Employee Expense Reimbursements - Using an Accountable Plan
It is not uncommon that employees of a business will sometimes need to pay for something related to the business out of pocket. Depending on the employer, such an expense may or may not be reimbursed by the business. I have my own thoughts about the equity of an employer NOT reimbursing a business expense incurred by an employee, but the fact remains that some do not.
In the past, if an employee had to bear the brunt of the expense, there was at least the silver lining for some that, if they itemized deductions on their personal tax returns, they potentially could take a deduction for "unreimbursed employee business expenses" by the filing of a Form 2106. This deduction is still available on some state returns, including Arkansas.
This deduction, however, was of limited value to many because, as stated above, you could only take it if you itemized your deductions (as opposed to just taking the standard deduction), and even then, only the amount that, when added to other "miscellaneous" itemized deductions, exceeded 2% of your adjusted gross income was deductible. Still, for many, it was a valuable deduction.
All that changed with the passage of the Tax Cut and Jobs Act (TCJA) at the end of 2017. Under TCJA, for the years 2018-2025, the federal miscellaneous itemized deduction was eliminated entirely, with a few very focused exceptions such as for armed forces reservists, qualified performing artists, fee-basis state or local government officials, and disabled individuals claiming impairment-related work expenses.
The elimination of the employee deduction has focused the attention of many employers on the need and advisability of reimbursing employees for their out-of-pocket business expenses. Doing so and in the right way can be beneficial tax-wise, and certainly is a morale booster to your employees. And let's face it, with many employers facing staffing challenges, it can also be an important employee retention move.
It's important though, as just alluded to, that this be done the right way. By this I mean that employers who decide to reimburse employee business expenses (or who already are doing so) should do so through what is known as an "accountable plan".
Failing to use an accountable plan will result in the loss of favorable tax benefits to both employer and employee. This is because under an accountable plan, the payments made to the employees are NOT considered taxable compensation to them. Therefore, there is no 000payroll tax nor any income tax that is due on the payments made.
According to the Internal Revenue Code and related regulations, accountable plans must meet three basic criteria:
- The reimbursed expenses must be connected to the business;
- The employee must substantiate the expenses within a reasonable time period; and
- In the case of an advance, the employee must return to the employer any unspent money within a reasonable time period.
Failure to meet even one of these criteria causes the arrangement to not be considered an accountable plan, making taxable the payments made to the employee, and causing unnecessary income taxes to them and payroll taxes to both employer and employee. Obviously, not a good outcome.
There is no required IRS form needed to set up an accountable plan. It also doesn't necessarily have to be in writing. However, I strongly recommend having a written plan, to make clear to employees and employer alike what the plan rules are, and to help make sure the standards required by the law for favorable tax treatment are met.