Small Business Taxes & ManagementTM--Copyright 2011, A/N Group, Inc.
Tool Plans and Reimbursed Expenses
It's commonplace for an employer to reimburse employees for job-related expenses. In some industries, an employee is expected to have his own small tools for which he may or may not be reimbursed. One of the most common examples are auto mechanics. The employer will provide large or expensive tools (such as a diagnostic computer), but the employee is expected to provide his own hand tools such as wrenches, etc. The concept isn't that far removed from turning in an expense report.
How you reimburse an employee will determine the tax consequences. In an effort to minimize accounting and recordkeeping, some employers have attempted to use a tool plan that doesn't require the employee to account for expenses incurred. That was the subject of a recent IRS Legal Memorandum (ILM 201120021).
In this situation an employer participated in a tool plan administered by a third party. The tool plan is intended to reimburse the employer's employees for the use of their tools and equipment. Under the plan, tool payments are made to employees as purported nontaxable reimbursement for the cost of the tools they are required to provide as a condition of employment. However, neither the employer nor the plan administrator verifies that the tools being claimed by the employees are actually required in the performance of services for the employer.
Prior to enrolling in the tool plan, an employer compensates its employees on an hourly wage basis, with no specific amount attributed to the provision of tools or equipment. Once an employer and its employees enroll in the tool plan, the employees' hourly wages are split into two components: a reduced hourly wage and a tool plan payment, which is calculated as a set percentage of the employee's hourly wage. Under the tool plan, an employer issues its employees one check for the reduced hourly wage amount; the employer also issues a second check for the tool plan payment which is treated as not subject to employment taxes. The employer's employees continue to receive essentially the same amount per hour under the tool plan as they did before implementation of the tool plan, but under the tool plan the amount is split into two portions, one treated as wages and the other treated as nontaxable reimbursement for tool expenses and the tool plan's administrative fee. Once an employee has received an amount equal to the total amount to be "reimbursed" under the tool plan (i.e., the value or estimated cost of the employee's tool and equipment inventory), the employee stops receiving tool plan payments and returns to his or her regular pay at the hourly wage rate earned prior to implementation of the tool plan.
The amount to be "reimbursed" is determined by taking an inventory of each employee's tools and equipment. The tool plan administrator asks each employee for a list of their tools and equipment and for any available receipts. The inventory includes tools or equipment the employee acquired prior to being employed with his or her current employer. If an employee does not have receipts to establish cost, the initial inventory of tools is valued using estimates, valuation publications, or current price lists. The tool plan did not obtain information regarding any previous depreciation taken by the employee for the tools in inventory or prior reimbursements, which is necessary to determine the expenses actually incurred by the employee in performing services for the employer. Purchases made after implementation of the tool plan are generally determined at actual cost and require receipts.
Under the law, if an employer simply provides the employee with a "tool allowance" and the employee does not have to account for the funds received, the amount is additional income, subject to withholding as well as FICA and any other employment taxes. The employee may be able to deduct the cost of the tool as an employee business expense, but he'll have to show it was required as a condition of employment and prove the amount and timing of the purchase. In addition, the deduction is taken on Schedule A of the employee's tax return. If the employee doesn't have other deductions (such as real estate taxes, mortgage interest, etc.) to allow him or her to itemize, the deduction won't provide a benefit. And the deduction is subject to the 2-percent floor on miscellaneous itemized deductions. Thus, assuming the employee has no other miscellaneous itemized deductions (that's frequently the case) the tax benefit is limited to the amount that exceeds 2 percent of his adjusted gross income. For example, if his adjusted gross income is $60,000, and the reimbursed amount is $2,000, only $800 would be deductible ($2,000 less 2% of $60,000 or $1,200). Moreover, both the employer and employee will have paid FICA taxes of 7.65% on the reimbursed amount.
In order for an arrangement to be treated as a reimbursement and not taxable to the employee, the employee must substantiate the expenses covered by the arrangement to his employer (e.g., an expense report) and the employee must return any amount in excess of the substantiated expenses covered under the arrangement. If the employee substantiates the amount and the expense is incurred in connection with the performance of services as an employee of the employer (and otherwise meets the requirements of an accountable plan, see below) the amount reimbursed will be deductible by the employer, but not income to the employee.
The tool plan described above fails a number of the tax law requirements. First, the employer is reimbursing for a tool expense that the employee paid or incurred prior to beginning employment. Second, the amounts are paid regardless of whether the employee pays or incurs or is reasonable expected to pay or incur expenses or the employer pays based on an approximation. Third, where a plan serves to recharacterize amounts as a reimbursement allowance that would otherwise be paid if there were no expenses reasonably expected to be incurred for the employer, amounts paid under the plan will not be treated as paid under an accountable plan. In other words, the employee receives the same amount, whether or not the arrangement is in effect, it's just that part of his compensation is recharacterized as a reimbursement.
There is one tool plan that is sanctioned by the IRS, but it applies only to pipeline construction industry workers providing their own rigs. (See Rev. Proc. 2002-11.)
You're probably already familiar with the basics of an accountable plan. The reimbursement arrangement must meet the following basic rules:
While the definition of a reasonable period of time depends on the facts and circumstances, the IRS has created a safe harbor:
If the plan meets the requirements above, it's considered an accountable plan and the reimbursements are not included in the employee's wages. If it doesn't meet the requirements, it's a nonaccountable plan and the reimbursement is income to the employee and must be included on his or her W-2.
Adequate accounting consists of an expense report, account book, diary, or similar record in which the expense is entered at or near the time incurred, along with documentary evidence (e.g., receipts) of travel, mileage, and other employee business expenses. The employee must also account for any advances received.
The employee must document all reimbursed amounts. That includes not only travel, meals, and entertainment expenses incurred but also amounts spent for office supplies, etc. for the business. For example Fred works for Madison Inc. and is asked to purchase a toner cartridge on his way back from calling on a customer. Fred should include the cost on his monthly expense report and be reimbursed by Madison.
In the case of out-of-town travel, an employer may reimburse a per diem amount based on the IRS tables for the area the travel occurs. In that case the employee doesn't have to account for the detailed expenses, but must be able to prove the time (dates), place, and business purpose of the expenses. The per diem rule can't be used if the employee is related to the employer (Sue is a saleswoman for Madison Inc. which is wholly owned by her brother). The rules with respect to relationships can be complex. Ask your tax advisor. Similarly, you don't have to detail auto expenses if you use the standard mileage rate.
If your business is audited, there's a high probability the agent will ask to see expense reports. They know that most small businesses are lax. You could lose a lot of deductions if you can't produce them or they're sloppy. If you're unsure, review the requirements with your tax advisor.
Copyright 2011 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 05/27/11