It seems simple enough — an employee pays for a business expense out of pocket, and the employer reimburses the employee. But, there are some complications involved, such as compliance issues and how to report the reimbursements on taxes.
While expense reimbursement is only required if it is stipulated in an employment contract or if the business expenses bring the employee’s wages below minimum wage, most businesses reimburse work-related expenses incurred by employees as a job perk. Be aware, however, that some states have their own laws surrounding expense reimbursement. Illinois, for example, requires employers to reimburse employees for all “necessary expenditures … incurred by the employee within the employee’s scope of employment and directly related to services performed by the employer.”
Whether or not you pay taxes on expense reimbursements depends on whether you use an accountable plan or nonaccountable plan. Work with a Professional Employer Organization such as Resourcing Edge to ensure compliance with applicable laws and develop an accountable expense plan to help maximize tax benefits.
What is an employee expense reimbursement?
When an employee spends his or her own money on “ordinary and necessary” business expenses, a reimbursement or allowance arrangement is the system used to pay them back. Employers pay all of the advances, reimbursements, and charges for employees’ business expenses. Reimbursements are most common when employees travel for work. They will need to be reimbursed for meals, gas, lodging, entertaining clients, and more.
It’s important to know which business expenses are valid or not, and to separate business expenses from personal expenses, capital expenses, and expenses to figure the cost of goods sold. See IRS Publication 535 to learn more about business expenses.
Common business expenses that can be reimbursed include:
- Gas/mileage for business use
- Travel and lodging
- Meals and entertainment
- Tools and supplies
- Training and development
- Dues and subscriptions, professional licenses
Are expense reimbursements taxable?
Usually, when you pay an employee, you will need to withhold and contribute taxes on the payment, but what about reimbursements? It depends on what plan you use: accountable or nonaccountable. The IRS has different reporting requirements depending on whether you have an accountable or nonaccountable plan.
If you haven’t revisited your employee expense reimbursement policies recently, some business expenses may no longer qualify for an accountable plan. As a result of the Tax Cuts and Jobs Act of 2017, you can no longer reimburse employees’ moving expenses. According to the IRS, employees must now include moving expense reimbursements in employees’ wages, except for certain members of the Armed Forces.
Businesses should re-examine their reimbursement and allowance policies in light of the new Tax Cut and Jobs Act, effective for 2018 through 2025 tax years.
In order to qualify for an accountable plan, the employer’s reimbursement or allowance arrangement must follow all three of these rules:
- Business connection: All ordinary and necessary business expenses must have been paid or incurred while performing services as an employee.
- Substantiate expenses: There must be accounting with substantiation (date, place, amount, purpose) made within a reasonable period of time (60 days).
- Return unsubstantiated amounts: Any excess reimbursements or allowances must be returned within a reasonable time (120 days).
Since accountable plan amounts aren’t considered wages, they aren’t subject to income, social security, Medicare, and FUTA taxes. They are deductible by the employer as business expenses.
If any of these conditions are not met, the reimbursements are treated as paid under a nonaccountable plan, which are considered wages, treated as supplemental wages subject to income, social security, Medicare, and FUTA taxes. They are reported on the employee’s Form W-2 and deductible by the employer as employee compensation.
Under a nonaccountable plan, any reimbursement or other allowance arrangement is treated as supplemental wages and subject to taxes. Your payments are regarded as nonaccountable if:
- The employee fails to properly substantiate expenses in a reasonable amount of time.
- The employee fails to return excess reimbursements or allowances in a reasonable amount of time.
- The employer advances or pays an amount to an employee regardless of whether they expect the employee to have business expenses.
- The reimbursement would have otherwise been paid as wages.
See IRS Publication 15 for more details.
Expense Reimbursement for Independent Contractors
There are different expense reimbursement rules for independent contractors, who are paid via Form 1099. Most businesses prefer to include reimbursement amounts in the 1099 income rather than go through reimbursing expenses. The contractor can then deduct business expenses on their own tax return.
Creating an Accountable Expense Reimbursement Policy for the Employee Handbook
Work with the HR experts at Resourcing Edge to help you create accountable reimbursement policies and add them to the employee handbook.
The expense reimbursement policy should include the following:
- A reasonable time period for employees to submit expenses. Some reimbursement laws require employees to submit reimbursable expenses within 30 days of incurring the expense.
- The process for requesting reimbursement.
- The process for submitting work-related expenses, including substantiation requirements.
- The process for returning excess reimbursements or allowances.
- The types of expenses that are reimbursable.
- The maximum allowable amount for certain expenses.
- Preferred suppliers for reduced expenses.
Employees should have a clear and consistent understanding of the proper procedure for business expense reimbursement. If an employee fails to properly substantiate expenses and follow procedure, any expense reimbursements could become taxable income. Keep in mind that if one employee fails to meet the requirements of the accountable plan, this does not disqualify other reimbursements that meet the requirements. The IRS determines reimbursements on an employee-by-employee basis.
For more information on accountable plans, see IRS Publication 463.
With a clearly written accountable plan document, none of your reimbursements should count as taxable income. Of course, there should also be some sort of internal oversight to make sure all reimbursements are properly received, reported, and maintained.
To create a detailed reimbursement procedures guide, team up with Resourcing Edge. Rely on us for all your payroll, HR, benefits, and compliance needs.