fringe benefits

The Right Way and The Wrong Way to Reimburse Employees

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When a business reimburses an employee for incurring business expenses, there is a right way and a wrong way to do so.  The right way is through what is known as an accountable plan.  The wrong way is through…wait for it…a nonaccountable plan.

The Wrong Way

If the employer has a nonaccountable plan, when the employer reimburses an employee for business expenses the employer takes a deduction in the amount of the reimbursements.  The deduction is treated as a compensation deduction and the reimbursement is included in the employee’s income.  Payroll taxes on this amount are due.  If the employee has substantiation for the expenses, she can deduct them as an itemized deduction on her personal tax return.  These expenses are reported on Form 2106, and are subject to the 2% of AGI floor.  Additionally, if the employee had meal expenses, she can only deduct 50% of them.

Example:  JoJo Corp employs John and JoJo Corp does not have an accountable plan.  John incurs business expenses of $1,000 for travel and supplies and $500 for meals.  JoJo Corp reimburses $1,500 of John’s expenses.  JoJo Corp takes a $1,500 deduction (JoJo Corp’s deduction for meals is not reduced by 50%).  JoJo Corp pays FICA, FUTA, and state unemployment tax on this $1,500 compensation deduction.  John’s W-2 is increased by the $1,500 reimbursement.  John will also pay his share of FICA tax.  John can take an itemized deduction for $1,000 of the travel and supplies expenses and an itemized deduction of $250 for the deductible 50% of meal expenses.  However, these expenses are reduced by 2% of Jon’s AGI.  If John has AGI of $100,000, the $1,250 deduction is reduced by $2,000 (2% of $100,000 AGI).  Since the deductions are less than 2% of AGI, John cannot take a deduction.

The Right Way

If the employer has an accountable plan, expense reimbursements are deductible by the employer as business expenses rather than as compensation.  The 50% meal limitation now applies to the employer.  The reimbursements are excluded from the employee’s income and are exempt from payroll tax.

Example:  Same facts as above, except JoJo Corp has an accountable plan.  JoJo Corp will have a business deduction of $1,250 ($1,000 for travel and supplies plus 50% of the $500 meal expense).  John will not have to report the amount of the reimbursement as income.  Neither JoJo Corp nor John will owe any payroll taxes on the reimbursement.  Since JoJo Corp takes the deduction for the business expenses, the 2% of AGI floor is irrelevant.

There are three requirements of an accountable plan:

PROVING A BUSINESS CONNECTION

The plan pays reimbursement and allowances only for otherwise deductible business expenses (such as travel, lodging, or meal expenses)

MAINTAINING ADEQUATE SUBSTANTIATION

The employee accounts for the business expenses by submitting to the company a detailed written record substantiating the expense’s time, place, amount, and business purpose.

REQUIRING EMPLOYEES TO RETURN EXCESS ADVANCES

This mainly applies when an employer advances funds to the employee to pay business expenses.  Advances in excess of business expenses must be returned to the employer.

A few years back, the IRS had an audit initiative focused on executive compensation, fringe benefits, and employee reimbursement plans.  IRS found a great deal of noncompliance and, in future audits will spend more time auditing these items.  It is very important to properly comply with the three requirements of accountable plans if you want to take advantage of the benefits they offer.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

Getting Schooled—Providing Employee Educational Assistance

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There are two primary methods for business owners to provide tax-free educational assistance to themselves and to their employees.  The methods are:

  • Working Condition Fringe Benefit
  • Section 127 Plan

Working Condition Fringe Benefit

Educational expenses paid under this method are deductible by the employer and are tax free to the employee.  The educational expenses are also excluded from payroll taxes such as FICA and FUTA.  There is no limit on the amount of educational expenses that qualify; however, the educational expenses must be ordinary and necessary business expenses.

To qualify as a working condition fringe benefit, the educational program must relate to maintaining or improving the skills required by the employee’s job.  The education itself must NOT lead to the student qualifying for a new trade or business.  Education required to meet the minimum skill level required for the job does NOT qualify.  Job related education may be furnished directly by the employer or through a third party such as an educational institution or seminar organization.  The educational expenses of the business owner also qualify.

Example:  ABC Corp employees Joan as an engineer.  Joan is climbing the corporate ladder and believes an MBA will help her develop management skills to help her advance her career.  ABC Corp pays for her MBA.  Since the MBA will improve her skills, the educational expenses paid by ABC Corp will not be taxable to her.  In addition, ABC Corp can take a deduction for the educational expenses.

Example 2: John is a law student working in a law firm as a legal assistant.  The law firm offers to pay John’s law school tuition.  These expenses will NOT qualify as a working condition fringe benefit because the law degree is required for John to meet the minimum requirements for his job as an attorney.  However, the tuition may qualify for exclusion as a Section 127 plan.

Section 127 Plan

A Section 127 plan is a qualified education assistance program.  The first $5,250 of qualified educational assistance provided during the year is exempt from tax, including FICA and FUTA.

To qualify under Section 127, a plan is required.  The plan must:

  • Be in writing
  • Provide educational assistance exclusively to employees (possibly including owners)
  • Not provide employees with a choice of education assistance and taxable compensation
  • Provide reasonable notice of the availability and terms of the program
  • Not discriminate in favor of highly compensated employees or their dependents
  • Not pay more than 5% of the benefits to more-than-5% owners or their spouses or dependents

Children of owners can participate in a Section 127 plan if they are at least 21 years of age, are legitimate employees, are not more than 5% owners, and are not dependents of the owner.  Children under age 21 can still participate in Section 127 plans, but their educational expenses are subject to the nondiscrimination rules (which could disqualify the plan).

Example:  ABC Corp is owned by John.  ABC Corp has three employees—Adam (John’s son) and two unrelated employees.  All employees are 22 years old.  John does not claim Adam as a dependent.  ABC Corp pays $5,000 towards each employee’s tuition.  Since Adam is at least 21 years old, is a legitimate employee, is not a dependent, and is not a more-than-5% owner, the tuition paid on his behalf is not counted as being for a highly compensated employee or a more than 5% owner.  All employees may exclude the $5,000 tuition payment from their incomes.

Example 2:  Same facts as above except that Adam (John’s son) is 20 years old.  Since Adam is under age 21, he is attributed ownership from his father (i.e., Adam is considered a 100% owner).  Since 33% of the benefits ($5,000 tuition for Adam divided by $15,000 total tuition paid) are paid for a more-than-5% owner, EACH employee must report the $5,000 tuition payment as income.

Key Difference between a Working Condition Fringe Benefit and Section 127 Plans:

  • A $5,250 cap applies to Section 127 Plans, but not working condition fringe benefits
    • If over $5,250 is spent on educational expenses under a Section 127 plan, the excess may qualify as a working condition fringe benefit
  • The cost of travel, meals, and lodging may qualify as a working condition fringe benefit but not under a Section 127 plan
  • The working condition fringe benefit is not subject to nondiscrimination rules
  • The limitation on expenses that qualify a student for a new job or to meet minimum eligibility requirements will not qualify as a working condition fringe benefit, but may qualify under a Section 127 plan.

These rules are fairly complex.  If you need help navigating through these rules, give us a call and we’ll be happy to help.

 

If you found this article informative, subscribe to our Tax Newsletter.

 

 Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

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