiated expenses.
Both the requirement of substantiation and the requirement to return excess reimbursements must be met within a “reasonable period of time”. What exactly constitutes a reasonable period of time depends on all the facts-and-circumstances. Two safe harbor rules exist to establish that the “reasonable period of time” requirement has been met:
1. Fixed Date Method. If an advance is made within 30 days of when the anticipated expense is paid or incurred, and the expense is substantiated within 60 days after it is paid or incurred, or the excess amount, if any, is returned by the worker to the payor within 120 days after the expense is paid or incurred, the “reasonable period of time” requirement has been met.
2. Periodic Statement Method. If the payor provides employees with periodic statements (no less frequently than quarterly):
Stating the amount, if any, paid under the arrangement in excess of the expenses the employee has substantiated; and…
Requesting the worker to substantiate any additional expenses that have not yet been substantiated, and/or return any amounts remaining unsubstantiated within 120 days of the statement, then, any expense substantiated or nay amount returned within that time period will be treated as being substantiated or returned within a “reasonable period of time”.
V. Reasonableness Requirement
Where money is advanced to a worker to defray expenses, such advance must be reasonably calculated to not exceed the amount of anticipated expenditures, and must be made on a day within a reasonable period of time prior to the day that the anticipated expenditures will be paid or incurred by the worker.
Keys to Understanding Accountable Plan Requirements
The keys to understanding the accountable plan requirements are:
1. amounts reimbursed must actually be for legitimate, properly substantiated business expenditures; and –
2. not only must the plan require advances or allowances which are not actually spent on business expenses to be returned to the employer, such amounts must actually be returned to the employer within approximately 120 days.
Different Categories of Expenses
Different categories of expenses are eligible for different treatment in expense reimbursement plans, as follows:
1. Transportation expenses (local automobile expenses);
2. Away-from-home travel (meals, incidentals and lodging, or meals and incidentals only) expenses; and
3. Other expenses.
The options available regarding each of the three foregoing types of expenses are set forth below. Any option for transportation expenses may be freely combined with any option for away-from-home travel and any option for other expenses, In other words, options in each of the three main expense categories may be freely mixed and matched with the options available in each of the other categories in any desired order.
1. Transportation Expenses
Options available for the reimbursement of local transportation expenses include:
1) IRS Standard Mileage Rate. The IRS standard mileage rate changes each year. In 2012 it was 55.5 cents per mile. If a worker substantiates the number of miles driven, and the business purpose for the mileage, a monetary reimbursement for each such mile at any amount of cents per mile up to, but not exceeding, the standard IRS mileage rate, will not be taxable wages to such worker.
2) Actual Cost Method. Reimbursable actual car expenses include the costs for gas, oil, repairs, maintenance, insurance, taxes, licenses, and other similar items. Interest incurred by employees on loans after December 31, 1986 to purchase a car is not an employee business expense and, therefore, not reimbursable.
Under the actual cost method, actual expenses such as these are totaled and multiplied by the business use percentage to determine the business expense. In addition to the above expenses, all business parking fees and tolls may also be deductible at one hundred percent if related to business use.
3) FAVR Method. the FAVR allowance method allows an employer to calculate a standard mileage rate per mile. This method is described in Rev. Proc. 90-34 and if you are interested in it, I suggest reading the Rev Proc. But, since it is very complex, and since it is not available to board members or management employees, I will not discuss it here.
2. Away-from-home travel
You are allowed to use the IRS approved per-diem expenses to reimburse employees for their away from home travel expenses. These per-diem expenses are separated between meals and lodging. In addition, you can use per-diem rates specified for certain “high cost” locations, such as LosAngeles and New York city. If you are a business owner you can use the per-diem for meals and incidental expenses but you must substantiate your lodging expenses.
3. Other expenses
Any true business expense, unless it is considered to be “lavish” can be deducted as long as you provide the substantiation required.