As a result of changes in the treatment of employee business expenses in the Tax Cuts and Jobs Act of 2017 (“TCJA”), some employers may wish to revisit their policies on reimbursement to employees for those expenses. An employer may currently be using what is called a “nonaccountable” plan. By taking the steps to shift to a reimbursement arrangement that would qualify as an accountable plan, the employer may be able to provide a much more tax efficient way to handle these expenses. This might also serve as a means to provide more after-tax income to the employee and be more competitive in the marketplace.
Before TCJA, an employee who incurred unreimbursed business expenses (or received taxable allowances or reimbursements for those expenses) could deduct the expenses on their tax return as an itemized deduction. Under TCJA, those expenses are no longer deductible so the employee would no longer have an offset against the taxable reimbursements. This is very inefficient from a tax standpoint, since if the employer made a reimbursement from an employee reimbursement arrangement called an accountable plan, the reimbursement would not be taxable to the employee and the employer would still get a tax deduction (subject to certain limits on meals & entertainment deductions).
Accountable plan rules
To be an accountable plan, the employer’s reimbursement or allowance arrangement must include the following:
- The employee must have paid or incurred expenses that are deductible while performing services as an employee (“ordinary and necessary” business expenses),
- There must be an accounting with substantiation – date, place, amount, business purpose – to the employer for these expenses within a reasonable time period and
- Any excess reimbursements or allowances must be returned within a reasonable time
The IRS provides a safe harbor for what would be a reasonable time: 60 days for accounting and substantiation; 120 days for returning excess amounts. If a reimbursement arrangement does not meet these conditions, reimbursements will be considered as paid from a nonaccountable plan and should be included in taxable wages.
Examples of expenses that may be made in an accountable plan:
- Mileage for business use of personal automobile
- Travel and lodging for business purposes
- Meals and entertainment (including per diem payments)
- Tools and supplies
- Business related training
- Dues and subscriptions, professional licenses
Restructuring employee compensation when changing to a reimbursement arrangement
Some employers have arrangements whereby their employees are expected to pay for certain business related expenses out of their income, rather than be reimbursed. This may be done for various non-tax reasons such as administrative simplicity, allowing the employee more autonomy in their work, etc. Obviously, there is a financial cost involved for a company to begin reimbursing employee expenses where that has not been the practice.
Employers will need to consider how to incorporate reimbursement arrangements into an overall compensation policy, as a matter of being both fair and competitive. This would likely mean a reduction in the employee’s wages, and it may not be easy to determine what this should be because of the variability in expenses and employee situations. In addition, there are IRS rules designed to prevent an employer from reducing employees’ wages in a manner inconsistent with an accountable plan. This could be the case, for example, where an employer pays an employee the same gross amount regardless of the amount of expenses the employee incurs. The IRS would treat this as though being paid from a non-accountable plan and recharacterized as taxable wages. Thus, it is important to consider the IRS rules before making changes to employee compensation when using an accountable plan.
Because employee W-2 wages may drop in transitioning to a reimbursement arrangement, both the employer and employee will want to consider the indirect effects such as contribution coverage and limits on FICA tax, 401(k) and pension plans, etc.
The discussion above has centered on employees, those receiving W-2 wages. The rules for independent contractors are different and beyond the scope of this article. As with employees, some companies reimburse expenses and others do not. Generally, all amounts paid to an independent contractor are reported as taxable income on a 1099. However, there may be situations where some expenses are accounted for to the company and reimbursed to the contractor – in such case, these amounts are not included on the 1099 and the company paying the reimbursement bears the primary responsibility for maintaining adequate records and any limitation on deductions. To keep it simple, most companies would prefer to include any expense reimbursements to contractors as 1099 income or not reimburse expenses at all.
We Can Help
The rules for an accountable plan can be complex. If you would like assistance in understanding how an employee expense reimbursement arrangement might benefit you – whether an employer or an employee – please contact your Elliott Davis tax advisor.