Posted on January 27th, 2014

ACCOUNTABLE EMPLOYEE REIMBURSEMENT PLANS

The tax treatment of an employee reimbursement plan varies dramatically, depending on whether the plan qualifies as an “accountable” reimbursement plan. Typically, reimbursements paid under accountable plans are not subject to income taxation or employment taxes. In contrast, reimbursements from non-accountable plans are included in the gross income of the employee and are classified as “wages” subject to FICA taxation. Hence there is a high motivation to have an accountable plan. Moreover, the corresponding expenses in a non-accountable plan are deductible only as miscellaneous itemized deductions on the employee’s income tax return and subject to a reduction when itemized.

Given this stark contrast of tax consequences, the IRS has worked to distinguish the legitimate accountable employee reimbursement plans from the “wage re-characterization” schemes that seek to obtain favorable tax treatment by masquerading as employee reimbursement plans

The regulations define “accountable plans” as arrangements that require three things: the “business connection” test, the “substantiation” test, and the “returning amounts in excess of expenses” test. Depending on the situation, the consequences of failing to comply completely with all of these requirements can range from the mild (e.g., treating an individual payment to an employee as being from a separate, non-accountable plan to the draconian (i.e., causing the entire arrangement to be classified as a non-accountable plan. Thus, it is imperative that employee reimbursement plans satisfy all three requirements. The “substantiation” and “returning excess amounts” requirements are more concrete and have been the subject of much administrative guidance.

The business connection test

The “business connection” test limits “accountable plan” status to those arrangements that provide advances, allowances, or reimbursements only for business expenses that are deductible and that are paid or incurred by the employee in the performance of services for his or her employer. 

Reimbursement, not ‘wage recharacterization.’

Implicit in the business connection test is the notion that the employee is merely a conduit through which the employer pays expenses of the business. The ultimate economic burden of these business expenses is borne by the employer, and, from an economic perspective, the employee is in the same position before and after the transaction is complete. This is true whether the employee pays the expense using the employer’s money obtained ahead of time in the form of an advance or allowance (and returning any excess funds), or whether the employee pays the expense first and is later reimbursed by the employer.

Deductible business expenses paid or incurred by an employee.

As previously mentioned, the regulations explicitly limit “accountable plan” treatment to advances, allowances, and reimbursements for expenses that are deductible. Although not obvious, the first line of inquiry is whether a plan permits the reimbursement for items other than those properly classified as “expenses.” Next, in the case of reimbursement arrangements, the expense must be “paid or incurred,” by the employee receiving the reimbursement. For plans that provide an advance or allowance to the employee, the payment must be for deductible expenses that the employee is “reasonably expected to incur.” Deductible expenses.  However, what about plans that reimburse employees, not only for deductible business expenses, but also for bona fide business expenses that are not deductible or are deductible under some other provision of the Code? To answer this question, the regulations provide the example of an employee who is reimbursed for bona fide business travel expenses incurred while the employee was not away from home overnight. Rather than cause the entire plan to fail, the regulations treat the arrangement as being two separate reimbursement plans. Payments in reimbursement of expenses that are deductible retain their status as reimbursements from an accountable plan, and the reimbursement of nondeductible expenses is treated as being paid under a separate, non-accountable reimbursement plan.

In connection with the performance of services as an employee.

The final element of the business connection test requires the recipient of the reimbursement to be an employee. More to the point, the reimbursement must be for an expense paid or incurred by the employee while serving the business interests of the employer paying the reimbursement.

Tax planning opportunities

Given all of the pitfalls outlined by, is it possible for an existing business to establish a reimbursement plan that satisfies the accountable reimbursement plan’s business connection test? The employer, could, prospectively revise the company’s compensation structure, reducing the wages of all its employees and introducing a reimbursement arrangement. To obtain a reimbursement, the employee must substantiate the actual amount of deductible cleaning supplies that were purchased for use in cleaning the homes of the employer’s clients. Reimbursements for substantiated expenses are paid in addition to the hourly wage earned. Employees who do not incur additional expenses or who fail to substantiate the expenses incurred, receive only their wages calculated at the new lower hourly rate. The employer reports all hourly wages as compensation on the Forms W-2 of the employees. All reimbursements paid for substantiated employee business expenses are excluded from wages for both income tax and employment tax purposes.

Conclusion

The pitfalls to be avoided include implementing a reimbursement plan that (1) temporarily reduces the wages of employees receiving business expense reimbursements, (2) pays higher wages to employees who do not receive reimbursements and lower wages to those who do receive reimbursements, and (3) routinely pays “reimbursements” to employees who do not pay or incur business expenses on behalf of the employer. Conversely, to ensure that the “business connection” test is satisfied when instituting an employee reimbursement plan, reminds employers (1) to apply any changes to wage rates in a uniform manner and (2) to reimburse only those employees who actually incur business expenses and substantiate them to the reimbursing employer

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