Does your business have an IRS compliant employee reimbursement policy?

By Jerry Meek

Employees are typically reimbursed when they pay or incur expenses on behalf of their employer.  But, unless those reimbursements are made in compliance with federal regulations, they are treated as wages to the employee.  The consequences for both employer and employee can be crushing:  the employer may owe payroll taxes on the amount reimbursed; the employee may be forced to treat the funds as taxable income.

That’s why every business should have a written reimbursement policy that complies with prescribed Treasury regulations.  (You can find a sample policy here.)  When an employer adopts – and follows – an “accountable plan” for reimbursement, reimbursements are excluded from the employee’s income and exempt from payroll taxes.

To qualify as an “accountable plan” the policy must, at a minimum:

1.  Provide that employees will only be reimbursed for ordinary and necessary business expenses paid or incurred by the employee in connection with the performance of services as an employee.

2.  Require that all expenses be substantiated within a reasonable period of time.  Substantiation within 60 days of the expense is always deemed reasonable.  Generally, substantiation requires documentation of the amount of the expense, the date and time of the expense, the place of any travel (if applicable), and the business purpose of the expense.

3.  Require employees to return to the employer, within a reasonable period of time, any amount advanced to the employee for expenses which are not later substantiated.  For this purpose, 120 days is always deemed reasonable.

Having a proper, written reimbursement policy is especially important when an owner-employee incurs expenses on behalf of a business that doesn’t have the money to make a prompt reimbursement.  Such situations frequently give rise to thorny issues about whether the owner-employee has made a loan to the business or a capital contribution, with all of the resulting tax and other legal implications.  By substantiating the expenses in accordance with a proper reimbursement policy, you can eliminate questions about how these expenses should be characterized.

Of course, it is not enough to simply have a written policy.  The policy must also be followed and enforced.  The IRS decides how to treat reimbursements on an employee-by-employee basis.  In addition, if an employer’s actual reimbursement practices reflect a pattern of abusing the provisions relating to employee reimbursement, the IRS can treat all of the reimbursements as having been made under a nonaccountable plan, even when there’s a compliant plan in place.