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Reimbursing Employee Expenses: Why It Pays to Follow the Rules

By Leah Davis, CPA

Your employee travels out-of-state to attend a conference on behalf of your company. When he returns, he submits an expense report and receipts. You (or your accounts payable department) reimburse him for the total amount—separate from his regular paycheck. You don't pay taxes on it, and he doesn't report it as income.  

Sounds fairly straightforward and simple, right? 

It can be…if you've established a compliant accountable employee expense reimbursement plan (i.e., arrangement). Under this type of plan, employee expense reimbursements or advances are deductible as business expenses by the company and employees aren’t required to report the reimbursements as compensation, meaning they aren't subject to income or employment taxes. That said, in order for the IRS to deem your plan "accountable," it must adhere to three rules on an employee-by-employee and expense-by -expense basis. Here's a quick discussion of each:

1.    Your plan must only reimburse or provide advances for deductible business expenses. 
In other words, you can't reimburse employees for an expense that wouldn't otherwise qualify as a deductible business expense. Examples of business expenses include uniforms, travel, lodging, etc. Keep in mind, however, that, under the new tax laws, certain business expenses, such as meals and entertainment, may no longer be fully deductible.  

2.    Employees must submit documentation of (i.e., substantiate) their expenses.
For an expense to be reimbursed under an accountable plan, it must be substantiated by a written record or itemized receipt. What's more, the record or receipt must include the time, place, amount, and purpose of the expense. The reimbursement or advance must take place within reasonable time periods, as required by regulation and identified by the plan. 

3.    Employees must return excess advances. 
Your plan must stipulate that any advance that exceeds the actual substantiated business expense must be returned. If an employee doesn't return the excess amount, it would qualify as compensation—and therefore be subject to income and employment taxes. You cannot, however, simply waive the return requirement and reclassify excess advances as compensation, as this will forfeit your plan's accountable status. 

What happens if your accountable plan doesn't follow the rules? 

If any reimbursement or advance were to break any of these rules, the IRS could potentially disqualify your plan—not only for the current year but also retroactively. Any reimbursements or advances you made, to all employees, would be reclassified as compensation and subject to employment taxes. And, yes, related amendments, taxes, and penalties could add up quickly. 

Be a rule-follower. 
If you're reimbursing and advancing employee expenses under an accountable plan, it pays to know the rules and follow them every time. If you have questions about establishing or managing an accountable plan for your business, we’re here to help. http://www.aemcpas.com/aem-workforce-solutions-services.html