Employee reimbursements need careful compliance.
Employees, including business owner/employees, often are required to pay expenses out of pocket on behalf of their employer or business. In most cases, they do so either expecting to be reimbursed or, until the end of 2017, expecting to claim the expenditures as a miscellaneous itemized deduction (above a threshold of 2% of adjusted gross income (AGI)). If employers reimburse the expenditures, employees might have to include the amount as taxable compensation but would generally prefer to receive a reimbursement tax-free, especially where they received no net benefit. They can do so — and the business can still claim a deduction for the expenditure — if their employer reimburses them through an accountable plan.
Accountable plans work on the simple concept that if reimbursement payments to business owners and their employees are properly claimed and documented, they are not taxable to the recipient. Conversely, if reimbursements are not legitimate business expenses or are not properly documented, they are taxable income to employees. Accountable plans are a flexible tool to incentivize employees to pursue business goals and to facilitate employee-owners’ deductions of expenses they incur in running their businesses.
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, redefined the deductibility of business expenses and disallowed the deduction of out-of-pocket expenses paid by employees on their personal tax return. Given the changes, it is a good time for CPA tax practitioners to review their clients’ existing accountable plans and help those who want to establish one.
Generally, AGI is defined by Sec. 62(a) as gross income minus certain deductions. These deductions include expenses of employees paid or incurred by them in connection with their performance of services as an employee, if the expenses are reimbursed under a reimbursement or other expense-allowance arrangement with the employer (including such a reimbursement provided by a third party) (Sec. 62(a)(2)(A)). Sec. 62(c) further specifies that an arrangement will not be treated as a reimbursement or other expense-allowance arrangement if it does not require the employee to substantiate the expenses covered under the arrangement (apart from certain exceptions under Sec. 274(d)) or if it allows the employee to retain any amount exceeding the substantiated covered expenses. It may be helpful to analyze these requirements and related regulations from the employer’s and employee’s respective viewpoints.
FROM THE EMPLOYER’S POINT OF VIEW
To offer an accountable plan, an employer must comply with three standards:
- The expenses must have a business connection;
- The expenses must be substantiated within a reasonable period; and
- The employee must return any money not spent to the employer, also within a reasonable period.
If any of the three conditions isn’t met, the reimbursement arrangement is treated as a nonaccountable plan. In other words, the reimbursements are taxable compensation to the employee and subject to employment taxes.
Before a reimbursement can be made, the employer must authorize the purchase for a legitimate business purpose. A purchase for a legitimate business purpose is anything that is deductible under Regs. Sec. 1.62-2, including:
- Travel expenses (either actual or per diem);
- Gas or mileage expenses (either actual or per diem);
- Tools and supplies;
- Home office, including depreciation;
- Training and development; and
- Dues, subscriptions, and professional licenses.
Reimbursing an expense does not change the deductibility of the expense itself. For instance, meals may be reimbursed at 100% of the cost, even though the expense is only 50% deductible by the company. Entertainment expenses are no longer deductible as such at all under the TCJA (Sec. 274(a)(1)). If an employer reimburses entertainment expenses, the reimbursement must be treated as wages (Regs. Secs. 1.62-2(c)(5) and 1.62-2(d)). Examples of nondeductible entertainment expenses under the TCJA include (Regs. Sec. 1.274-2(b)(1)(i)):
- Cocktail lounges;
- Country clubs;
- Golf and athletic clubs;
- Sporting events; and
- Hunting and fishing.
Reimbursement for small tools can be a gray area that should be documented carefully (see Rev. Rul. 2012-25 and IRS Letter Rulings 200930029 and 201120021). In instances where employees are required to routinely provide their own tools and materials, reimbursement schemes should not resemble wages. For instance, if a janitor is required to provide his or her own cleaning supplies and is paid $200 per day, an employer cannot simply designate $50 of the janitor’s pay as reimbursed cleaning supply expense. If the employee would receive the same amount of compensation anyway, the business connection requirement is not met. Reimbursements must have a clear correlation to actual expenses.
Proving telephone and internet expenses can test practical limits as well. Telephone expenses reimbursed under an accountable plan must be for telephone calls made with a real business connection. This means substantiating the reimbursement amount with actual billing statements, with business calls noted and an offset for the cost that the employee would have paid anyway. This level of paperwork can be daunting. While these expenses can be reimbursed under an accountable plan, consider a set dollar reimbursement instead, which can be accomplished by treating the expense as a working-condition fringe benefit under Sec. 132(a)(3) (see also Notice 2011-72 and IRS Small Business/Self-Employed field memo SBSE-04-0911-083).
