Reimbursing Employees' Expenses

Frequently it happens that employees pay some of your company's expenses out of their own pocket, and then ask you for reimbursement. This is often the case with automobile, travel, or meal and entertainment expenses. How do you treat these expenses for tax purposes?

The answer is that reimbursements made under an "accountable plan" are deductible by your business, and are also excluded from the employee's gross income for payroll tax purposes. If you are a sole proprietor filing Schedule C, you would deduct these reimbursed expenses in the Schedule C categories to which they pertain; for example, reimbursed employee travel expenses would be added to your own travel expenses on Line 24a; reimbursed meals would be reported on Line 24b etc.

However, if the reimbursements are not made under an accountable plan, you must include the reimbursements in the employee's wages on IRS Form W-2. In that case, the employee must generally claim a miscellaneous itemized deduction for the allowable business expenses if he or she wants to get any tax benefits from them. You would treat the reimbursements as part of the employee's compensation. If you are a sole proprietor, you'd include the reimbursements on Line 26 of Schedule C, "wages."

The catch is that you are required to withhold income taxes and employment taxes on reimbursements made, or considered made, under a nonaccountable plan because the reimbursements are included in the employee's taxable wages. You'll also have to pay the employer's portion of the payroll taxes on these amounts.

Clearly, reimbursing under an accountable plan is better for both you and your employees, from a tax perspective. So, what is an accountable plan? A reimbursement arrangement that meets the following three requirements is considered an accountable plan:

• The reimbursements must be for your deductible business expenses that are paid or incurred by an employee in the course of performing services for you.
• The employee must be required to substantiate the amount, time, use, and business purpose of the reimbursed expenses to you. In order to do this, the employee should submit an account book, diary, log, statement of expense, trip sheet, or similar record, supporting each of these elements, that is recorded at or near the time of the expenditure. The records should include any supporting documentary evidence, such as receipts. An employee who receives a mileage allowance is considered to have substantiated the amount of the expenses if the employee substantiates the time, place (or use), and business purpose of the travel.
• The employee must be required to return to you any excess of reimbursements over substantiated expenses within a reasonable period of time.

How long is a "reasonable period?" The IRS will generally accept your plan if the employee is required to provide substantiation within 60 days or return unsubstantiated amounts within 120 days after an expense is paid or incurred. If you furnish your employees with periodic statements (not less frequently than quarterly) of unsubstantiated expenses, amounts substantiated or returned within 120 days of the statement will be considered returned or substantiated within a reasonable time.

You can use a mileage allowance — even one that exceeds the standard mileage rate — and if it is reasonably calculated not to exceed the employee's actual or anticipated expenses, it will be treated as meeting this return requirement even if the employee does not have to return the excess of the allowance over the standard mileage rate.

Is all this recordkeeping worthwhile? The major financial advantage to having an accountable plan is that you are not required to pay the employer's portion of FICA taxes on reimbursements. An important side benefit is that your employees will not have to pay taxes on the amounts, or deduct them on their own tax returns.

In contrast, if you don't meet the requirements for an accountable plan, you will have to withhold income taxes and employment taxes on any reimbursements you make.

While an accountable plan is not required, it could be a real money saver in the long run depending on how many employees you have and the extent to which reimbursement plays a part in your business.