Are Employee Expense Reimbursements Taxable?
Understand when employee expense reimbursements are taxable or non-taxable. Learn the IRS rules governing their tax treatment and reporting.
Employee expense reimbursements are a common practice, allowing employees to recover costs incurred while performing their job duties. The answer largely depends on how the employer structures the reimbursement plan, which dictates their taxability.
Understanding these rules is important for both employees and employers. For employees, knowing the tax treatment of reimbursements impacts their personal tax liability and take-home pay. For employers, correctly classifying and reporting reimbursements is essential for compliance with federal tax regulations.
Properly managing expense reimbursements helps ensure accurate tax reporting. Misunderstandings can lead to errors and unexpected financial consequences. The Internal Revenue Service (IRS) provides clear guidelines on how these arrangements should be managed.
Understanding Reimbursement Plans
The Internal Revenue Service categorizes employee expense reimbursement arrangements into two types: accountable plans and non-accountable plans. These classifications determine the tax treatment of reimbursed amounts. The IRS framework differentiates legitimate business expense reimbursements from additional compensation.
Accountable plans generally allow employers to reimburse employees for business expenses without the reimbursement being considered taxable income to the employee. This benefits both parties by ensuring employees are not taxed on money spent for the employer’s benefit. These plans require adherence to specific criteria to maintain their non-taxable status.
Conversely, non-accountable plans result in reimbursed amounts being treated as taxable income to the employee. When a reimbursement arrangement does not meet the necessary conditions for an accountable plan, the funds provided are viewed as wages. This means the employee will owe income tax and employment taxes on those amounts.
The distinction between these two types of plans is fundamental to understanding the tax implications of expense reimbursements. The classification dictates whether the reimbursed funds are subject to income tax withholding and employment taxes.
Requirements for Non-Taxable Reimbursements
For an employee expense reimbursement plan to be considered “accountable” by the Internal Revenue Service and thus render reimbursements non-taxable, it must satisfy three criteria. These requirements ensure that only legitimate business expenses are reimbursed tax-free. If any of these conditions are not met, the entire plan may be reclassified as non-accountable, making all reimbursements taxable.
The first requirement is that expenses must have a business connection, meaning they must be incurred while performing services as an employee. Common examples include expenses for business travel, meals, transportation, or supplies directly related to job duties. Personal expenses do not qualify under this condition.
The second criterion is substantiation, requiring the employee to adequately account for expenses to the employer within a reasonable period. Adequate accounting involves providing details such as the amount, time, place, and business purpose. This typically involves submitting receipts, invoices, or other documentation. A reasonable period for substantiation is generally within 60 days after the expense is paid or incurred, or after the employee returns from a business trip.
The third condition mandates that the employee must return any excess reimbursement or allowance within a reasonable period. If an employer provides an advance and the employee spends less, the unspent portion must be returned. A reasonable period for returning excess amounts is typically within 120 days after the employee incurs the expense, or after the employer provides a statement of the account. Meeting all three conditions ensures reimbursements are excluded from gross income and are not subject to income tax withholding or employment taxes.
Taxable Reimbursements
When an expense reimbursement arrangement fails to meet one or more of the three requirements for an accountable plan, the arrangement is classified as a non-accountable plan. This classification has direct tax consequences for the employee, as all reimbursements received are considered taxable income. Failure to meet even one condition, such as proper substantiation or the return of excess funds, can lead to this taxable outcome.
Reimbursements made under a non-accountable plan are treated as additional wages paid to the employee. Consequently, these amounts are subject to all applicable income tax withholding. Employers are required to withhold federal income tax from these reimbursements.
Furthermore, these taxable reimbursements are also subject to employment taxes, Social Security and Medicare taxes. These taxes (FICA) are withheld from the employee’s pay and matched by the employer. This significantly increases the employee’s overall tax burden.
Situations that commonly lead to a non-accountable plan include an employer providing a flat allowance for expenses without requiring receipts or documentation. Another example is when an employer reimburses personal expenses or allows employees to retain any unspent portion of an advance. In these scenarios, the reimbursements are fully taxable because the arrangement does not satisfy IRS accountable plan rules.
Reporting Reimbursements for Tax Purposes
The way employee expense reimbursements are reported on tax forms depends on whether they fall under an accountable or non-accountable plan. This distinction is crucial for both employees filing personal tax returns and employers fulfilling reporting obligations to the IRS. Correct reporting ensures compliance and avoids discrepancies.
Non-taxable reimbursements from an accountable plan are generally not reported on the employee’s Form W-2. Since these amounts are considered a recovery of business expenses, they are excluded from the employee’s gross wages. They do not appear in Box 1 (Wages, tips, other compensation) or any other box on the W-2, simplifying the employee’s tax situation.
Conversely, taxable reimbursements under a non-accountable plan are included in the employee’s gross wages. These amounts are combined with regular salary and reported in Box 1 of Form W-2. As part of the taxable wages, they are subject to federal income tax withholding, Social Security tax, and Medicare tax, all reflected on the W-2.
Due to changes by the Tax Cuts and Jobs Act of 2017, employees generally cannot deduct unreimbursed employee business expenses on their federal income tax return. This change (effective for tax years 2018 through 2025) underscores the importance of employers maintaining an accountable plan. Without an accountable plan, employees bear the full tax burden on reimbursements, as they cannot claim a deduction.