Accountable plans can be structured to provide advances or allowances that are substantiated after the fact. For example, a brokerage might offer a set meals allowance that is based on the revenue generated by a broker group. However, the recipients must document that all the dollars were spent for business activity. Detailed expense reports help to distinguish accountable plan reimbursements from nonaccountable plan allowances. For instance, a car allowance with no requirement to account for mileage, dates, and destinations should be fully reported on the employee’s Form W-2, Wage and Tax Statement, as wages, even if the employee incurs substantial business mileage.
Accountable plans are not employee benefit plans and do not have to follow the nondiscrimination rules applicable to employee benefit plans. A business can reimburse an owner, but not other employees, for a home office, for example. An employer can have different arrangements with different employees, and if one employee fails to comply with the plan requirements, only that employee will be affected.
“Substantiated” means the employer must collect documentation that shows the amount, time, place, and business purpose of the expense. This generally entails an account book, log, receipt, bill, or credit card statement. It doesn’t have to be the original, but the proof must be specific enough to differentiate the types of expenses. For instance, a credit card statement for a hotel expense would not be enough unless it clearly separated meals and entertainment from an overnight stay expense. A list of categorized expenses is also not enough, unless the individual purchases are detailed and supported. The required documentation is covered under two different sections of the Code.
REIMBURSEMENTS AND PER DIEMS
Businesses and their employees may rely upon federal per-diem tables and mileage allowances to report meal and travel expenses rather than documenting specific costs. This is true even if the amount claimed is less than the amount the employee spent. Employers must still retain dates, times, and the business purpose of the expense. If your client is using per-diem reimbursement amounts, be sure to adjust for cost differences in different areas for per-diem amounts and prorate for partial days of travel.
The federal rate for travel can be figured in different ways: the federal per-diem rate, the standard meal allowance, or the high-low rate (see Rev. Proc. 2011-47 for rules and Notice 2019-55 for the relevant rates for the period Oct. 1, 2019, through Sept. 30, 2020).
Business owners and related parties cannot themselves use per-diem amounts to prove their expenses. Owners must provide actual receipts in all circumstances. Expenses related to an employee’s spouse and family attendance at business events are not deductible and not reimbursable under an accountable plan, unless it can be clearly shown that the family presence has a bona fide business purpose.
For payments made to independent contractors under a reimbursement plan, the 50% limitation on meal expenses might not apply. If the independent contractor has not fully accounted for the meal expenses, the business would treat the payments as made to the contractor for services rendered. If the meal expenses are fully accounted for, the meal expenses would be 50% deductible by the business (Regs. Sec. 1.274-2(f)(2)(iv)). Businesses and independent contractors can stipulate how meal expenses are treated in their contract.
Car expenses can be reimbursed at the standard mileage rate or the fixed and variable rate. If an individual receives reimbursements using the IRS mileage rate, actual expenses need not be substantiated, but other elements of business driving (date, mileage, destination, etc.) must be reported to the employer using an expense account report, app, or other written record.
Regs. Sec. 1.274-5(c)(2)(iii)(A)(2) provides some flexibility in the types of documentation necessary to prove an expense. Individual Sec. 274 expenses of less than $75 do not require a specific receipt, with the express exception that lodging expenses, regardless of amount, must be documented (Regs. Sec. 1.274-5(c)(2)(iii)(A)(1)).
SUBSTANTIATION: SMALL AMOUNTS
The IRS acknowledges that it may be difficult for small businesses to maintain detailed records and supporting documents for all expenses. The Service allows some latitude in the collection of data, stating, “Detailed records of small expenditures … as for example, tips, will not be required” (Regs. Sec. 1.162-17(d)(2)). However, Regs. Sec. 1.162-17 does not offer a de minimis amount for this purpose. The IRS’s idea of proper substantiation is “the preparation of a daily diary or record of expenditures, maintained in sufficient detail to enable [a taxpayer] to readily identify the amount and nature of any expenditure, and the preservation of supporting documents” (id.). The burden of proof is on the taxpayer, and it is wise to counsel clients to preserve enough documentation to avoid any discussion of adequacy with an agent. The IRS is more likely to give latitude for missing receipts if the taxpayer can show otherwise detailed and accurate support for the expenses that are claimed.
