Employee Allowance: Tax Rules for Your Business

An employee allowance is a fixed, recurring amount of money provided to an employee for specific, anticipated business-related costs, separate from regular salary or wages. Unlike a direct expense reimbursement for an exact cost already incurred, an allowance is a pre-determined sum to cover expected expenses. For example, a company might provide a set $50 monthly technology allowance instead of reimbursing an employee’s actual mobile phone bill. This structural difference has tax implications for both the employer and the employee, as the tax treatment depends on its administration under Internal Revenue Service (IRS) rules.

Understanding Accountable vs. Non-Accountable Plans

The taxability of an employee allowance is determined by whether it operates under an accountable plan. If an allowance arrangement meets specific government rules, it qualifies as an accountable plan, and the payments are not considered taxable income to the employee. This means the money is not subject to income, Social Security, or Medicare taxes. For the employer, these reimbursements are deductible as a business expense.

If the arrangement fails to meet even one of the required tests, it is classified as a non-accountable plan. Under a non-accountable plan, all allowance payments are considered taxable wages. The full amount must be included in the employee’s income and is subject to all standard payroll taxes.

To qualify as an accountable plan, the arrangement must satisfy three core IRS requirements. The first is a business connection, meaning the expense must be a deductible business expense incurred as part of the employee performing their job duties. Personal expenses, or those without a clear business purpose, fail this test.

The second requirement is substantiation. The employee must account for their expenses to the employer within a reasonable period by providing documentation, such as receipts or logs, that prove the amount, time, place, and business purpose of the expense. The IRS considers substantiation within 60 days of the expense being incurred as reasonable.

The final requirement is the return of excess funds. An employee must return any allowance money that exceeds their substantiated business expenses within a reasonable period. For example, if an employee receives a $300 travel allowance but only substantiates $250 in expenses, they must return the extra $50. The IRS considers returning excess funds within 120 days of the expense being incurred as a reasonable timeframe.

Common Types of Allowances and Their Tax Considerations

The principles of accountable and non-accountable plans apply to various common allowances. A car or auto allowance is a fixed amount given to employees to cover the business use of their personal vehicle. To be non-taxable under an accountable plan, the employee must substantiate the business use by maintaining a mileage log detailing the date, destination, business purpose, and miles driven for each trip. The substantiated mileage is then multiplied by the current IRS standard mileage rate to determine the non-taxable amount.

Technology allowances are common for expenses like cell phones and home internet. For cell phone allowances, if an employer requires an employee to use their personal cell phone for business reasons, a reimbursement for reasonable phone expenses can be treated as non-taxable. This removes the need for detailed logs of business versus personal calls if the phone is a business requirement and not a form of hidden pay. Allowances for other technology, such as home internet, may still require substantiation to separate the business-use portion from personal use to qualify as non-taxable.

Home office stipends provide funds for employees to maintain a workspace at home, covering costs like a portion of utilities, internet service, or office supplies. To meet accountable plan rules, the employee must substantiate these specific expenses and their business connection. This requires record-keeping to separate business costs from personal household expenses.

A wellness stipend, which provides funds for gym memberships or fitness classes, is almost always treated as taxable income. These expenses fail the business connection test because the IRS does not consider them ordinary and necessary business expenses directly related to the performance of an employee’s duties. As such, wellness stipends are paid under a non-accountable plan and included in the employee’s wages.

Information and Documentation for an Allowance Program

Before implementing an allowance program, an employer must determine a fair allowance amount and payment frequency, such as monthly. A formal, written allowance policy is necessary to establish an accountable plan and should be distributed to all participating employees. The policy must state the business purpose of the allowance and define which expenses are covered.

This written policy must detail the requirements for substantiation, including what constitutes adequate proof and the information required on an expense report or log. The policy must also outline the process and timeline for submitting these documents.

The policy must also state the rule for returning any excess allowance funds, including the procedure and timeframe for doing so. Creating a standardized expense submission form can simplify compliance for both the employee and the payroll department.

Payroll Processing and Tax Reporting

The administration of an allowance through payroll is dictated by its classification. For an accountable plan, the payment is a non-taxable reimbursement, not wages. It is not subject to federal income tax withholding, Social Security, or Medicare taxes and appears as a separate line item on the employee’s pay stub.

Under a non-accountable plan, the entire allowance amount is treated as supplemental wages. The employer combines the allowance with the employee’s regular salary and withholds the applicable income and payroll taxes from the total. This increases the employee’s gross taxable income.

The distinction carries over to year-end tax reporting on the employee’s Form W-2. For an accountable plan, the allowance payments are not reported on the W-2. Since they are not considered income, they are excluded from the wage totals, which simplifies tax filing for the employee.

In contrast, all payments from a non-accountable plan must be included on the employee’s Form W-2. The total amount of the allowance paid during the year is added to the employee’s wages in Box 1 (Wages, tips, other compensation), Box 3 (Social Security wages), and Box 5 (Medicare wages and tips).