Every business incurs costs and expenses that reduce the business's taxable income. Sometimes, these expenses may be incurred by employees during the course of business.
A common practice is to reimburse such expenses, but the question then arises: Are these expense reimbursements taxable income to the employee?
Page 15 of IRS Publication 15, (Circular E), Employer's Tax Guide, states that expense reimbursements do not have to be included in an employee's wages if the business has an “accountable” plan.
Your Employee Expense Reimbursement Guide
Building an expense plan will save employers time, confusion, and stress.
In order to be an accountable plan, an expense reimbursement plan or advance payment program must meet the following three conditions:
- Business connection: The expense must have been incurred in the performance of services as an employee of the employer.
- Substantiation: The employee must substantiate his business expenses by providing the employer with evidence of the amount, time, place, and business purpose of the expense within a reasonable period of time after they are paid or incurred.
- Returning excess amounts: Amounts paid by the employer to the employee that exceed amounts spent by the employee must be returned to the employer within a reasonable period of time.
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Valid Business Expenses Incurred by Employees
In order for an employee expense to be a valid business expense, it must be an expense that the business can deduct on its income tax returns.
IRS Publication 535, Business Expenses, states the following: “To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”
What are some of the ordinary and necessary expenses that an employee might incur that would require reimbursement by his employer? The most common are supplies, travel, meals, entertainment, and gifts.
Supplies that an employee may purchase can be reimbursed at cost, but there are special rules and restrictions on the other categories mentioned. The rules for these categories are discussed in IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses.
Why does your business need an accountable expense plan?
The most important concept that Publication 463 discusses is the “tax home.” The publication states: “Generally, your tax home is your regular place of business or post of duty, regardless of where you maintain your family home. It includes the entire city or general area in which your business or work is located.”
The cost of transportation (other than in a personal vehicle), lodging, meals, and entertainment that meet the criteria outlined in Publication 463, and that take place away from the employee's tax home, are reimbursable expenses. Even though meals and entertainment can only be deducted by the employer at 50% of the cost, the employee may be reimbursed 100%.
Many employers will reimburse an employee who uses his personal vehicle for business at a standard mileage rate. The standard mileage rate is set by the IRS each year. (The standard federal mileage rate for business in 2014 is 56 cents per mile.)
Meals & Entertainment
Meal and entertainment costs that are incurred within the employee's tax home are reimbursable only if the meal or entertainment can be shown to have a clear business purpose.
Gifts to others, such as clients, are deductible only up to a total of $25, so an employee who incurs the cost of a gift can only be reimbursed up to $25 for the expense.
Can Reimbursed Business Expenses Become Taxable Wages?
If an employer does not have an accountable plan in place, then IRS Publication 15 states: “Payments to your employee for travel and other necessary expenses of your business under a nonaccountable plan are wages and are treated as supplemental wages and subject to the withholding and payment of income, social security, Medicare, and FUTA taxes.”
So even if the expenses are ordinary and necessary, if the employer does not have an accountable plan, then any reimbursements are taxable income. Consider building a plan; doing so will likely save your employers time, confusion and stress. We share how on our blog.
On the other hand, if the employer has an accountable plan, but the employee fails to properly substantiate the expenses within a reasonable time, or the employee fails to return excess advance payments, then any reimbursements could become taxable income.
In addition, if any expenses are paid in excess of IRS limitations, then the excess is taxable income. For instance, if an employer reimburses an employee for mileage at more than the standard mileage rate, then the excess is taxable income.
Complying with the IRS’ Rules for Expense Reimbursements
Employees should only have to pay income taxes on the wages they earn and certain taxable fringe benefits. Expenses incurred by employees in the course of business should be costs incurred by the employer, not by its employees.
If the employer establishes a written accountable plan, and the employees submit properly documented expenses under that plan, then the reimbursements are not taxable income.
However, a key to maintaining any accountable plan is to properly substantiate expenses, and that is the subject of the next article: Proper Substantiation of Business Expenses.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.