‘REASONABLE PERIOD OF TIME’
The IRS allows that “a reasonable period of time” in requirements 2 and 3 for an accountable plan (see “From the Employer’s Point of View” above) depends on the facts and circumstances. However, in Regs. Sec. 1.62-2(g)(2) it offers two safe harbors:
- Fixed–date method: An advance is acceptable if it is made within 30 days of when the expense is paid or incurred. An expense must be substantiated to the payer within 60 days after it is paid or incurred. Repayment of any overpaid advance must be made within 60 days after the expense is paid or incurred.
- Periodic–statement method: If the business provides at least quarterly statements detailing any payments in excess of the amount substantiated by an employee and requesting substantiation of additional business expenses or requesting the return of overpaid advances within 120 days of the statement, an expense substantiated or amount returned within that time will be treated as substantiated or returned in a reasonable time under the safe harbor.
Relying instead on facts and circumstances gives an employer more flexibility but requires more diligence. In one case, the taxpayer submitted expense reports annually but also provided a receipt of each expenditure at the time of each purchase. Since the employer was informed of each expenditure when it was made, the submission of the detailed reimbursement request once a year was enough (Namyst, T.C. Memo. 2004-263, aff’d on other issues, 435 F.3d 910 (8th Cir. 2006)).
As noted above, employers can offer an advance account to cover employee expenses. However, if the employee does not actually spend the advance on business purchases, the overpayment must be returned. The IRS says a “reasonable period” in this case is 120 days. In practice, the employer needs to try to match expenses to the reimbursement in a timely way. Estimates, even if reasonable, are not acceptable (Rev. Rul. 2005-52). The regulations provide that the “reasonable period” safe harbors are not available to businesses that regularly overestimate advances versus expenses (Regs. Sec. 1.62-2(g)(3)).
REQUIREMENTS FOR A WRITTEN POLICY
An accountable plan need not be in writing; however, a written document provides a structure to ensure that the three required elements are addressed. A written expense reimbursement policy should clarify:
- The time period for employees to submit expenses;
- The process for requesting reimbursement, including what documents are required to prove the request;
- The process for returning excess reimbursements or allowances;
- The types of expenses that are reimbursable;
- The maximum allowable amount for certain expenses; and
- Preferred suppliers for reduced expenses.
FROM THE EMPLOYEE’S POINT OF VIEW
The TCJA has changed the landscape for employees who pay out-of-pocket business expenses. Before the TCJA, if an employer did not provide an accountable plan, or if the employee did not receive reimbursement, the employee could deduct those expenses under Sec. 67(b) on his or her own Form 1040, U.S. Individual Income Tax Return, on Schedule A, Itemized Deductions, as a miscellaneous itemized deduction subject to a 2%-of-AGI threshold. Under the TCJA’s new Sec. 67(g), these miscellaneous itemized deductions are suspended for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026. Employees must now choose between spending for business expenses without any deduction benefit and complying with an existing employer accountable plan or, where an employer does not offer one, requesting that the employer institute one.
If an employer has an accountable plan but incorrectly reports expense reimbursements as income to an employee on his or her Form W-2, the employee should request a corrected W-2.
TIPS FOR BEST PRACTICES
Accountable plans are important tools to encourage employees to promote business goals. They are also excellent tools to help a business owner recapture expenses paid on behalf of the company, without fear of the payments being treated as compensation or as an equity contribution.
CPAs can take the lead to help clients collect and document the information required for an accountable plan. As with many IRS regulations, what is “reasonable” is hard to pin down. The IRS’s definition is probably more exacting than your business owner client’s definition. Counsel your business owner clients not to ignore the paperwork involved. Provide them with templates for accountable plan documents, resolutions, and reimbursement requests. Become familiar with apps that help your clients comply. There are several: MileIQ, BizXpenseTracker, Receipt Bank, Expensify, Shoeboxed, Receipts by Wave, and many others. Request a signed copy of a corporate resolution and accountable plan document for your files.
Help clients to develop a regular and consistent reimbursement process that becomes part of their organizational structure. If the owner is reimbursing himself or herself as an employee, make sure that separate checks are written in response to specific reimbursement requests. Help your clients avoid the discussion with an IRS agent about what “adequate” and “detailed” is by encouraging them to collect thorough documentation on an ongoing basis.
By Dayna E. Roane