Are Expense Reimbursements Considered Wages?
Are your expense reimbursements taxable? Get clarity on the IRS criteria that determine if these payments are considered wages for tax purposes.
Expense reimbursements are payments from an employer to an employee for business-related costs the employee incurred. These payments cover expenditures made on behalf of the company, such as travel, meals, or supplies. A common question arises regarding their tax treatment: are these reimbursements considered wages subject to income tax and payroll taxes? The answer depends on whether the employer’s reimbursement arrangement adheres to specific Internal Revenue Service (IRS) regulations.
Understanding Accountable Plans
For expense reimbursements to avoid being classified as taxable wages, an employer’s reimbursement arrangement must qualify as an “accountable plan” under IRS rules. These rules are outlined in Internal Revenue Code Section 62 and Treasury Regulation 1.62-2. An arrangement must meet three distinct criteria to be considered an accountable plan.
The first criterion is the “business connection” requirement. This means the expenses must have a clear business purpose and be incurred while the employee is performing services for the employer. For instance, costs for client meetings, business travel, or necessary work tools generally satisfy this requirement.
The second criterion is “substantiation.” Employees must adequately account for their expenses to the employer within a reasonable period. This involves providing detailed records, such as receipts, invoices, or logs, that show the amount, time, place, and business purpose of the expense. The IRS considers 60 days after the expense was paid or incurred to be a reasonable period for substantiation.
The final criterion for an accountable plan is the “return of excess” requirement. If an employee receives an advance or reimbursement that exceeds the actual substantiated expenses, the employee must return the excess amount to the employer within a reasonable period. Failure to return these excess funds can cause the entire reimbursement arrangement to be treated as a non-accountable plan. A reasonable period to return excess amounts is 120 days after the expense was paid or incurred.
Meeting these three requirements ensures that the reimbursements are not considered taxable income to the employee. This structure benefits both parties by providing a tax-efficient way for employers to cover business costs. Employers must maintain thorough records in case of an audit.
When Reimbursements Are Wages
When an employer’s expense reimbursement arrangement does not satisfy all three criteria of an accountable plan, it is classified as a “non-accountable plan.” Under such an arrangement, any amounts reimbursed to the employee are treated as taxable wages. This means the payments are considered part of the employee’s gross income, similar to their regular salary.
One reason a plan becomes non-accountable is the failure to meet the substantiation requirement. If an employer provides a fixed allowance for expenses without requiring receipts or detailed expense reports, this arrangement would be considered non-accountable. Also, if an employee fails to provide adequate documentation or is not required to return excess funds, the reimbursements become taxable.
Another situation leading to a non-accountable plan occurs when an employer pays a fixed amount regardless of whether the employee incurs business expenses. For instance, providing a flat monthly stipend for “business expenses” without any requirement for proof of spending or return of unused funds would make the entire amount taxable.
Amounts received under a non-accountable plan are subject to federal income tax withholding, as well as Federal Insurance Contributions Act (FICA) taxes. FICA taxes include Social Security and Medicare taxes. This means that a portion of the reimbursed amount will be withheld from the employee’s payment to cover these tax obligations.
How Reimbursements Impact Your Taxes
The tax implications for employees differ significantly based on whether reimbursements are made under an accountable or a non-accountable plan. For reimbursements paid through an accountable plan, the amounts are not reported as wages on the employee’s Form W-2. These tax-free reimbursements are excluded from the employee’s gross income and are not subject to federal income tax withholding, Social Security tax, or Medicare tax.
In contrast, reimbursements received under a non-accountable plan are fully included in the employee’s gross wages. This amount will appear in Box 1 of the employee’s Form W-2, increasing their taxable income. Consequently, these amounts are subject to federal income tax withholding, reducing the employee’s take-home pay.
Beyond income tax, non-accountable plan reimbursements are also subject to FICA taxes. The employee’s portion of Social Security tax is 6.2% of wages up to an annual wage base limit. The Medicare tax rate for employees is 1.45% of all wages. An additional Medicare tax of 0.9% applies to wages exceeding $200,000 for individual filers, without an employer match.
The Tax Cuts and Jobs Act (TCJA) of 2017 suspended deductions for unreimbursed employee business expenses for tax years 2018 through 2025. This means that for most employees, any business expenses not reimbursed by their employer, or reimbursed under a non-accountable plan, cannot be deducted on their federal income tax return during this period.