Employees are typically reimbursed for business expenses that are ordinary and necessary. Generally, ordinary expenses are considered as common in a line of business where necessary expenses are helpful to conducting business. Examples include expenses related to business travel, meals and entertainment, lodging, mileage, tools and supplies, professional dues and education. The employer must be able to deduct the expenses on its income tax return for them to be valid business expenses.
The tax treatment of reimbursed and unreimbursed employee business expenses depends on whether the employer uses an accountable or non-accountable plan. Employers and employees should understand the tax consequences of both types of plans and when employee expenses are included in taxable income.
To qualify as an accountable plan, the IRS requires:
- A valid business connection for all reimbursed employee expenses
- Employees to substantiate business expenses in a timely manner by submitting documentation such as an expense report, travel log or receipts
- Employees to return reimbursements that exceed substantiated expenses to the employer
If the employer does not require employees to substantiate business expenses or return reimbursements that are more than the expenses incurred, the IRS considers the arrangement a non-accountable plan.
Tax Consequences to Consider
Employee expense reimbursements under an accountable plan are generally not included in taxable income and therefore there are no tax consequences. Even so, if the employer incorrectly reports all or part of the expense reimbursements under an accountable plan as income to the employee, both the employer and employee will overpay payroll withholding taxes. In this case, the employee should ask for a corrected Form W-2. If the employer does not provide one, the employee is entitled to an above-the-line deduction in the amount of the reported income and can also file a Claim for Refund and Request Abatement (Form 843) for the additional FICA taxes paid.
If an employee’s actual expenses under an accountable plan are more than the amount reimbursed by the employer, the employee can report the difference as Unreimbursed Employee Business Expenses (Form 2106) and take an itemized deduction subject to the 2% of adjusted gross income (AGI) limitation.
Under a non-accountable plan, reimbursed employee expenses are considered taxable income and reported on the employee’s W-2. The tax consequences include:
- Paying taxes at a higher tax rate if the reported income is more than the threshold of the employee’s current tax bracket.
- Increasing the employee’s federal and state tax obligation.
- Subjecting both the employee and employer to paying higher employment taxes (withholding taxes, FICA, and federal and state unemployment taxes).
The employee may be able to take an itemized deduction on their personal income tax return if they are reimbursed more than they spent. For example, if the employee is reimbursed $75 per day but only spent $50, the $25 difference can be deducted (less the 50% meal and entertainment disallowance). In this case, $12.50 per day times the number of days traveling on business would be included on Schedule A as a miscellaneous itemized deduction (subject to the 2% of adjusted gross income (AGI) limitation).
Depending on the employee’s individual tax situation, expenses may or may not be deductible as itemized deductions.
Per Diems Exception
An employer may provide per diems or monthly allowances to employees for travel-related expenses. In certain situations, per diems may be considered as an accountable plan, even if documentation is not required for the amount reimbursed. The employee must substantiate the time, place and business purposes related to the expenses.
If per diems are usually higher than expenses, they would be considered a non-accountable plan if the difference is not repaid or treated as income. In this case, all per diems are treated as employee compensation subject to employment tax.
Employers should consider the advantages and disadvantages to each type of plan when deciding how to structure the reimbursement of employee business expenses. If you have any questions or want to discuss your situation, contact a member of the LaPorte tax team. We are always happy to help.