Helping small businesses grow strategically is at the very core of our business. Recently, we worked with a client in planning out his tax strategy. Specifically, we looked at how reimbursing employee expenses through an “accountable plan” could help reduce their employee withholding taxes.
While any organization may provide employee expense reimbursements, your business’ tax advantage depends on whether you have an accountable or a non-accountable plan. Amounts paid under an accountable plan are not wages and are not subject to the withholding and payment of income, social security, Medicare, and federal unemployment (FUTA) taxes.
In order to be classified as an accountable plan, the IRS provides that the arrangement must include all of the following:
- Employees must have paid or incurred deductible expenses while performing services as employees. The reimbursement or advance must be paid for the expense and must not be an amount that would have otherwise been paid by the employee,
- Employees must substantiate these expenses to employer within a reasonable period of time,
- Employees must return to employer any amounts in excess of substantiated expenses within a reasonable period of time.
Business connection is met when the employer reimburses the employee for reasonable expenses paid or incurred in connection with the performance of services for their employer. The employer has two options of distributing the reimbursement. The employer may specifically identify the travel reimbursement compensation when it is combined with employee wages or the employer may make a separate payment to reimburse employee travel expenses.
In order to constitute an adequate record of business purpose within the meaning of IRS Code Section 274(d), a written statement of business purpose generally is required. However, the degree of substantiation necessary to establish business purpose will vary depending upon the facts and circumstances of each case. Where the business purpose is evident from the surrounding facts and circumstances, a written explanation of such business purpose will not be required. Employees must generally submit information sufficient to substantiate the time, place, business purposes and amount of the expense to their employer.
Employees must return to their employer any amount paid by the employer in excess of the substantiated amount within a reasonable time. Any excess amount not returned within a reasonable period of time is considered paid under a non-accountable plan as employee wages. The determination of a reasonable period of time will depend on the facts and the circumstances. The IRS has provided for two safe harbors, but these safe harbors are not available where employers have shown a pattern of overcompensation to avoid reporting and withholding on excess expenses.
The fixed date method deals with advances made within thirty (30) days of when the expense is paid or incurred by the employee. The safe harbor is met if the employee’s expense is substantiated within 60 days and the excess amount is returned to the employer within 120 days after the expense is paid or incurred.
The periodic statement method requires employees to be given periodic statements at least quarterly, stating any amount paid under the arrangement in excess of their substantiated expenses. The statement must also request that the employee substantiate any excess expenses that would qualify under an accountable plan. If the employee cannot substantiate any excess expenses, they must return any amounts remaining unsubstantiated within 120 days of the statement.
A reimbursement plan that does not meet the specified guidelines of an accountable plan is called a non-accountable plan. Payments to employees for travel and other necessary expenses, under a non-accountable plan are wages and are treated as supplemental wages and subject to the withholding and payment of income, social security, Medicare, and FUTA taxes. Employer payments are treated as paid under a non-accountable plan if:
- The employee is not required to or does not substantiate timely those expenses to you with receipts or other documentation,
- The employer advances an amount to the employee for business expenses and the employee is not required to or does not return timely any amount he or she does not use for business expense,
- Employer advances or pays an amount to an employee regardless of whether employer reasonably expects the employee to have business expenses related to the business, or,
- Employer pays an amount as a reimbursement employer would have otherwise paid as wages.
If an organization provides a business employee an expense reimbursement, in order to minimize employee withholding taxes the organization must follow an accountable plan of reimbursement. As of the date of this blog post, the IRS does not have any requirements that an accountable plan must be in writing.