Employee expense reimbursements are one of the areas where rumors prevail and the facts are confusing. So let’s start fresh and review the IRS rules about reimbursing employees. Why? The consequences of doing it wrong could be non-deductibility for your business or taxable income for your employees. And either one stinks.
- Have a documented expense reimbursement plan that complies with IRS guidelines.
- Be consistent.
- Create a process (preferably paperless) for reimbursement requests and archiving receipts, approvals, and proper reporting on W-2’s.
- Refer to Publication 535, Business Expenses; Travel and non-entertainment related meals for more information.
The Basics of Reimbursing Employee Expenses
The IRS distinguishes between accountable and non-accountable plans. In short, an accountable plan will usually be non-taxable to the employee, while a non-accountable plan will always be taxable to the employee. So you want an accountable plan.
To be an accountable plan, the following 3 requirements must be met. Employees must:
- Have paid or incurred deductible expenses while performing services as an employee.
- Adequately accounted for these expenses in a reasonable amount of time.
- Returned any excess reimbursement in a reasonable amount of time.
Reasonable Amount of Time
- In the case of advances, they should not proceed the expense by more than 30 days.
- In the case of substantiation, the expense should be accounted for within 60 days.
- If there is an excess of reimbursements to return, it should be returned within 120 days.
So, an annual accounting and reimbursement schedule won’t cut it for IRS purposes. A monthly or quarterly one will.
This refers to the documentation the employee should provide to back up his or her expenses. In general, it includes a receipt that includes time, place, and amount as well as a description of the business purpose. The receipts do not need to be original documents, but can be copies or scans.
Obviously, machine-generated receipts look more authentic than hand-written ones, but nothing in the code excludes handwritten receipts. But you can imagine how an IRS auditor might look strangely at a handwritten receipt for, let’s say, a luxury hotel room. For gas purchased in West Texas, probably not.
Types of Reimbursement Plans
Reimbursing Actual Expenses
This plan is easy. Employees provide substantiation for all expenses (receipts and business purpose) within 60 days and the employer reimburses them. The employer can deduct all expenses and the employee recognizes no taxable income. (The exception is non-travel meals, which are only 50 percent deductible by the employer.)
The employer may also advance the expenses to the employee. The employee must then return any excess within 120 days. Again, the employer can deduct all expenses and the employee recognizes no taxable income.
Reimbursing Per Diems for Travel
These types of plans are a little more complicated. Instead of reimbursing for actual expenses when an employee travels, you may create a plan where you reimburse a set amount per day (a per diem) for lodging and meals and incidentals. You can set your per diems at whatever you would like. However, if they exceed the federal rates (set by the GSA), you will have to report the excess over the federal rates to the employee as wages. The employee must substantiate the place traveled and dates.
The easy way to determine the federal rates is to use the GSA website to look up the city and month and use the corresponding rate. There is an alternative method called the High-Low method, which uses just two rates, but you must identify which cities and months are high expense and which are low. Quite frankly, by the time you sift through the complicated table of high expense cities, you’ll wish you had just used the regular method.
When an employee uses their personal vehicle for business, you may reimburse them using the IRS standard mileage rate of $0.58 cents per mile (as of 2019). The employee must substantiate the expense with the date, place, miles, and business purpose.
You can also reimburse employees using the FAVR method (Fixed and Variable Rate). It’s more complicated and I personally would pass on it.
|Plan Type||Actual Expense Reimbursements||Per Diem for Lodging / Meals||Mileage @ Standard Rate|
|Documentation Requirements||Document with receipts including date, time, place & business purpose||No receipts necessary – just document date, time, place and business purpose.||No receipt necessary, but document date, place, number of miles and business purpose.|
|What if not documented?||100% reported as wages to employee||100% reported as wages to employee||100% reported as wages to employee|
|What if excess not reimbursed?||Excess is reported as wages to employee.||Excess is reported as wages to employee.||Excess is reported as wages to employee.|
|What if per diem exceeds federal rates?||NA||Excess over federal rates is reported as wages to employee.||NA|
|Reported as wages to employee?||No, unless no substantiation (then 100%) or excess not returned (excess).||No, unless no substantiation or excess not returned. ALSO if reimbursed over the federal rate, excess is reported as wages.||No unless no substantiation or excess not returned.|
|Deductible by Employer? *||Yes||Yes||Yes|
* In the case of nonsubstantiated expenses, the employer deducts the expense as wages. In the other cases, the employer deducts as the appropriate expense.
The bottom line: don’t “tax” your employees with unexpected income. Make sure your reimbursement policies pass muster with the IRS. And you guessed it… we’ll help you with that.