Employers often cover the cost of employee outlays for certain expenditures they incur while doing their job. The way in which employers handle these reimbursements can produce significant tax savings for both the company and employees.
Two reimbursement strategies: accountable vs. nonaccountable plans
Companies can cover employees’ expenses in two ways: through an “accountable plan” or a “nonaccountable plan.”
- An accountable plan is a reimbursement arrangement adopted by the company that requires employees to substantiate their business-related expenses to the company within a reasonable time (no more than 60 days from the date of the expense) and to refund to the company any excess advances within a reasonable period (no more than 120 days from the date of incurring or paying the expense); no advances can be made more than 30 days prior to the time of the expense.
- A nonaccountable plan is a reimbursement that does not satisfy the requirements of an accountable.
Tax treatment under the two strategies
If there is no accountable plan in place, then the company must report reimbursements as income to employees. This means the reimbursements are taxable compensation reported on the employees’ W-2 forms; the reimbursements are also subject to payroll taxes. The employees report the income and then, if they itemize, can deduct their business expenses as miscellaneous itemized deductions to the extent they exceed 2% of adjusted gross income. However, if employees are “high-income taxpayers,” they lose some of the benefit from any deduction because of the phase-out of itemized deductions. If they are subject to the alternative minimum tax (AMT), they lose all of the benefit because itemized deductions are not deductible for AMT purposes.
With an accountable plan, reimbursements are not reported as income so the employer avoids payroll taxes and W-2 reporting. The employer deducts the business expenses. The employee does not have any income to report and does not have any expenses to claim as miscellaneous itemized deductions. Not having additional income means that adjusted gross income is minimized; this in turn may increase eligibility for certain tax breaks and/or avoid triggering certain phase-outs or additional taxes.
Steps for creating and operating an accountable plan
There is no IRS form used to adopt an accountable plan. The law does not even require that an accountable plan be in writing. However, formalities count when it comes to accountable plans. It’s wise to put the terms of the plan in writing (e.g., the type of expenses the can be reimbursed, a statement that only expenses with a business reason can be reimbursed, and the time frame for advances, substantiation, and returning expense reimbursements). There are some sample plans posted on the Web that can be adapted for a company’s own purposes. Corporations should add the adoption of accountable plans in their minutes.
It is most important to operate an accountable plan in accordance with its terms. Having a requirement to substantiate costs within 60 days is not enough. If there is no substantiation, the plan will fail to be treated as an accountable plan, despite the written plan, and reimbursements will be treated as having been paid under a nonaccountable plan.
Ways to use an accountable plan
Typically, an accountable plan is used for reimbursing employees’ travel and entertainment (T&E) costs. For example, it can be used to reimburse employee driving on business at the IRS standard mileage rate (56 cents per mile in 2014). Employees substantiate their T&E expenses on expense account forms (written, online, or via mobile) and provide receipts where required.
Accountable plans are not limited to T&E expenses. They can be used for other employee costs covered by the company. Some examples include:
- Small tools. If employees are required to use their own tools for work, employers can cover the costs under an accountable plan. Be sure that reimbursements are only for actual expenses. If there is a flat small tool allowance, without regard to reimbursement or correlation to actual costs, this arrangement will fail from a tax perspective. The reimbursements will be taxable and subject to payroll taxes.
- Home office expenses. If employers require employees to work from home, they can reimburse employees for expenses, such as Internet access. Again, the reimbursements must conform to accountable plan rules.
Using an accountable plan is a win-win for employers and employees. But things have to be done right. Find more information about accountable plans from the IRS in Publication 535 and in Revenue Ruling2012-25.