Do Expense Reimbursements Get Taxed?

Expense reimbursements can be tax-free or taxable. The tax treatment depends on whether the employer’s reimbursement arrangement adheres to specific Internal Revenue Service (IRS) guidelines. Understanding these distinctions is important for both employees, as it impacts their taxable income, and employers, as it affects payroll tax obligations and deductible business expenses.

Understanding Accountable Plans

An accountable plan is a reimbursement arrangement that allows employers to repay employees for business expenses without those payments being considered taxable income. To qualify, the arrangement must meet three requirements.

First, expenses must have a business connection, meaning they were incurred while performing services for the employer. Second, employees must adequately substantiate these expenses to their employer within a reasonable timeframe. This involves providing detailed records, such as receipts, dates, amounts, and the business purpose of the expense.

A reasonable time means accounting for expenses within 60 days after they were paid or incurred. Third, employees must return any excess reimbursements or advances that exceed the substantiated expenses within 120 days after the expense was paid or incurred.

When these three criteria are met, reimbursements are not considered wages or compensation to the employee. Instead, they are treated as ordinary and necessary business expenses of the employer, which can be deducted by the business, thereby lowering its taxable income. Employees benefit by receiving these reimbursements tax-free, as they are excluded from their gross income and are not subject to income or employment taxes.

Understanding Non-Accountable Plans

A non-accountable plan is any expense reimbursement arrangement that fails to meet one or more of the three requirements for an accountable plan. If an employer’s plan lacks a business connection, does not require adequate substantiation, or does not require the return of excess advances, it will be classified as non-accountable. Reimbursements made under such a plan are treated as taxable income to the employee.

Common situations that result in a non-accountable plan include employers providing flat allowances for general expenses without requiring receipts or detailed accounting. Another scenario is when employees are reimbursed for personal expenses, or when advances are given but never reconciled with actual expenses, and excess amounts are not returned. In these cases, the IRS considers the reimbursements to be additional compensation rather than a repayment of business costs.

Reimbursements from a non-accountable plan are fully taxable to the employee. They are subject to federal income tax withholding, Social Security taxes (FICA), Medicare taxes, and federal unemployment taxes (FUTA). For the employer, these amounts are also subject to payroll taxes. Any payment not adhering to accountable plan rules is viewed as regular wages, increasing the employee’s gross income and tax liability.

Common Examples and Tax Reporting

Mileage reimbursement, often based on the IRS standard mileage rate, is non-taxable if it adheres to accountable plan guidelines and does not exceed the IRS-published rates. If the reimbursement rate exceeds the IRS standard, the excess amount becomes taxable income. Business travel expenses like flights, hotels, and meals are non-taxable when properly substantiated with receipts and a clear business purpose.

Per diem allowances, which are fixed daily amounts for lodging, meals, and incidental expenses during business travel, can also be non-taxable. These are considered “deemed substantiated” if they do not exceed federal per diem rates for a given location, even without specific receipts for each expense. However, if the per diem allowance exceeds the IRS-approved rate for the location, the difference is considered taxable income to the employee.

Home office expenses, such as a portion of rent, utilities, or internet, can be reimbursed tax-free under an accountable plan, provided the space is used exclusively and regularly for business and the expenses are properly documented.

Non-taxable reimbursements made under an accountable plan are generally not reported on the employee’s Form W-2. These amounts are excluded from the employee’s gross income because they are not considered wages. Conversely, taxable reimbursements paid under a non-accountable plan are included in the employee’s gross wages. These amounts appear in Box 1 (Wages, tips, other compensation), Box 3 (Social Security wages), and Box 5 (Medicare wages) of the employee’s Form W-2, and are subject to all applicable payroll tax withholdings.