Every company incurs costs as part of doing business. You can use some of those expenses to reduce your business's taxable income. Of course, your employees will also incur business expenses, which your company might have to reimburse. Some states (such as California and Illinois) legally require employers to reimburse their employees' reasonable work-related expenses. Read on to learn more about employee expense reimbursement and whether your business should offer it.
How do employee expense reimbursements work?
Employee expense reimbursement is when employers pay funds back to employees who have used their own money to pay for business-related expenses. Employees are usually not required to report expense reimbursements as either income or wages. According to the IRS Employer's Tax Guide (Publication 15), if the business has an "accountable plan," it doesn't have to count expense reimbursements as part of its employees' wages.
Self-employed? Check out this guide for self-employed tax deductions instead.
To qualify as an accountable plan, an expense reimbursement policy must meet the following conditions:
- The employee must pay or incur the allowable expense while performing services for their employer. The reimbursement must apply specifically to the expenses and cannot be an amount that would have been considered the employee's wages.
- The employee must provide evidence to substantiate the business expenses. The evidence must outline the amount of the expense, when and where the employee incurred the expense, and the purpose of the expense. Business expenses must be submitted within a reasonable amount of time after the expenses occurred.
- The employee must pay back any excess amount of reimbursement (if the employer paid the employee more than the employee spent) within a reasonable timeframe.
Employee reimbursements paid under an accountable plan are not considered wages, so these payments are not subject to any taxation. However, if the expenses do not meet the above criteria, the employee reimbursement is treated as paid under a nonaccountable plan. This amount becomes subject to taxation in the next payroll period.
Reasonable time period
There is no fixed definition for a "reasonable" amount of time, as the time period depends on the circumstances. The IRS considers it reasonable to:
- Give employees an advance within 30 days before they'll pay the expenses.
- Have employees provide the necessary details of their expenses within 60 days after they paid the expenses.
- Have employees return any amounts the employer paid them above their expenses within 120 days after paying those expenses.
- Provide employees with a periodic statement to either return or explain any outstanding amounts, which they must do within 120 days.
Any payments made to employees for necessary business expenses under a nonaccountable plan count as supplemental wages, which means they are subject to all applicable income and payroll taxes. Payments qualify as part of a nonaccountable plan if they meet one or more of the following criteria:
- The employee does not provide receipts or other documentation to substantiate their expenses in a timely manner.
- The employer advances an amount to cover the employee's business-related expenses, and the employee does not return the unspent amount in a timely manner.
- The employer advances an amount to the employee with no reasonable expectation that the employee will use the amount for business expenses.
- The employer pays reimbursement expenses that would have otherwise been paid as wages.
The COVID-19 pandemic has forced many employees to work from home. Employers can use work-from-home reimbursements to cover some of the expenses that employees incurred from remote work. A remote work reimbursement may cover:
- Internet services
- Telephone service
- Desks and chairs
According to the Fair Labor Standards Act, employers must provide work-from-home reimbursement to cover expenses that would lower the employee's hourly wage rate below the minimum wage.
What qualifies as an employee expense?
Employee expenses that the employer must reimburse are subject to the rules of deductible business expenses. As IRS Publication 535 says, "To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary."
These are some examples of ordinary and necessary expenses:
- Work clothes and uniforms
- Tools and supplies used at work
- Licenses and regulatory fees
- Professional society dues
- Educator expenses
- Medical exams required by employers
- Work-related education
- Job-related legal fees
- Laboratory breakage fees
- Home office
- Passport fee for business trips
Expenses that could qualify for employer reimbursement typically fall into one of these categories:
- Work-related supplies
- Travel and transportation
- Meals and entertainment
If an employee purchases supplies for business purposes, the employer can reimburse the expenses at cost.
Travel and transportation
According to the IRS, travel expenses are ordinary and necessary expenses when an employee has to travel to do their job. Employees can be reimbursed for using their personal vehicle for business. The IRS sets the standard mileage rate for reimbursing an employee's business-related use of their vehicle. (The commute from home to work is not usually a reimbursable expense.)
Transportation expenses are separate from travel expenses that the employee incurs while traveling away from their home area. The employer may reimburse transportation expenses if the employee is traveling to a temporary workstation under one of the following circumstances:
- The employee travels to one or more regular work locations (not including the employee's residence).
- The residence is the employee's principal place of business.
Meals and entertainment
You can reimburse employees for meal and entertainment costs that they incur within the employee's tax home if those expenses have a clear business purpose. Employees can be imbursed for 100% of meal and entertainment costs, although employers can only deduct 50% of the cost.
You may reimburse employees with a fixed allowance (e.g., fixed travel days or miles). Under this arrangement, the employee has sufficiently accounted for their expenses as long as the reimbursement rates are in line with government-established rates. You can find details of the government per diem rates for meals and accommodations on the U.S. General Services Administration website. IRS Publication 15-B lists the standard mileage rates to cover driving expenses.
If your employees gives gifts as part of doing business, you can reimburse them for the cost of those gifts. You can deduct a maximum amount of $25 per person per year for gifts. If an item your employee gives a client could be considered either a gift or entertainment, it defaults to the entertainment category.
Other non-taxable reimbursements
These are some other expenses you can reimburse your employees for on a tax-free basis:
- Specific insurance premiums (e.g., health benefits, group life insurance, accident benefits)
- Gifts with minimal value (such as trophies)
- Retirement planning services under a qualified plan
- Discounts on employer-provided services
Each of these non-taxable reimbursements falls into its own category with specific guidelines on taxability.
According to the IRS Employer's Tax Guide to Fringe Benefits (Publication 15-B), a fringe benefit is "a form of pay for the performance of services." