Should Reimbursements Be Taxed? What to Know

A reimbursement occurs when an employer pays an employee back for expenses incurred while performing business duties. The tax treatment of these payments can be complex, as it depends on specific rules established by tax authorities. This article clarifies when reimbursements are, or are not, considered taxable income.

Distinguishing Taxable from Non-Taxable Reimbursements

The Internal Revenue Service (IRS) distinguishes between taxable and non-taxable reimbursements through “accountable plans.” For a reimbursement to be non-taxable, the employer’s arrangement must meet three specific requirements. If an employer’s reimbursement plan satisfies these criteria, the payments are generally excluded from the employee’s gross income.

First, expenses must have a business connection, meaning they were incurred by the employee while performing services for the employer. Second, the employee must provide adequate substantiation for expenses within a reasonable period. This includes detailed records like receipts, invoices, or mileage logs, along with information about the amount, date, place, and business purpose.

Third, the employee must return any unsubstantiated excess reimbursement within a reasonable timeframe. A “reasonable period” for substantiation and return of excess funds is generally within 60 days after the expense is incurred, or within 120 days after the end of the employer’s expense reporting period.

If an employer’s reimbursement arrangement fails to meet even one of these three requirements, it is considered a “non-accountable plan.” Under a non-accountable plan, all reimbursements paid to an employee are treated as supplemental wages. These amounts are then subject to federal income tax withholding, Social Security tax, and Medicare tax.

For example, the Social Security tax rate is 6.2% for both the employer and employee, up to an annual wage base limit. The Medicare tax rate is 1.45% for both parties, with no wage base limit. Reimbursements under a non-accountable plan are reported as wages on the employee’s Form W-2, Box 1, and are subject to all applicable payroll taxes.

Common Reimbursement Scenarios and Their Tax Implications

Business travel expenses, such as airfare, lodging, and meals incurred while away from home for business, are not taxable to the employee if the employer’s system requires proper documentation and the return of any unsubstantiated funds. These expenses must be ordinary and necessary for conducting business.

Mileage reimbursements for using personal vehicles for business are non-taxable. This holds true if the reimbursement rate does not exceed the standard mileage rate set by the IRS, which is 67 cents per mile for 2024 business use. If an employer reimburses mileage at a rate higher than the IRS standard, the amount exceeding the standard rate is considered taxable income to the employee and must be reported as wages.

Education expenses, when reimbursed by an employer, can be non-taxable if they are directly related to the employee’s job and are part of an accountable plan. For instance, if an employer pays for courses that maintain or improve skills needed in the employee’s current job, or if the education is required by the employer or by law to keep the job, it may be non-taxable. However, education that qualifies the employee for a new trade or business, or that is part of a program of study to meet the minimum educational requirements of the employee’s current job, is generally taxable.

Health and medical expenses reimbursed through employer-sponsored arrangements, like a Health Reimbursement Arrangement (HRA), are non-taxable to the employee. An HRA is an employer-funded plan that reimburses employees for out-of-pocket medical expenses and, in some cases, health insurance premiums. These reimbursements are excluded from the employee’s gross income if they are for substantiated medical care expenses, as defined in Internal Revenue Code Section 213.

Moving expenses reimbursed by an employer are taxable income for most employees. Under current law, only active duty members of the U.S. Armed Forces who move due to a permanent change of station may exclude qualified moving expense reimbursements from their income. For all other employees, any employer-provided moving expense reimbursement is considered taxable wages subject to income and payroll taxes.

Employer and Employee Responsibilities

Employers bear significant responsibilities in ensuring reimbursements are handled correctly for tax purposes. They must establish and maintain an accountable plan that strictly adheres to IRS requirements for business connection, substantiation, and the return of excess funds. This involves creating clear, written policies that outline reimbursable expenses and documentation procedures.

Employers are also responsible for proper tax withholding and reporting on Form W-2 for any reimbursements that do not meet accountable plan criteria. If reimbursements are considered non-accountable, they must be included in the employee’s gross wages and be subject to federal income tax withholding, Social Security tax, and Medicare tax. Clear communication of these reimbursement policies to employees is paramount to avoid misunderstandings.

Employees have duties to ensure the proper tax treatment of their reimbursements. They must understand their employer’s specific reimbursement policy, especially regarding what constitutes an eligible expense and the required documentation. Maintaining diligent records, such as keeping original receipts, invoices, and detailed logs for all business expenses, is essential for substantiating claims.

Employees must submit their expense reports and all supporting documentation in a timely manner as required by the employer’s accountable plan. Failure to provide adequate substantiation within the specified timeframe can result in the reimbursement being reclassified as taxable income. Employees are obligated to return any unsubstantiated or excess reimbursements to their employer within a reasonable period, typically within 120 days of the expense or as specified by the employer’s policy.