Expense Reimbursements for Employees: How They’re Taxed and How They’re Reported
Employees may accrue various expenses – meals, travel, lodging, etc. – that are eventually reported and reimbursed. Depending on how the employer and employee manage the expenses, they may be taxable or deductible.
Staying on top of company expenses is something every business struggles with at one time or another, so there is often plenty of confusion in this area. This guide will address how to avoid that confusion, and how an experienced tax professional can assist with proper expense reporting and reimbursement.
How a Business Tax Expert Can Help With Tax and Reimbursement Reporting
Before we dive into the topic, employers (and employees who regularly incur work-related expenses) are strongly encouraged to speak with a reputable tax professional when assessing expense-related taxes. Here’s why:
- A tax accountant will accurately identify qualifying expenses – Running a business is expensive, but employers have ways to offset employee business expenses. Some of these are obvious – meals and travel – but some aren’t. For example, uniform maintenance and workplace tools/equipment are also deductible.
A tax accountant will use their client’s financial records to identify deductible expenses and ensure they receive the maximum tax benefit possible.
- A tax accountant can help employers establish an optimal reporting and reimbursement plan – Reimbursement plans may be accountable or nonaccountable, depending on how they are set up. For most employers and employees, there are significant tax benefits to setting up an accountable plan. There are requirements, though, for establishing an accountable plan. We’ll go into these in detail but know that a tax accountant can provide targeted guidance on how to set one up.
- A tax accountant can walk their clients (employers and employees) through proper expense reporting – Expenses and reimbursements must be reported properly to the IRS to receive the relevant tax benefits. A tax professional can help their clients set up effective reporting channels, such as expense reports, to ensure they stay on top of their reporting requirements.
Accountable vs. Nonaccountable Plans – What’s the Difference?
When an employee pays for expenses that their employer is responsible for, they may be reimbursed through either an accountable or nonaccountable plan. Here’s the difference:
- Accountable plans – Accountable plans are preferred by the vast majority of employers and employees, due to their enhanced tax benefits. For expenses to qualify for reimbursement through an accountable plan, they must meet a few requirements. Specifically, the expense must qualify as a deductible employee expense, they must be accounted to the employer within a reasonable amount of time, and any excess reimbursement must be returned to the employer within a reasonable amount of time.
Cash advancements may also qualify if they are calculated such that they are not expected to exceed expenses. Such advancements must also be made within a reasonable timeframe to qualify.
If expenses can be reimbursed through an accountable plan, they are not included in the employee’s taxable income (what’s reported on their W-2). Instead, they are deducted by the employer. The employee reduces their taxable income, and the employer enjoys a modest tax benefit. It’s a win-win.
- Nonaccountable plans – Any expense that doesn’t qualify for reimbursement through an accountable plan is instead considered a nonaccountable expense. These are added to the employee’s W-2 as taxable income and the employer is liable for payroll tax withholding.
What’s the Definition of a Reasonable Timeframe for Accountable Expenses?
“Reasonable timeframe” is an unclear term. So, what does the IRS consider to be reasonable when it comes to business expense reporting? Here are some generally accepted timelines that fit into the agency’s concept of “reasonable:”
- The employer reimburses an employee-incurred expense within 30 days.
- The employee accurately accounts for the expense within 60 days of incurring it.
- The employee returns any excess reimbursement within 120 days of incurring the expense.
- The employer provides the employee with a quarterly (at least) statement that requires the employee to either return or account for any expense advancements. The employee has 120 days to comply with the statement to remain within a reasonable timeframe.
Other Reimbursement Issues: Excess Reimbursement and No Reimbursement Requested
Any reimbursement over the expense amount must be returned to the employer within the above time frame or they must be included on the W-2. If meal-related reimbursements are in excess of the federal per diem rate for meal-related expenses, there must be a tracking mechanism in place to account for expenses beyond this per diem rate. If there isn’t, the entire meal-related reimbursement is included with the employee’s wages, including any reimbursement above the per diem rate.
Also, if an employee does not request reimbursement for uncompensated business expenses, those expenses are not deductible by the employee or employer, as they are considered unnecessary expenses.
How Reimbursements are Reported: W-2 and Form 2106 Guidelines
Some (or all) of a business expense reimbursement may need to be reported by either the employer (on the employee’s W-2) or by the employee (on Form 2106). Here is what the relevant reporting guidelines look like for an accountable plan:
- Actual expense reimbursement with adequate accounting and excess returned – No reporting necessary on the W-2 or Form 2106.
- Actual expense reimbursement with adequate accounting, but excess not returned – The excess amount is reported in box 1, box 3 and box 5 as wages on the employee’s W-2. Nothing is reported on Form 2106.
- Per diem or mileage allowance reimbursement, with adequate accounting and excess returned – No reporting necessary on the W-2 or Form 2106.
- Per diem or mileage allowance reimbursement, with adequate accounting but excess not returned – The excess amount is reported in box 1, box 3 and box 5 as wages on the employee’s W-2. The amount up to the federal rate is reported in box 12, but not in box 1. Nothing is reported on Form 2106.
- Per diem or mileage allowance in excess of the federal rate, with adequate accounting only to the federal limit, and the excess not returned – The excess amount is reported in box 1, box 3 and box 5 as wages on the employee’s W-2. The amount up to the federal rate is reported in box 12, but not in box 1. Any portion of the excess that can be substantiated as a business expense may be reported in box 12 on Form 2106.
On a nonaccountable plan, if there is adequate accounting or if the excess is returned, then the entire amount is included as wages in box 1, box 3 and box 5 on the employee’s W-2. The employee may report what can be substantiated as a business deduction on Form 2106.
How are Taxes Handled if an Employer Expense is Paid by an Employee?
Prior to the Tax Cuts and Jobs Act, employees could deduct some of their unreimbursed business expenses, but that’s no longer on the table. Currently, if an employee pays for company expenses out of pocket, they may not deduct them as personal expenses. That means employees are hit with a double whammy – paying out of pocket for the expense and treating that spent income as fully taxable.
It’s important, then, for employees to seek reimbursement through an accountable plan. These expenses are not intended for the employee’s W-2.
Business Expenses and Reimbursements are Tied to a Ton of Tax Laws, so Speak to an Expert when Preparing Taxes
Business expenses can quickly get tangled up in esoteric tax laws, leaving employers and employees uncertain of what they can claim, what they can deduct, and what they cannot. A tax professional experienced in business accounting can sort those rules out for their clients. Whether employee or employer, there are significant tax benefits available to those that follow proper reimbursement and reporting rules. A tax expert can optimize them for both parties.
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