Unless you want to give money away to the IRS, expense reimbursements shouldn’t be taxed. When employees pay for expenses out of their pocket, they use their taxed income and so taxing the reimbursements for those expenses is like double taxing that money. You don’t want to do that. Your employees definitely don’t want you to do that.
Some employers that offer an expense allowance or reimburse expenses on employees’ paychecks, lump that reimbursement amount into an employee’s taxable income, figuring in social security, Medicare, and FUTA taxes. Employers might think that it’s easier to do this than to keep reimbursements separate but, for one thing, it’s really not all that complicated to break it up, and two, it’s a waste of everyone’s hard earned cash.
Reimbursing Employees, Un-taxed
In order to give employees reimbursements as non-taxable wages, there are a few simple rules that everyone needs to follow. The IRS calls this an accountable plan, as described on page 15 of the IRS’s Employer’s tax guide.
Having an accountable plan in place, just means that three simple rules are communicated to employees and are followed by employees.
- Deductible expenses
- Return excess
Deductible expenses – First, the expenses incurred must be deductible to begin with. Deductible expenses are things like car rental, hotel, and meals for a business trip and not things like admission to the museum, the ferry out to Alcatraz, and the like. If employers choose to reimburse employees for all the fun they have on business trips, most of those expenses wouldn’t fall under the accountable plan and would need to be reimbursed as taxable wages. Again, this isn’t so complicated. Business owners generally know what is deductible and what is not. They just need to communicate this to employees in their written plan.
Substantiated – Second, employees must submit receipts and other necessary substantiation. The need to submit receipts is pretty obvious. What employer is going to reimburse based on verbal claims that an employee spent some money for the company. What might not be so obvious is that employees also need to submit record of how those expenses were related to the business. So, yes, dinner can be deductible but only when it is related to business. For an expense to properly fall under the accountable plan, it is the employee’s job to substantiate the claim with not only a receipt but documentation of the work purpose. In order for the IRS to accept the reimbursements as non-taxable wages, there needs to be adequate substantiation.
Excess Returned – This last rule doesn’t apply to everyone since not everyone uses an allowance. If an expense allowance is offered for mileage or other expenses, then employees need to keep track of how much is spent and then give the employer back any excess. So for example, if the employer gives an employee a $100 monthly mileage allowance and the employee only drives 100 miles that month, the employee would need to return the excess 46 dollars (based on the 54 cent per mileage reimbursement rate).
Creating an accountable plan or expense policy is not difficult. Sketching one up involves laying out the rules above as well as the specific expenses that your business allows for its different employees.
Expenses Considered Taxable Income
There are a few cases in which an employer might reimburse expenses as taxable wages.
- No accountable plan
- Not substantiated
- Not submitted within a reasonable amount of time.
If an employer does not have an accountable plan, i.e. they haven’t presented these rules to employees and employees are not submitting receipts for valid deductible expenses, then any reimbursements made by the employer must be paid as wages.
Likewise, if an employer does have an accountable plan but employees don’t either substantiate their expenses or don’t submit them within a reasonable amount of time, the expenses could also be considered taxable wages.
A lot of employees who get reimbursed in this way on their regular paycheck wonder if it’s legal. It is perfectly legal; it’s just not all that smart.