Getting Accountable Expense Reimbursement Plans Up-to-speed

August 26, 2015

Companies, including physician medical practices, that cover their employees’ business expenses can either reimburse them for their actual expenses or pay a travel or mileage allowance. Although such arrangements have been a common business practice for decades, expense reimbursements have been subject to guidelines that separate legitimate reimbursement arrangements from those that more closely resemble additional compensation since 1989.

According to the tax rules, the key to distinguishing between true expense reimbursements and disguised compensation is whether the employer’s payments are made in accordance with an accountable plan. So, what’s an accountable plan? The term may have been around for over 25 years, but in a 2010-2012 IRS audit initiative, agents apparently found that not many businesses knew the answer, or at least, they weren’t following the rules.

Accordingly, the IRS is taking a close look at expense reimbursement arrangements when auditing businesses and their owners. With that in mind, I want to address with you what it takes to have an accountable plan and why it matters – so let’s take a look at the benefits of having an accountable plan and the mechanics of setting one up.

Accountable versus Non-accountable Plan

If a company’s arrangement meets the requirements for an accountable plan, expense reimbursements and allowances to employees, who properly comply with the terms of the plan, are deductible by the company (subject to the 50% limit for most meals and entertainment). In addition, the payments are excluded from the employee’s gross income and, thus, are exempt from income tax withholding and employment taxes. Although companies generally maintain a company-wide accountable plan, the rules apply on an employee-by-employee basis.

If a company maintains an overall non-accountable plan, or if an employee fails to comply with the terms of the company’s accountable plan, expense reimbursements and allowances are deductible by the company as employee compensation. The 50% disallowance rule for meals and entertainment is not applicable because the deduction is claimed as compensation, not as a business expense. In addition, the payments are (1) included in the employee’s gross income as wages, (2) reported on Form W-2, and (3) subject to income tax withholding and employment taxes.

Employees can deduct the expenses on their personal tax returns (subject to the 50% limit for most meals and entertainment), but only as miscellaneous itemized deductions subject to the 2% of adjusted gross income limit provided the expenses are deductible and properly substantiated. Thus, with a non-accountable plan (or an accountable plan that isn’t followed), the employee will pay more tax because at least part of the reimbursed expenses won’t produce a tax benefit, yet the entire reimbursement is subject to income and payroll taxes. The company may also be worse off because the payroll taxes owed on the taxable reimbursements may exceed the tax savings available because of being able to deduct 100% (rather than 50%) of any meals and entertainment expenses.

Establishing an Accountable Plan

Because the tax ramifications of a non-accountable plan are unfavorable, most companies (medical practices) will want to establish an accountable plan for employee business expense reimbursements. Such a plan must satisfy the following requirements:

1. Business Connection. The plan can provide reimbursements or allowances only for otherwise deductible business expenses (such as travel, lodging, or meals incurred while away overnight on business) that are paid or incurred by individuals in connection with their performance of services as employees for the employer. The reimbursements and allowances must be clearly identified as such when the employee is paid (for example, by paying them in separate checks or by specifically identifying the reimbursement or allowance on the check stub if both wages and an expense reimbursement are paid together).

2. Substantiation. The plan must require substantiation of the expenses being reimbursed through use of an expense report, diary, log, trip sheets, or similar record (such as a detailed receipt). The purpose of this record is to identify the specific nature of each expense and to allow the employer to conclude that the expense is attributable to its business activities. In addition to these general requirements, for travel, entertainment, gifts, and listed property (such as a computer used in a home office or an automobile), a receipt or other documentary evidence is required if the expense is $75 or more or if it relates to lodging. This documentary evidence should substantiate (1) the amount and business purpose of the expense, (2) the time and place of any travel or entertainment, (3) the date and description of any gifts, and (4) the business relationship to the company of each person entertained or receiving a gift.

If an employer provides expense allowances, an allowance that doesn’t exceed the federal per diem rate is treated as meeting the substantiation requirement (and is considered paid under an accountable plan) with respect to expenses incurred for which the allowance was paid. Thus, such an allowance is exempt from withholding and reporting. If an allowance exceeds the applicable federal per diem rate, then the excess does not meet the substantiation requirements for the related expenses. Thus, such excess is deemed paid under a non-accountable plan and is subject to income tax withholding and payroll taxes as additional compensation.

3. Return of Excess Advances. The plan must require employees to return any advance that exceeds substantiated business expenses. Any excess not actually returned should be treated by the company as compensation to the employee and is subject to income and payroll tax withholding like any other compensation. (Of course, because the amount will have already been paid, the actual withholding will have to come from the employee’s regular compensation.)

Note: A plan need not require employees to return the portion of an expense allowance that exceeds the federal rate for the days of business travel or business miles as long as such travel and miles are adequately substantiated with respect to everything but the amount of the actual expenses. However, as discussed in item 2, such excess does become wage income to the employee.

Observation: As long as an employer’s expense allowance does not exceed the federal per diem rate, employees may retain any excess allowance (i.e., “keep the change”) for days of travel or business miles substantiated without disqualifying the accountable nature of the employer’s plan (or requiring the employees to report any income from the advance). In contrast, plans that reimburse actual expenses must require employees to return all excess advances.

The Reasonable Time Period Requirement

Both the substantiation of expenses and the return of any excess (unsubstantiated) advances must occur within a reasonable period of time. Generally, a facts-and-circumstances approach determines what constitutes a reasonable period. Thus, an employee, who is on an extended travel assignment, would have a longer period to substantiate expenses and return excess amounts than an employee whose travel consisted of a single overnight trip.

The regulations offer two safe harbors for satisfying the reasonable period requirement:

1. Fixed Date Safe Harbor. Under this safe harbor, the timeliness requirement is met if the employer’s reimbursement plan requires:

a. an advance to be made no more than 30 days before the employee pays or incurs the expense (against which the advance is made),

b. an expense to be substantiated within 60 days after it’s paid or incurred, and

c. excess advances to be returned to the employer within 120 days after the expense is paid or incurred.

2. Periodic Statement Safe Harbor. Under this safe harbor, the timeliness requirement is met if the company no less often than quarterly provides applicable employees with statements of the amount of advances not yet substantiated, and requests that any advance either (a) be substantiated or (b) returned to the company, within 120 days after the statement is issued.

There are no formal procedures for adopting these safe harbors, and they may be elected simply by using them.

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