No matter whether a company is big or small, every business incurs costs and expenses that may reduce the business' taxable income. Sometimes, employees — not just employers — are the ones who incur business expenses. That’s where employee expense reimbursement comes in.
Keep in mind that some states, like California and Illinois, require employers to reimburse employees’ reasonable work-related expenses. Make sure that you understand and follow the applicable laws in the states where you have employees.
Business Expenses: A Beginner's Guide To Building A Plan
Why do businesses need an accountable expense plan?
What Is Employee Expense Reimbursement?
The expense reimbursement process allows employers to pay back employees who have spent their own money for business-related expenses. When employees receive an expense reimbursement, typically they won’t be required to report such payments as wages or income.
These types of reimbursable expenses tend to occur when employees travel for work, but can be associated with other activities related to their employment, including, for example, certain purchases of work-related supplies or tools.
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Most businesses reimburse such expenses, but are business expense reimbursements taxable income to the employee?
Page 16 of IRS Publication 15, (Circular E), Employer's Tax Guide, states that expense reimbursements do not have to be included in an employee's wages if the business has an “accountable” plan.
What Is an Accountable Plan for Reimbursing Employees?
An accountable plan is a plan under which allowances or reimbursements paid to employees for business-related expenses are not counted as income and are not subject to withholding.
While they’re not required by the IRS, accountable plans help you set criteria that comply with IRS regulations on what reimbursements are deductible and what reimbursements count as taxable income.
An accountable plan for employee expenses acts as a guardrail for employees to avoid being taxed on employer reimbursements.
Qualify Employee Expense Reimbursements
In order to have an accountable reimbursement plan, an expense reimbursement policy or advance payment program must meet the following three conditions:
Business connection: The expense must occur in the performance of services as an employee of the employer.
Substantiation: The employee must substantiate his or her business expenses by providing the employer with evidence of the amount, time, place, and business purpose of the expense. The employee also must submit business expenses within a reasonable period of time after they occurred.
Returning excess amounts: If any amounts the employer pays to the employee exceed the amounts the employee spent, the employee must return excess amounts to the employer within a reasonable period of time.
What Counts as Employee Business Expenses?
When an employer reimburses an employee pursuant to an accountable plan, the reimbursement won’t count as wages or income to the employee. Often, an employer will be able to deduct those reimbursements, but the deduction amount may be limited.
IRS Publication 535, Business Expenses, states the following: “To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”
What are some examples of ordinary and necessary expenses that would require employer reimbursement? The most common are work-related supplies, travel, meals, and entertainment.
Supplies that an employee purchases for business purposes can be reimbursed at cost, provided that they are reimbursed pursuant to an accountable plan.
The cost of work-related travel, including transportation, lodging, meals, and entertainment that meet the criteria outlined in IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses, are generally reimbursable expenses.
Many employers will reimburse an employee who uses their personal vehicle for business at a standard mileage rate. Generally, this won’t include commuting expenses between an employee’s home and workplace. The standard mileage rate is set by the IRS each year. (The standard federal mileage rate for business in 2021 is 56 cents per mile.)
Meals & Entertainment
Meal and entertainment costs incurred within the employee's tax home are reimbursable expenses only if the meal or entertainment can be shown to have a clear business purpose.
Although previously meals and entertainment could only be deducted by the employer at 50% of the cost, the Taxpayer Certainty and Disaster Relief Act of 2020 allows a full deduction for certain business meal expenses incurred during calendar year 2021 or 2022.
Implement an Accountable Reimbursement Plan
In order to reimburse employees for expenses, it’s vital for an employer to have an accountable plan.
If an employer does not have an accountable plan in place, then IRS Publication 15 states: “Payments to your employee for travel and other necessary expenses of your business under a nonaccountable plan are wages and are treated as supplemental wages and subject to the withholding and payment of income, social security, Medicare, and FUTA taxes.”
So, are reimbursements taxable? It depends on the situation. If the employer does not have an accountable plan, then any reimbursements, even those that are ordinary and necessary, are taxable income. Consider drafting a plan — doing so will likely save everyone time, confusion, and stress.
Even with an accountable plan, there are some things to look out for. For instance, if the employer has an accountable plan, but the employee fails to properly substantiate the expenses within a reasonable time, or the employee fails to return excess advance payments, then any reimbursements could become taxable income.
In addition, if any expenses are paid in excess of IRS limitations, then the excess is taxable income. For example, if an employer reimburses an employee for mileage at more than the standard mileage rate, then the excess is taxable income.
Comply with IRS’ Rules
Employees should only have to pay income taxes on the wages they earn and certain taxable fringe benefits. Expenses incurred by employees in the course of business should be costs incurred by the employer, not by its employees.
If the employer establishes a written accountable plan, and the employees submit properly documented expenses under that plan, then the reimbursements shouldn’t count as taxable income.
However, a key to maintaining any accountable plan is to properly and timely substantiate expenses. Having a business accountant and referring to employment counsel are two ways for businesses to ensure they’re deducting and reporting the right expenses.
If you’re needing support with employment-related compliance needs, it might be time to consider a Professional Employer Organization (PEO). Justworks keeps you informed on employment regulations while taking care of your employer payroll tax filings. Learn more about our compliance support.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.