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