Reimbursing Employees for Business Expenses: Tax Benefit or Tax Bomb?

Since I had to write a big check to Uncle Sam last week, I wanted to share my family’s experience with unreimbursed employee expenses and the unintended impact it could have on you and your employees.

There are two ways an employer can choose to pay employees in order to reimburse them for out of pocket expenses for costs dealing with overnight travel, business use of their vehicle, home office use, and other business related expenses.

The Accountable Plan – Amounts paid to employees under this plan are not considered wages and are NOT subject to federal/ state income tax or FICA tax (Social Security and Medicare). Your employees can either receive an advance or be reimbursed after paying for the expense, but must meet three requirements:

1. They must have incurred the expense while acting as your employee.

2. They must substantiate these expenses to you within a reasonable time frame.

3. They must return any advanced amounts beyond the substantiated expenses.

The Non-Accountable Plan – Payments to an employee under this plan for travel or other necessary business expenses are treated as supplemental wages and ARE subject to income and FICA taxes. Employees are not required to submit expense reports and may even receive a higher amount than they might actually spend on the business expenses. In addition, the employee may choose to deduct the expenses on Form 2106 as unreimbursed employee expenses.

So in my case I am covered under the Accountable Plan, which means I have to go through the hassle of keeping track of all my receipts and filling out an expense report every week. I submit my expense report to my employer, then Financial Finesse cuts me a check as reimbursement for all the acceptable business expenses and the amounts I receive are not considered part of my taxable income and DO NOT appear on my W2 form. I also cannot claim these costs as my own business expenses.

On the other hand, my husband’s employer pays him a monthly expense allowance to cover his vehicle costs and other expenses he has as part of his duties as a project manager in the field of industrial heating and A/C. This involves hundreds of miles of daily travel visiting different job sites. Because they have chosen to pay him under the Non-Accountable Plan, he doesn’t have to worry about handing in expense reports to his employer, but we do have to claim this monthly allowance as income.

He may not have to turn in his receipts to his employer, but he does have to turn over his receipts to me, since I am our DIY (Do It Yourself) tax preparer. I am able to complete a federal form 2106 that provides a deduction for all his mileage (in 2010 it was 50 cents a mile), tolls, and any overnight travel expenses he had.

The total of his business expenses is then brought over onto our Schedule A to add to our itemized deductions. So here is the problem: on the Schedule A, unreimbursed employee expenses are subject to a 2 percent income threshold – not just of my husband’s earnings but of our joint earnings AND on top of that we got hit with the AMT (alternative minimum tax) which basically invalidates any of the deduction we may have been entitled to.

So, although it means more administrative work from the payroll department, the Accountable Plan is much more tax-friendly to your employees. If you do pay based on the Non-Accountable Plan, it is very important to provide some sort of tax education and guidance to help your employees understand the tax impact and tips to reduce the tax bite out of their expense check.

This was originally published on the Financial Finesse blog for Workplace Financial Planning and Education.