Know the Rules for Reporting Reimbursements, Deductions

A taxpayer who is reimbursed for expenses paid or incurred in connection with his services as an employee doesn’t include the reimbursement in gross income if it’s paid under a reimbursement or other expense-allowance arrangement that’s an ‘accountable plan.’

A reimbursement or other expense-allowance arrangement is an arrangement that meets the following three requirements:

(1) A business-connection requirement, which requires the advances, allowances, or reimbursements to be for only specified deductible business expenses that are paid or incurred by the employee in connection with his services as an employee;

(2) A substantiation requirement, which requires the employee to substantiate each business expense to the payor; and

(3) Returning amounts in excess of expenses requirement, which requires that the employee return to the payor, within a reasonable time, any amount paid under the arrangement in excess of the expenses substantiated.

Although reasonable expectations for expenses can be used to establish that a plan meets the business connection requirement, satisfaction of the substantiation and return of excess requirements must be based on expenses actually incurred.

If the arrangement meets the three requirements listed above, all amounts paid under the arrangement, up to the amount of expenses treated as substantiated, are treated as paid under an accountable plan, i.e. the amounts are excluded from the employee’s gross income, aren’t reported as wages or other compensation on the employee’s Form W-2, and are exempt from withholding and payment of employment taxes.

If the arrangement doesn’t satisfy one or more of the requirements above, all amounts paid under the arrangement are treated as paid under a non-accountable plan, i.e. the amounts are included in the employee’s gross income, must be reported as wages or other compensation on the employee’s Form W-2, and are subject to withholding and payment of employment taxes.

For this reason, a court rejected a taxpayer’s argument that his substantiated payments should be treated as made under an accountable plan while the unsubstantiated payments wouldn’t be so treated, because doing so would effectively eliminate the substantiation requirement from the accountable plan test.

The above requirements are applied on an employee-by-employee basis. So, for example, the failure by one employee to properly substantiate expenses under an arrangement won’t cause amounts paid to other employees to be treated as paid under a non-accountable plan.

The requirements must be fully complied with; ‘substantial compliance’ won’t suffice. Additionally, there is no industry-practice exception to the accountable-plan requirements.

If a payor provides a non-accountable plan, an employee who receives payments under the plan can’t compel the payor to treat the payments as paid under an accountable plan by voluntarily substantiating the expenses and returning any excess to the payor.

Automobile expenses can be reimbursed based on actual operating expenses, using an optional mileage allowance, or based on a fixed and variable rate allowance. Travel expenses (lodging, meals, etc.) can be reimbursed based on per-diem allowances for the particular location.

To qualify as an accountable plan, a reimbursement plan must require an employee to return to the payor (i.e., his employer, its agent, or a third party), within a reasonable period of time, any amount paid under the arrangement in excess of the expenses substantiated. However, this requirement doesn’t apply to a reimbursement arrangement in which only the substantiated expenses are reimbursed. In such a plan, there should be no excess to return. The determination of whether a plan requires an employee to return amounts in excess of substantiated expenses will depend on the facts and circumstances.

Illustration 1: Employer W pays its employees a mileage allowance to cover automobile business expenses that exceed the deemed substantiated amount by 50 cents per mile. The allowance is reasonably calculated not to exceed the amount of the employee’s expenses or anticipated expenses.

Illustration 2: In anticipation of employee business expenses that Corporation V doesn’t reasonably expect to exceed $400 in any quarter, Corporation V advances $1,000 to Employee A. Whenever Employee A substantiates an expense, Corporation V provides an additional advance in an amount equal to the amount substantiated, thereby providing a continuing advance of $1,000. The amounts advanced under this arrangement aren’t reasonably calculated so as not to exceed the amount of anticipated expenditures.

The requirement to return excess amounts is also satisfied only if the employee actually returns those excess amounts. Satisfaction of this requirement must be based on expenses actually incurred; reasonable expectations aren’t sufficient.

Although reasonable expectations for expenses can be used to establish that a plan meets the business-connection requirement, satisfaction of the substantiation and return of excess requirements must be based on expenses actually incurred.

Illustration 3: Employer Y provides expense allowances to certain of its employees to cover bona-fide employee business expenses under an arrangement that requires the employees to substantiate their expenses within a reasonable period of time and to return any excess amounts within a reasonable period of time. Each time an employee returns an excess amount to Employer Y, however, Employer Y pays the employee a bonus equal to the amount returned by the employee. The arrangement fails to satisfy the requirement to return excess amounts.

If an expense arrangement has no mechanism or process to determine when an allowance exceeds the amount that may be deemed substantiated, and the arrangement routinely pays allowances in excess of the amount that may be deemed substantiated without requiring actual substantiation of all the expenses or repayment of the excess amount, the failure of the arrangement to treat the excess allowances as wages for employment-tax purposes causes all payments made under the arrangement to be treated as made under a non-accountable plan.

As a result, the payments will be included in the employee’s gross income. They will be reported as wages or other compensation on the employee’s Form W-2, and will be subject to withholding and payment of employment taxes.

Even though amounts may be paid or reimbursed under an accountable plan, additional hurdles may apply.

Expenses paid or incurred for lodging are not incurred in carrying on your trade or business if the lodging is extravagant or lavish under the circumstances, or primarily provides an individual with a personal benefit, such as allowing an employee to avoid a long commute, or social benefit.

In addition to meeting the requirements for deductibility, entertainment expenses must also be directly related to the actual conduct of the taxpayer’s trade or business or, if directly preceding or following a business discussion, be associated with the actual conduct of the taxpayer’s trade or business. v