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Accountable Plans, Reimbursements and Per-Diem Allowances (Part I) Employers and employees risk unfavorable treatment if reimbursements and expense allowances are not accountable-plan payments. Part I of this two-part article describes the basic requirements for reimbursements and other accountable-plan payments that are excludible from gross income and exempt from income and employment tax withholding.
William J. Kenny, J.D., CPA
For more information about this article, contact Prof. Kenny at billk@sba.pdx.edu or Dr. Christensen at annec@montana.edu.
Executive Summary
Reimbursement of employees business and travel expenses is a common and straightforward transaction. Unfortunately, the tax implications of these simple transactions are fraught with complexity that can cost both employers and employees additional taxes. This two-part article describes the requirements and consequences of reimbursement, per-diem and expense allowance arrangements. Part, I below, discusses accountable-plan requirements in general. Part II, in the August 2003 issue, will examine the various types of per-diem and travel-allowance arrangements and present the pros and cons of each type of arrangement in the context of applicable accountable-plan rules. Employers and employees generally view reimbursements from accountable plans as desirable, because they have a lot to lose if reimbursements are not handled properly. Accountable-plan treatment obviates the need for income tax and FICA withholding, excludes the payments from the employees gross income and negates the employees need to take deductions. When expense reimbursements are from nonaccountable plans, they are includible in the employees wages and subject to withholding and payroll taxes; the employees expenses, if deductible, are only allowed as miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income threshold. To qualify for accountable-plan treatment, several requirements must be met:
Reimbursement Requirement A payment to an employee must be a true reimbursement of an actual business expense. For example, in Lickiss,1 an outside salespersons commissions were reduced by $100 per week to reflect estimated business expenses; he received a single check with a statement that indicated the amount of his commission and the expense reimbursement. The Tax Court ruled in the IRSs favor, finding no reimbursement, because Lickiss was not required to provide his employer with any information regarding his actual business expenses. Payments for travel expenses made to employees, whether or not they are expected to travel, will not qualify as accountable-plan reimbursements. Regs. Sec. 1.62-2(j), Examples 1 and 2, further clarify the reimbursement requirement in this context. If an employer pays its engineers $200 per day, whether or not they are away from home, it cannot characterize $50 of that amount as an accountable-plan reimbursement, even for the days when an engineer is traveling away from home. The entire $200 must be treated as wages, because the amount of the payment remains the same regardless of whether the engineers travel. In contrast, an airline that pays its pilots and flight attendants an allowance in addition to their salary, regardless of whether or not they are away from home, has both an accountable and a nonaccountable plan. Such treatment is permitted, because pilots and flight attendants can reasonably be expected to be away from home. The pilots and flight attendants who are actually away from home are deemed reimbursed from an accountable plan; those who make day trips and are not away from home are reimbursed from a nonaccountable plan. Generally, any expense allowance figured on the same basis as compensation (e.g., hours worked, miles traveled or products sold) will not qualify as a reimbursement from an accountable plan.2 In any case, the employer must show that the allowance is paid with a reasonable expectation that the employee will actually incur such expenses.3 The IRS permitted4 broker-dealer commissions for salesmen of mutual funds to be reduced in advance for certain employees who were expected to incur travel expenses, and held that they were reimbursed under a fully accountable plan. However, it has stated5 that it is reconsidering the circumstances under which the concurrent adoption of a salary reduction arrangement and a reimbursement or other expense allowance arrangement constitutes, in substance, a recharacterization of wages that is not permitted under section 62(c).
Anti-Abuse Rule Even when a reimbursement arrangement meets the technical requirements of an accountable plan, it may still be characterized as a nonaccountable plan under Regs. Sec. 1.62-2(k) if the IRS finds that it evidences a pattern of abuse of the rules. For example, in one ruling,6 a company in the courier, messenger and delivery business paid its messenger-drivers 40% of the fee charged to customers. The messenger-drivers used their own vehicles to provide service and submitted detailed records of the miles driven on a daily basis. The company calculated each messengers compensation and then allocated it first to a $4.25 per-hour wage, with the balance to a cents-per-mile payment for mileage. Interestingly, the payments resulted in a cents-per-mile amount less than the Federal mileage allowance. Although the IRS agreed that the arrangement met the technical requirements of an accountable plan, it held that the plan was an abuse of the rules and thus not an accountable plan. According to the IRS, as in Lickiss, the amount a driver would receive was unrelated to the potential expense and determined without reference to the actual expense incurred.
