It doesn't matter if a business is big or small; all businesses incur costs and expenses to reduce the business's taxable income. Sometimes employees, and not just employers, pay for the business expenses. This is where expense reimbursement comes in.
Keep in mind that some states, such as California and Illinois, require employers to reimburse employees for reasonable work-related costs. Make sure you understand and follow the applicable laws in the states where you work.
What is the work-related expense reimbursement?
The expense reimbursement process allows employers to reimburse employees who incurred work-related costs. When employees are reimbursed for their expenses, they are normally not required to report these payments as wages or income.
These types of reimbursable expenses tend to occur when employees travel for work but may be associated with other activities related to their job, including, for example, certain purchases of work-related goods or tools.
Most businesses reimburse these expenses, but are business expense reimbursements taxable to the employee?
The tax guide for employers states that claims should not be included in an employee's salary if the company has an accountable plan.
What is an accountable plan for reimbursement plan?
An accountable plan is a plan whereby grants or reimbursements paid to employees for professional expenses are not recorded as income and are not subject to withholding tax.
Although not required by the IRS, accountable plans help determine criteria that meet IRS regulations under which refunds are deductible and considered taxable income.
An employee accountable expense plan acts as a barrier to avoiding paying employer reimbursement taxes.
Qualified Employee Expenses reimbursements
To have an accountable plan, a reimbursement policy, or prepayment program, the following three conditions must be met:
Business connection: The costs must be borne to provide services as an employee of the employer.
Substantiation: The employee must justify his work-related cost by providing the employer with proof of the amount, time, place, and business purpose of the expenses. The employee must also submit business expenses within a reasonable time after they occur.
Reimbursement of excess amounts: If an amount paid by the employer to the employee exceeds the amount spent by the employee, the employee must return the excess amount to the employer within a reasonable time.
What counts as work-related expenses?
When an employer reimburses an employee under an accountable plan, the reimbursement will not be considered the employee's salary or income. Often, the employer will be able to deduct these reimbursements, but the deduction amount may be limited.
According to the IRS, "to be deductible, a business expense must be common and necessary. An ordinary expense is a common and accepted expense in your industry. A necessary expense is a useful and appropriate expense for your business or trade. An expense does not have to be essential to be considered necessary. "
What are some examples of ordinary and necessary expenses that would require reimbursement from the employer? The most common are consumables related to work, travel, meals, and entertainment.
Consumables for business
Goods purchased by an employee for business purposes may be reimbursed at cost, provided they are reimbursed on an accountable plan.
Travel costs
Work-related travel expenses, including transportation, lodging, meals, and entertainment that meet the criteria outlined in IRS Publication 463, are generally reimbursable expenses.
Many employers reimburse an employee who uses their personal business vehicle at a standard mileage rate. This usually does not include travel expenses between the employee's home and place of work. The IRS sets the standard mileage rate each year. (The standard federal mileage rate for businesses in 2021 is 56 cents per mile.)
Meals and entertainment
Meal and entertainment expenses incurred at the employee's tax address are only reimbursable if the meal or entertainment has a clear business purpose.
Although previously the employer could deduct meals and entertainment at only 50% of the cost, the Taxpayer Safety and Disaster Act of 2020 allows a full deduction for certain expenses related to business meals incurred during the course calendar year 2021 or 2022.
How to implement an accountable plan
In order to reimburse employee expenses, the employer must have an accountable plan.
Suppose an employer does not have an accountable plan. In that case, the IRS states: "Payments to the employee for travel and other activities under a nonaccountable plan are wages and are treated as additional wages and are subject to withholding tax, and payment of income tax, social insurance, Medicare and FUTA."
Developing an expense plan will save employers time, confusion, and stress. If the employer does not have an accountable plan, all reimbursements, even ordinary and necessary, are taxable.
Even with an accountable plan, there are a few things to keep in mind. For example, if the employer has an accountable plan, but the employee does not adequately justify the expenses within a reasonable time, or if the employee does not reimburse excess advance payments, any reimbursement may become taxable income.
Additionally, if expenses that exceed IRS limits are paid, the excess will be taxable income. For example, if an employer reimburses an employee for miles above the standard mileage rate, the excess will be taxable income.
Comply with IRS rules
Employees should only pay income tax on wages earned and certain additional taxable benefits. Expenses incurred by employees in carrying out their business activities should be costs incurred by the employer and not by its employees.
If the employer establishes a written accountable plan and employees report properly documented expenses under that plan, reimbursements should not be recognized as taxable income.
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