Do you have employees? Are you an employee? (Remember, if you operate your business as an S or a C corporation, you are an employee of the corporation.)
We ask about employees because with an accountable plan, tax rules give both the employer and the employee tax breaks. It works like this:
The employer deducts the expenses that the employees submit for reimbursement.
The rules treat the reimbursed expenses as tax-free to the employee.
Reimbursements Are Not Wages
Normally when you pay an employee, you pay him or her “wages,” which are subject to employment taxes and income taxes.1
Wages do not include amounts that you pay employees to reimburse them for expenses they incur in the course of their employment for you.
However, unless you create a valid accountable plan, the IRS will treat these reimbursements as if they were wages and tax them the same way.2 The wage classification triggers employment taxes that drain cash from both the employer and the employee.
But with an accountable plan, you or your corporation does not pay employment taxes on the reimbursement, and you deduct the payment as a business expense.
Thus, a good accountable plan creates tax savings both for you and your employees.
How to Form the Plan
An accountable plan is simply a list of guidelines that you create that explains how you will reimburse expenses, and which expenses qualify for reimbursement.
Tax rules do not require you to put the accountable plan in writing. However, you or your corporation should put the plan in writing to make it clear and useable both for you and your employees. (And should the IRS come knocking, your written plan puts you in the driver’s seat.)
The IRS gives you a lot of flexibility in arranging the plan. It sets forth four major requirements:
Business connection. The expense must be a deductible expense that arises in the course of business (See business expense);3
Documentation. The employee must submit documents showing the nature of the expense and how it relates to the business;4
Substantiation. Employees must prove to the employer that the expense meets the documentation requirements of the tax law (mileage log for vehicles; who, where, and why for entertainment; etc.)5
No Excess Payment. If your plan allows for expense advances, the employee must return any excess advances within a reasonable time or the IRS will tax that excess as wages.6
Of course, once you establish the plan, you must also follow what it says. The IRS may invalidate your plan if you show a pattern of disregarding the rules.7
1 See IRC Section 3306(b).
2 IRC Sections 62(a)(2) and 62(c); Reg. Section 1.62-2(c)(4).
3 Reg. Section 1.62-2(d).
4 Reg. Section 1.62-2(e).
6 Reg. Section 1.62-2(c).
7 Reg. Section 1.62-2(k).