Accountable and Nonaccountable Plans Generally, when tax professionals contemplate a plan requirement (such as in a qualified retirement, welfare or fringe benefit plan), they think of a written document containing stringent parameters and covering a defined class of persons. The meaning of the term plan in accountable plan is not necessarily consistent with that interpretation. A plan is simply an explicit or implicit understanding between the employer and the employee as to the conditions of a particular reimbursement. An accountable plan need not be in writing or cover a particular class of employees. Under Regs. Sec. 1.62-2, an employer can have an accountable plan for some employees and a nonaccountable plan for others (e.g., for the flight attendants noted above). In addition, an employee may receive reimbursements from both an accountable plan and a nonaccountable plan in the same reimbursement. This might occur, for example, when an employer has an otherwise accountable plan, but reimburses employees at 40 cents per mile when the standard mileage rate is 36.5 cents per mile. For each 1,000 miles traveled and substantiated, $365 of the reimbursement would be from an accountable plan and $35 from a nonaccountable plan.7 The employer must withhold and pay employment taxes on $35. If an employee who is eligible for a reimbursement does not apply for payment, he or she will be denied a business expense deduction.
Business Connection The business connection requirement of an accountable plan is the easiest to meet and is automatic in most cases. To meet the test, Sec. 62(a)(2)(A) requires the reimbursed expense to be deductible under Secs. 161196. Thus, reimbursement for any customary business expense meets the test. Regs. Sec. 1.62-2(d)(2) considers any reimbursement that fails the test to be automatically from a nonaccountable plan. For example, the Service ruled8 that employer-provided airline tickets for employee transportation to a remote job site constituted wages (subject to income and employment taxes), because commuting is a personal, not a business, expense. Similarly, if an employer reimbursed an employee who it transferred to another state, for both the cost of shipping the employees household goods (deductible) and a house-hunting trip (nondeductible), part of the reimbursement would be from an accountable plan (shipping household goods) and part from a nonaccountable plan (house-hunting trip).
Substantiation The substantiation requirement contains two sets of rulesone for accountable plans and one for Sec. 274. Sec. 274 mandates recordkeeping and receipts for travel, entertainment, meals and listed property expenses (e.g., automobiles, computers and cell phones). Although the two sets of requirements have similarities, some of their differences may pose a trap. For expenses governed by Sec. 274(d), if employees provide adequate records to their employer in a manner consistent with Sec. 274, they automatically meet the Sec. 62 accountable-plan substantiation requirement. For expenses not covered by Sec. 274(d), employees substantiate when they submit sufficient information for each element of the expense, to enable the employer to identify the specific nature of the expense and determine whether it is attributable to the employers business activities. According to Sec. 274(d) and Temp. Regs. Sec. 1.274-5T, each element of the expense must be substantiated by adequate records or by sufficient evidence corroborating the taxpayers own statement. The exhibit below describes the elements of expenses.
