Are Expense Reimbursements Taxable Income?

Reimbursable Mileage Expense
Every business incurs costs and expenses that reduce the business’s taxable income, and sometimes these expenses may be incurred by employees during the course of business. A common practice is to reimburse such expenses, or to pay for such expenses by allowing the employees to pay for them with a company credit card. Page 11 of IRS Publication 15, (Circular E), Employer’s Tax Guide, states that such expenses do not have to be included in an employee’s wages if the company has an “accountable” plan.

What Kind of Valid Business Expenses May Be Incurred by Employees?

Expenses incurred by an employee are defined as valid business expenses only if they are considered to be necessary for the operation of the business and they are properly documented. Out-of-pocket expenses are business expenses that are incurred by an employee but are not directly paid for by the business. This would include expenses that have been paid for with cash, personal check, or an employee’s personal credit card.

Some businesses allow certain employees to use a company credit card to pay for certain business expenses. However, since control over the use of the credit card is in the hands of the employee, all business expenses charged to the credit card may also be treated as employee-incurred expenses.

In addition to the direct expenses described above, some employee-incurred expenses may be indirect expenses. For instance, when an employee uses his personal vehicle for company business, his employer may choose to not reimburse him for direct expenses, such as gasoline, oil, insurance, depreciation and maintenance. Instead, he would be reimbursed at a set rate, such as a certain number of cents per mile driven on business.

In some cases, an employer may make advance payments to employees for expenses, or the employee may be given an expense allowance. Provisions for these types of advance payments must also be included in an accountable plan.

What is an Accountable Employee Business Expense Reimbursement Plan?

According to IRS Publication 15, in order to be an accountable plan, an expense reimbursement plan or advance payment program must meet the following conditions:

  • Business connection – The expense must have been incurred in the performance of services as an employee of the employer.
  • Substantiation – The employee must substantiate his business expenses by providing the employer with evidence of the amount, time, place, and business purpose of the expenses within a reasonable period of time after they are paid or incurred.
  • Returning excess amounts – Amounts paid by the employer that exceed amounts spent by the employee must be returned to the employer within a reasonable period of time.
There are two methods of determining the reasonable period of time for substantiation and returning excess amounts:

  • Fixed-date method – The expense must be substantiated by the employee within 60 days of being paid or incurred, and the excess amount of any advance must be returned to the employer within 120 days of when the expense was paid or incurred.
  • Periodic statement method – The employer can issue a periodic statement to the employee detailing amounts that have been paid and not substantiated and require the employee to either substantiate the excess amount or return it to the employer within 120 days of receiving the statement.
An employer may have a hybrid plan that uses both methods described above. For instance, out-of-pocket expenses and mileage reimbursements may have to be substantiated under the fixed-date method, but the employer may use the periodic statement method for substantiating company credit card charges.

How Can Business Expenses Become Taxable Wages?

If an employer does not have an accountable plan in place, then IRS Publication 15 states: “Payments to your employee for travel and other necessary expenses of your business under a nonaccountable plan are wages and are treated as supplemental wages and subject to the withholding and payment of income, social security, Medicare, and FUTA taxes.” So even if the business expenses are valid and necessary, if the employer does not have an accountable plan, then any reimbursements are taxable income.

On the other hand, if the employer has an accountable plan, but the employee fails to properly substantiate the expenses within a reasonable time, or the employee fails to return excess advance payments, then any reimbursements could become taxable income. In addition, if any indirect expenses are paid in excess of IRS limitations, then the excess is taxable income. For instance, in 2010 the federal rate for business travel is 50 cents per mile. If the employer pays 55 cents per mile (which was the rate in 2009), then the additional 5 cents per mile is taxable income.

Complying with the IRS’ Rules for Expense Reimbursements

Employees should only have to pay income taxes on the wages they earn and certain taxable fringe benefits. Expenses incurred by employees in the course of business should be costs incurred by the employer, not by its employees. If the employer establishes an accountable plan, and the employees submit properly documented expenses under that plan, then the reimbursements are not taxable income. However, a key to maintaining any accountable plan is to properly substantiate expenses, and that is the subject of the article Proper Substantiation of Business Expenses.