If you reimburse employees for work-related expenses which they pay out-of-pocket, it’s important to structure your reimbursement plan as an accountable plan in line with IRS guidelines. If not, the reimbursements will be considered income to employees and taxed at the same rate as their regular wages.
To be considered an accountable plan, the IRS has 3 requirements:
- There must be a business purpose for the expense, i.e. a connection to the employee’s performance of services.
- The expense must be substantiated within a reasonable period of time. In most cases, this is fulfilled with receipts and invoices showing the nature of the expense and the amount paid. If an employee is being reimbursed for travel by car, he or she can use the mileage rate determined by the IRS.
- The employee must return any excess reimbursement, or excess cash advance, within a reasonable period of time.
For determining the business purpose of an expense, the main goal is to determine that it was work-related, and not a personal expense. How does it further the work of your organization? Think of the “W” questions – what, where, when, why, who. For example, for a meeting expense, show what was purchased, who and what it’s for, and the time frame; e.g. “snacks for 20 youth in the Young Writers afterschool program the week of March 21.” A travel reimbursement would include details such as “dinner in Washington, D.C. on March 2, 2011 with Jane Smith, board member of XWY organization, to discuss development plan.”
If an employee is being reimbursed for meals and/or a hotel stay while traveling, he or she can substantiate these expenses either with receipts of actual expenses, or with the daily per diem rate set by the General Services Administration (GSA). GSA per diem rates vary based on the location of travel and can be found at this site. Whichever method a traveler uses, he or she must use for the entire trip and cannot switch methods between days. On the first and last day of travel, the meal per diem is limited to 75% of the daily rate. If an employee is in travel status for less than a full day, but more than 12 hours, he or she is limited to 75% of the per diem rate. Expenses for travel lasting less than 12 hours can only be substantiated with receipts documenting actual expenses.
What’s considered a reasonable period of time depends partly on the circumstances of an employee’s situation, but if the relevant actions take place in the following timeframes they will always be considered to be within a reasonable period:
- Receiving an advance within 30 days of incurring the related expense(s).
- Accounting for and substantiating expenses for a reimbursement within 60 days of the expenses being paid or incurred.
- Returning any excess reimbursement within 120 days of the expense being paid or incurred.
- The employee being given a periodic statement (at least quarterly) asking him or her to return or account for outstanding advances, and the employee complies within 120 days of the statement.
Note that some time frames are based on when an expense is “paid or incurred.” Most expenses are paid and incurred at the same time, such as meals, mileage, or having materials printed for a meeting, though for other expenses there is a lag. If you buy a plane ticket, or reserve a hotel room in advance, the expense is paid for before it is incurred. When there is a time difference between an expense being paid and incurred, the 30-, 60-, and 120-day windows can be based on the event that is more favorable to the employee. In the example of a plane ticket, the employee can be reimbursed as soon as he or she pays for it, but the 30-, 60-, and 120-day deadlines wouldn’t hit until after the flight has happened, and therefore the expense has been incurred.
Expenses that are reimbursed without following these guidelines are considered to be paid under a nonaccountable plan, and the reimbursements are reported as wages in box 1 of the employee’s W-2. Even if your organization uses an accountable plan overall, certain reimbursements will always be considered nonaccountable, namely:
- Excess reimbursements not returned to the employer
- Reimbursement of nondeductible expenses related to the employer’s business.
More information about accountable and nonaccountable plans can be found in IRS Publication 463.