Adequate records: Adequate records are required for taxpayers to substantiate each element of their expenditures. According to Temp. Regs. Sec. 1.274-5T(c)(2), adequate records can include an account book, diary, log, statement of expense, trip sheet or similar records in which the required facts are recorded. Although records need not be made contemporaneously with expenditures, they should be made near the time (e.g., within a week) of the expenditures or use. In addition, Regs. Sec. 1.274-5(c)(2)(iii) requires documentary evidence such as receipts, paid bills or similar evidence to support an expenditure recorded in an account book or diary. Receipts are not required for an expenditure under $75; however, they are required for lodging. The IRS ruled9 that electronic records taken directly from a credit card company can be used to substantiate travel and entertainment expenses of an employee for accountable-plan purposes. Also, electronic airline tickets can substantiate air travel.10 Further, Temp. Regs. Sec. 1.274-5T(c)(2)(ii)(C)(2) states, a record of the business use of listed property, such as a computer or automobile, prepared in a computer memory device with the aid of a logging program will constitute an adequate record. Temp. Regs. Sec. 1.274-5T(c)(5) indicates that if records are destroyed through circumstances beyond a taxpayers control (e.g., a casualty), the taxpayer has the right to substantiate a deduction through a reasonable reconstruction of the expenditures. However, the taxpayer must prove: (1) records existed that would have satisfied the substantiation requirement; and (2) those records were destroyed in a casualty beyond the taxpayers control. Thus, when a taxpayer loses, misplaces or entrusts substantiation records to a third party who loses them, he or she may not estimate the amount involved. For example, in Gill,11 the taxpayer claimed his alcoholic ex-wife threw out his substantiation records. The court disallowed the exclusion of his travel reimbursements based on estimated amounts, by holding there was no casualty. Other corroborative evidence: When adequate records are not kept, Sec. 274(d) and Temp. Regs. Sec. 1.274-5T(c)(3) indicate the taxpayer may substitute other corroborative evidence to support his or her own statement. The facts and circumstances will determine the type of evidence adequate to meet this test. The regulations provide some guidance for determining corroborative evidence needed to establish the business use of an automobile. For example, if a trip log is not maintained for an entire year, the taxpayer may use a sampling method. Temp. Regs. Sec. 1.274-5T(c)(3)(ii)(C), Examples (1) and (2), suggest that a trip-by-trip log kept for part of the year can be extrapolated to the whole year; a log for one week of the month can be extrapolated to the whole month. Records of automobile expenditures must be kept in addition to the log. Sampling also can be used for cell phones, computers and other listed property, to differentiate between personal and business use. Deemed substantiation: The recordkeeping burden posed by the substantiation requirements may be reduced by the use of per-diem arrangements. Under Sec. 274, travel expenses for lodging, meals and standard mileage are deemed substantiated when paid on the basis of predetermined rates. If a company adopts the Federal per-diem rates, reimbursements will be considered to be from an accountable plan as long as employees substantiate the business purpose, date and place of travel. If a company adopts reasonable rates, but they are greater than the Federal rates (e.g., 120% of the Federal rate, 40 cents per mile), Regs. Sec. 1.62-2(j), Examples (6) and (7), suggest reimbursements will be deemed from accountable plans to the extent of the Federal rates and from nonaccountable plans for the excess. The use of a per-diem or mileage allowance only documents the amount element of the expense. Employees must substantiate the remaining elementstime, place, business purpose and business use of automobiles or listed property.
Return of Excess Reimbursement Under Sec. 62(c), an accountable plan must require employees to return the excess of any advance or reimbursement over the amount substantiated. If there is no such plan requirement, the plan is automatically nonaccountable. The existence of the obligation will be determined according to Regs. Sec. 1.62-2(f) by reference to all the facts and circumstances of the arrangement. Also, when advances are made, they may not exceed the amount of anticipated expenditures, and must be made close in time to when the expenses will be incurred. A failure to return the excess within a reasonable time results in the entire reimbursement being treated as from a nonaccountable plan. In addition to the facts and circumstances, the regulations contain two safe harbors for determining a reasonable time for the return-of-excess requirement. Regs. Sec. 1.62-2(g) provides a fixed-date method and a periodic-statement method. The fixed-date method allows advances to be made within 30 days of an expense and requires substantiation 60 days after the expense is paid or incurred. Repayment of any excess funds must be made not longer than 120 days after the expense is paid or incurred. The periodic-statement method requires employers to provide employees with statements (not less frequently than quarterly) that indicate the amounts of advances and substantiated expenses. Employees must then either