Accountable Expense Reimbursement Plans

Most companies cover their employees’ business expenses by reimbursing them for their actual expenses or by paying a travel or mileage allowance. Such arrangements are subject to strict tax rules concerning what qualifies as a legitimate reimbursement arrangement and what is treated (at least for tax purposes) as additional compensation to the employee.

According to the tax rules, the key distinction between a true expense reimbursement and disguised compensation is whether the employer’s payments are made in accordance with what the IRS calls an “accountable plan.” (Such a plan basically requires employees to substantiate all reimbursed expenses and return any advances in excess of expenses incurred.)

If an employer has an accountable plan in place, expense reimbursements and allowances to employees who properly comply with the terms of the plan are deductible by the company (subject to the 50% limit for most meals and entertainment expenses) and nontaxable to the employees. If a company maintains a nonaccountable plan or an employee fails to comply with the company’s accountable plan, expense reimbursements and allowances are still deductible by the company. However, they are taxable to the employee as compensation. Thus, such amounts are included on the employee’s Form W-2 and subject to income tax withholding. In addition, both the employer and employee are subject to employment taxes on such payments. Although the employee is allowed an offsetting deduction for the expenses incurred, the deduction is claimed as a miscellaneous itemized deduction and thus normally provides little or no tax benefit.

Because the tax ramifications of a nonaccountable expense reimbursement arrangement are so unfavorable for employees and are potentially unfavorable for the employer, companies generally should use an accountable plan for employee expense reimbursements.

How to Operate an Accountable Plan

An accountable plan must meet the following four basic requirements, according to Reg. 1.62-2:

1. Business Connection Requirement. The plan must provide reimbursements or allowances only for business expenses that are paid or incurred by an employee in connection with the performance of services for the employer (such as expenses for business travel and expenses for lodging, meals, and incidentals incurred while away from home overnight on the employer’s business). The reimbursements or allowances must be clearly identified as such when the employee is paid. For example, this can be done by paying with separate checks or by noting amounts treated as expense reimbursements or allowances on the employee’s check stub when wages and reimbursements or allowances are paid together.

2. Substantiation Requirement. The plan must require substantiation of the employee’s expenses via an expense report, diary, log, trip sheet, or similar record that identifies the specific nature of each expense so that the employer can conclude whether it is a legitimate business expense. In addition, other documentary evidence, typically a receipt, is required for each expense item that exceeds $75. For lodging expense, a receipt is required regardless of the amount. (Temp. Reg. 1.274-5T for the general substantiation rules that apply to business travel and entertainment expenses.)

Rather than reimbursing employees for actual expense amounts, an accountable plan can instead pay predetermined mileage and per diem travel allowances that do not exceed the allowances paid to federal employees [Reg. 1.62-2d(d)(1) and (f)(2)]. Under this alternative, actual expense amounts need not be substantiated. However, other elements of the expenses still must be substantiated under the normal rules. The obvious advantage of using predetermined allowances is it avoids the hassle of collecting and maintaining batches of receipts. The maximum 2007 allowance for use of an employee’s personal car on business is 48.5 cents per mile per Rev. Proc. 2006-49. The maximum 2007 per diem travel allowances for out-of-town meals, lodging, and incidentals are listed in IRS Publication 1542 (available on the Internet at www.irs.gov). If all the accountable plan rules are met, but the allowance paid under the plan exceeds the federal limit, the amount over the limit is treated as a taxable wage payment (i.e., that amount is deductible by the employer but subject to federal income and employment taxes). [Reg. 1.62-2(h)(2)(i)(B).]

3. Requirement to Return Excess Payments. An accountable plan must require employees to return reimbursements or advances that exceed actual substantiated business expense amounts. Under an exception, the accountable plan rules do not require employees to return mileage or per diem travel allowances that exceed actual expenses. In other words, employees can “keep the change” under a mileage or per diem travel allowance arrangement without violating the accountable plan rules. (As mentioned earlier, the other elements of the expenses still must be substantiated under the normal rules.) As explained in requirement 2 unreturned mileage or per diem travel allowances that exceed the federal limits must be treated as taxable wages.

4. Reasonable Time Requirement. Last, but not least, the proper substantiation of expenses and the return of excess payments must occur within a “reasonable” period of time in order for an expense reimbursement or allowance arrangement to qualify as an accountable plan. The general rule is that the meaning of “reasonable” depends on the facts and circumstances. For example, it’s reasonable to give an employee more time to substantiate expenses incurred during a long overseas business trip than for a two-day jaunt to a nearby city.

To provide some certainty to employers, Reg. 1.62-2(g) also supplies two safe-harbor methods to meet the timeliness requirement. Under the fixed-date method, a plan meets the timeliness requirement if it stipulates that—(a) an expense advance or allowance cannot be paid more than 30 days before the employee pays or incurs the related expense, (b) the expense must be substantiated within 60 days after it is paid or incurred, and (c) excess amounts must be returned to the employer within 120 days. Under the alternative periodic statement safe-habor method, a plan meets the timeliness requirement if it—(a) gives employees statements (no less frequently than quarterly) detailing the amounts of advances or allowances that have not yet been substantiated and (b) requests that such amounts either be substantiated or returned to the employer within 120 days after the statements are issued. There are no formal procedures for adopting these safe-harbor methods. They are simply adopted by practice. However, an employer cannot use either of the safe-harbor methods if it follows a pattern of paying excess reimbursements or allowances without treating such excess amounts as taxable wages.

Warning: The accountable plan rules are an all-or-nothing proposition. To the extent employee expense reimbursements or allowances qualify as having been paid under an accountable plan, the payments are tax-free. Otherwise, the payments are taxable wages. The IRS drove this important point home, much to an employer’s dismay in Rev. Rul. 2006-56.