Taxable Wages as Nontaxable Reimbursements
The IRS has provided guidance which clarifies that an arrangement that recharacterizes taxable wages as nontaxable reimbursements or allowances does not satisfy the business connection requirement for accountable expense reimbursement plans.
In general, employee business expense reimbursements that are paid through an employer's accountable expense reimbursement plan are excluded from the employee's adjusted gross income. An accountable plan basically requires employees to submit receipts for expenses and repay any advances that exceed substantiated expenses. Amounts paid to employees through an accountable plan are not taxable compensation. Thus, they are not subject to federal or state income taxes or Social Security taxes, or employer payroll taxes and withholding.
On the other hand, business expense reimbursements paid through a system that does not meet the specific requirements for accountable plans are considered paid under a nonaccountable plan, and are treated as taxable compensation. An employer can have a reimbursement plan that is considered accountable in part and nonaccountable in part.
A reimbursement plan must meet three requirements in order to be considered an accountable expense allowance arrangement
1) Reimbursements must have a business connection;
2) Reimbursements must be substantiated; and
3) Employees must return reimbursements in excess of expenses incurred.
An arrangement satisfies the business connection requirement if it provides advances, allowances, or reimbursements only for business expenses that are allowable as deductions, and that are paid or incurred by the employee in connection with the performance of services as an employee of the employer. Therefore, not only must an employee actually pay or incur a deductible business expense, but the expense must arise in connection with the employment for that employer.
The business connection requirement will not be satisfied if a payor pays an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur deductible business expenses. Failure to meet this reimbursement requirement of business connection is referred to as wage recharacterization because the amount being paid is not an expense reimbursement but rather a substitute for an amount that would otherwise be paid as wages.
The IRS guidance includes four situations, three of which illustrate arrangements that impermissibly recharacterize wages such that the arrangements are not accountable plans. A fourth situation illustrates an arrangement that does not impermissibly recharacterize wages. In this arrangement, an employer prospectively altered its compensation structure to include a reimbursement arrangement.
Because of the difference in tax treatment of reimbursements under an accountable plan versus a nonaccountable plan, it is important to review your reimbursement policies. Please call our office for an appointment to discuss your options under this IRS guidance.