substantiate any excess or repay it within 120 days of the statement date. If an employer is found to have a pattern or practice of excess advances or over-reimbursements, the safe harbors are not available. Duty to withhold: When employers adopt reasonable per-diem rates or mileage rates in excess of the Federal rates, employees need not return the excess, as long as they appropriately substantiate their expenses. However, the reimbursements are deemed partially from an accountable plan and partially from a nonaccountable plan; the amounts in excess of the Federal rates must be included in wages and are subject to income and payroll tax withholding. If there is no requirement to repay an excess reimbursement (i.e., amounts are automatically deemed to stem from nonaccountable plans), the duty to withhold arises when the payment is made. All advances and reimbursements for unsubstantiated expenses must be included in wages. The duty to withhold income and employment taxes arises no later than the first payroll period following the expiration of the reasonable period for repayment. Employees who fail to substantiate their business expenses in a timely manner cannot subsequently substantiate their expenses and have their advances or reimbursements treated as arising from an accountable plan. In addition, employees who work for companies with nonaccountable plans, cannot compel their employers to treat the plans as accountable, even if the employees voluntarily substantiate their expenses and return excess reimbursements. Frequent flyer points: The return-of-excess requirement has received special attention in employee air travel arrangements, primarily because of frequent flyer points. In the past, the Service had ruled12 that the return-of-excess reimbursements requirement was not met when employees were not required to give frequent flyer mileage points to their employer for use on future business flights. In that ruling, the plan specifically directed employees to use transportation methods that provided the best advantage to the company. It required the employee to demand a penalty payment if he or she were bumped from a flight due to overbooking and to direct all such payments to the company. The plan also required employees to return incentives (such as discount coupons) to the company. However, because the Service considered the frequent flyer mileage to be a rebate, which lowered the ticket purchase price, the plan was nonaccountable. The National Defense Authorization Act for Fiscal 2002, signed into law on Dec. 28, 2001, allows Federal employees to retain frequent flyer miles for personal use. In addition, the IRS has stated13 that it will not take the position that taxpayers have understated their tax liabilities on the receipt or personal use of frequent flyer miles obtained from business or official travel, unless the miles are converted into cash or other compensation. The new law covering Federal employees travel, coupled with the IRS announcement, suggests that the air travel arrangement described above would now be deemed an accountable plan.
Record Retention A taxpayer who takes a deduction is required to maintain records to substantiate it. If an employee takes a deduction in excess of reimbursed amounts, he or she must document all expenses, including those reimbursed. The employer must document and retain records for the reimbursed amounts. Requirements for the use and retention of electronic records for documentation of travel expenses have evolved as technology and practice have changed. Currently, hard copy records may be retained in microfiche or microfilm format in conformity with Rev. Proc. 81-46,14 or in an electronic storage system in conformity with Rev. Procs. 97-2215 and 98-25.16 Rev. Proc. 97-22 provides guidance on storage and safekeeping requirements for images of hard copy documents and other records stored on media such as optical disks, which allow viewing with access to the original program that produced them. Rev. Proc. 98-25 provides general guidance for retention, periodic testing and documentation of records produced or maintained in a computer system. Once a reimbursement has been made, it is the employers duty to retain the records, not the employees. However, Temp. Regs. Sec. 1.274-5T(f)(5) contains three exceptions: (1) for expenses in excess of reimbursement; (2) for employees who are related to their employer (within the meaning of Sec. 267 (family members and controlled entities)); and (3) in cases in which the employers procedures are not adequate (something an employee is unlikely to know). If an employee deducts expenses in excess of reimbursed amounts, he or she must retain records for all travel expenses, including those reimbursed.
Conclusion Although most tax professionals are generally familiar with reimbursements and accountable-plan requirements, many may not be familiar with the more subtle complexities in this area. Professionals should review their clients reimbursement plans, especially those in construction, transportation, sales and consulting industries, in which these payments are common. If accountable plans do not conform to the requirements, the consequences for employers and employees can be severe. Part II of this article, in the August 2003 issue, will examine the various types of per-diem and travel-allowance arrangements generally in use and present the pros and cons of each type of arrangement in the context of the accountable-plan rules. |
