Accountable Plan Rules Denied Income Exclusion for Tool Reimbursements

In Rev. Rul. 2005-52, the IRS applied the standards of an accountable plan outlined in Sec. 62(a)(2)(A) and the regulations to recast an employers expense reimbursement payments as compensation to the employee recipients. Simultaneously, the IRS issued Notice 2005-59, explaining how an Industry Issue Resolution (IIR) Program could be used to give employers relief from the accountable plan rules.

Background

In Rev. Rul. 2005-52, an employer implemented an arrangement intended to use Sec. 62(a)s accountable plan standards to exempt from withholding and employment taxes payments made to employees as reimbursement for out-of-pocket tool expenses. The employer, an automobile repair business, required employees who worked as service technicians to provide and maintain the tools they used in performing repair and maintenance services. In addition to regular compensation, the employer paid each technician a pre-determined tool allowance to cover the cost of acquiring and maintaining their tools.

Tool allowances: The employer combined information derived from national statistical surveys on tool expenses incurred by automobile service technicians, with data provided by employees, to determine the average hourly expense ratio that was the basis for the tool allowance.

Each pay period, employees received their regular compensation and a reimbursement allowance payment. The employer gave each employee a quarterly statement detailing the individuals actual tool allowance paid, as well as his or her estimated tool expenses incurred during the period. The arrangement was based solely on estimated expenses; employees were not required to submit receipts or other documentation of their actual tool expenses, nor did the employer require employees to repay any excess allowance received over actual expenses incurred.

Law

Under Sec. 61, payments made by an employer to an employee as reimbursement for expenses incurred by the latter as a condition of employment, are treated as compensation unless specifically excludible under another Code provision. Sec. 62(a)(2)(A) excludes from an employees gross income amounts paid by an employer under certain arrangements (plans) that govern the reimbursement of business expenses incurred by the employee.

Accountable plan: To qualify for the exclusion, a plan must meet three requirements set forth in Regs. Sec. 1.62-2(c)(1), (2) and (d)(f):

1. The reimbursed expense must be allowable as a deduction by the employer in the course of its trade or business activities and must be incurred by the employee in connection with services performed as an employee of the employer.

2. The employer must be obligated to obtain evidence of each expense in a timely manner. For this purpose, the documentation must identify the nature of the expense and demonstrate its connection to the employers business activities.

3. The employee must be obligated to repay within a reasonable period any amount received in excess of his or her substantiated expenses.

If these three requirements are met, the plan is deemed an accountable plan. Payments made under its terms are excluded from amounts reported as compensation on the employees Form W-2; further, such amounts are not subject to withholding and employment taxes. If any of these requirements is not met, the plan is a nonaccountable plan. Payments from a nonaccountable plan are not excluded from income and, thus, are subject to withholding and employment taxes; see Regs. Sec. 1.62-2(c)(3).

Outcome

In the ruling, the IRS determined that the plan in question failed to meet two of the accountable plan conditions. First, employee participants in the plan were not obligated to provide substantiation of the expenses incurred; the employer relied wholly on its pre-determined expense ratio to calculate reimbursements. Thus, the employer was unable to determine whether the plan payments exceeded the employees actual tool expenses. This led to the plans second failureemployees were not obligated to repay the excess of their reimbursements over actual expenses.

To exclude expense reimbursement payments from compensation, each of the accountable plan requirements must be independently met. Because the plan failed on two counts, the reimbursements were reportable as compensation on the employees Forms W-2 and were subject to withholding and employment taxes.

Relief

Recognizing that the accountable plan rules are prohibitively burdensome in some instances, the IRS issued Notice 2005-59, outlining the criteria it will consider in an IIR Program to give employers and employees relief under the accountable plan rules. The notice makes it clear that this reprieve is not intended for employers that complain about the routine plan expense associated with record collection, substantiation and reconciliation. Instead, the relief effort is intended to address inherent difficulties that impede application of the existing rules to certain industry groups, because of factors like high employee turnover and a lack of expense uniformity across the workforce.

From Barbara S. Borczak, CPA, Frazier & Deeter, LLC, Atlanta, GA