Expenses 101: Proper Substantiation of Business Expenses

Posted May 22, 2018 by Justworks in Keeping Compliant
Without proper substantiation, business expenses may be treated as taxable income, forcing employees to pay the taxes. It's vital to get it right. Here, we outline some key tips.

In a previous article, Are Expense Reimbursements Taxable Income?, it was noted that expense reimbursements to an employee do not have to be included in an employee's wages if the business has an accountable plan.

An accountable plan must meet three conditions: having a business connection, substantiation, and returning excess amounts. Here, we’ll focus on substantiation.

What is Substantiation?

IRS Publication 15, (Circular E), Employer's Tax Guide, states that the employee must substantiate their 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.

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What Is “a Reasonable Period of Time”?

There are two methods of determining the reasonable period of time for substantiation and returning excess amounts:

  1. Fixed-date method – The expense must be substantiated by the employee within 60 days of being paid or incurred, and the excess amount of any advance must be returned to the employer within 120 days of when the expense was paid or incurred.
  2. Periodic statement method – The employer can issue a periodic statement to the employee detailing amounts that have been paid and not substantiated and require the employee to either substantiate the excess amount or return it to the employer within 120 days of receiving the statement. Periodic statements must occur at least quarterly.

An employer may have a hybrid plan that uses both methods described above. For instance, out-of-pocket expenses and mileage reimbursements may have to be substantiated under the fixed-date method. But the employer may use the periodic statement method for substantiating company credit card charges.

In addition, an employer may issue a statement to an employee for business expenses that have been submitted for reimbursement, but will not be reimbursed until proper substantiation is provided.

Related Article: What Is Employee Expense Reimbursement and How Does It Work?

How Can an Employee Prove Their Business Expenses Are Valid?

IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses, provides detailed information on how employees can prove expenses. Proof of an expense includes the following three items:

  • Adequate records
  • Sufficient evidence
  • Written record

Adequate records are defined by Publication 463 on page 25: “You should keep the proof you need in an account book, diary, log, statement of expense, trip sheets, or similar record. You should also keep documentary evidence that, together with your record, will support each element of an expense.”

Before submitting expenses for reimbursement, an employee should create a written record.

Records of expenses do not have to be in any particular format, but it must be in a form that allows the employee to keep a detailed record of the amount, time, place, and business purpose of the expense. The format used must also enable an employee the ability to document business meals that take place within the employee's tax home and meals provided for others when away from their tax home.

To substantiate these expenses, the employee must record the following information in their record:

  • The names of the individuals in attendance
  • The business purpose of the meeting
  • The date and place of the business meeting

The best sufficient evidence is documentary evidence that supports the employee's expenses. This may include receipts, canceled checks, or bills. Documentary evidence, however, is deemed adequate only if it shows the amount, date, place, and essential character of the expense.

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In most cases, the IRS requires documentary evidence for travel expenses only if the expense is greater than $75. However, there are exceptions, especially lodging expenses. Since lodging bills may contain other expenses in addition to room charges (such as meals, telephone calls, laundry, Internet access, and video rentals), a hotel or motel must provide an itemized bill. Personal expenses (such as video rentals) should not be included or reimbursed.

Before submitting expenses for reimbursement, an employee should create a written record. This is a record that provides detailed proof of the employee's expenses.

Why Business Expense Substantiation Is Vital

Businesses often require their employees to incur expenses that will later be reimbursed by the business. Without proper substantiation, expense reimbursements may be treated as taxable income, resulting in the employee having to bear the cost of the taxes on the income.

In some cases, however, there are some expenses that require less substantiation. These can be referred to as Safe Harbor expense allowances. Stay tuned to learn more about these.

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.