Should Reimbursements Be Paid Through Payroll?

Employee reimbursements are a common aspect of business operations, covering expenses employees incur while performing job duties. A frequent question is whether to process these payments through regular payroll or separately. Understanding this is important for tax compliance and operational efficiency, ensuring proper classification and avoiding issues for both the business and its employees.

Differentiating Reimbursement Types

Employee reimbursements are payments from an employer to an employee for out-of-pocket expenses incurred on behalf of the business. It is important to distinguish between two primary categories: non-taxable reimbursements for legitimate business expenses, and taxable payments that do not meet tax-free criteria. This distinction affects how the employer reports payments and how the employee is taxed, as misclassifying them can lead to incorrect wage reporting and potential tax liabilities for both parties.

The Accountable Plan Framework

For an expense reimbursement arrangement to qualify as non-taxable under Internal Revenue Service (IRS) regulations, it must adhere to specific requirements. This framework, known as an “accountable plan,” ensures reimbursements are tax-free to the employee and not subject to payroll taxes. Three main criteria must be met. First, expenses must have a business connection, meaning they were incurred while performing services as an employee of the business. This ensures the expense directly relates to the employer’s operations.

Second, employees must adequately account for these expenses within a reasonable period, typically within 60 days after the expense is paid or incurred. Adequate accounting involves providing substantiation, such as receipts or invoices, detailing the amount, date, place, and business purpose. Third, employees must return any excess reimbursement or allowance within a reasonable time, generally within 120 days after the employer pays the advance. Meeting these three criteria allows the employer to deduct the expenses, and the reimbursements are excluded from the employee’s gross income and are not subject to income tax withholding or Social Security, Medicare, and Federal Unemployment Tax Act (FUTA) taxes.

Taxable Reimbursements and Their Handling

When an expense reimbursement arrangement fails to satisfy any of the three rules for an accountable plan, all payments are considered part of the employee’s taxable wages. This means if an expense lacks a business connection, is not properly substantiated, or if excess amounts are not returned, the entire reimbursement becomes taxable. For example, payments for personal expenses or a general allowance without expense substantiation are taxable. Similarly, if an employee receives an advance but fails to account for it or return any unused portion, the entire advance becomes taxable income.

These taxable reimbursements must be included in the employee’s gross wages reported on Form W-2. They are subject to federal income tax withholding, as well as Social Security and Medicare taxes (FICA taxes). Employers are also responsible for their share of FICA and FUTA taxes on these amounts.

Preferred Payment Methods

The method for paying employee reimbursements differs based on their classification. Non-taxable reimbursements made under an accountable plan should ideally be paid separately from an employee’s regular payroll. As these amounts are not considered wages, they are not subject to payroll tax withholdings. Employers can disburse these non-taxable reimbursements through various non-payroll methods, such as direct deposit, a separate check, or a dedicated expense management system.

Conversely, any reimbursements or allowances considered taxable wages, because they do not meet accountable plan criteria, must be processed through payroll. These amounts are included in the employee’s gross pay. This ensures that all applicable income tax withholdings, employee and employer payroll taxes (Social Security, Medicare, and FUTA) are correctly calculated and remitted.