Guidance issued on employee expense reimbursement arrangements

The IRS issued guidance on situations in which employers recharacterized wages as nontaxable reimbursements and whether they satisfied the business connection and other requirements to be treated as paid under an accountable plan under Sec. 62(c) (Rev. Rul. 2012-25). The revenue ruling covers four situations. In three of the four situations, the IRS ruled that the employer’s payments were recharacterized wages that did not qualify as nontaxable reimbursements.

Sec. 62(c) requires employees’ reimbursed expenses to be substantiated by the employees and any excess amounts paid returned to the employer. In addition, the reimbursement must have a business connection, meaning the plan must restrict allowances, advances, or reimbursements to expenses that qualify as business expenses under the Code and that an employee pays or incurs in connection with the employee’s performing services for the employer.

Situation 1 covers a tool reimbursement plan, where an employer requires its employees to provide their own tools and equipment. The employer began a reimbursement program under which it took the total tool expenses for the year and divided that amount by the number of hours the employee was expected to work that year. Under the tool reimbursement plan, the “hourly tool rate” reduces the employee’s total compensation and is treated as a nontaxable reimbursement until the employee’s tool costs for the year have been reimbursed. After that, the employee’s compensation is increased to equal the pre-tool plan compensation rate.

The IRS ruled that this arrangement does not meet the business connection requirement to be an accountable plan because the employer pays the same gross amount to the employee whether or not the employee incurs or is reasonably expected to incur expenses. According to the IRS, the payments are merely an attempt to recharacterize wages as nontaxable reimbursements and “[t]he fact that a technician actually incurs a deductible expense in connection with employment does not cure the incidence of wage recharacterization.” 

Situation 2 involved nurses who were sent on assignments both near their tax homes and away. When the nurses were away, the employer treated a portion of their hourly compensation as a per diem allowance for expenses. When they were within commuting distance, all their pay was treated as wages, but they were paid the same hourly rate whether or not they were away. This arrangement did not satisfy the business connection requirement to be an accountable plan because the employer paid the same gross amount to the nurses whether or not they incurred or were expected to incur deductible travel expenses, and so the payments were again an attempt to recharacterize wages as nontaxable reimbursements.

The employer in Situation 3 employed workers to build commercial buildings and required some of its employees to travel between construction sites or otherwise use their personal vehicles for the business. The employer paid its employees an hourly wage and also paid all of its workers a flat amount per day as a nontaxable mileage reimbursement. Because the employer paid the mileage reimbursement regardless of whether the employees incurred or were expected to incur deductible business expenses, the business connection requirement was not met and the plan was not an accountable plan.

In Situation 4, the employer, a cleaning services company that compensated its employees hourly, set up a plan to reimburse employees for cleaning equipment and supplies they provided themselves. The employer reduced its employee’s hourly pay rate and then reimbursed the employees for supplies only if the employees substantiated the actual amount of deductible expenses. Employees who did not incur these expenses or did not properly substantiate them did not receive any reimbursement for the expenses. The hourly compensation was treated as taxable wages, and the reimbursements were treated as nontaxable reimbursements. This arrangement was the only one in the revenue ruling that met the accountable plan requirements because the reimbursement was not in lieu of wages that an employee would otherwise receive, even though the employer had reduced the employee’s compensation rate when it started the plan.    

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.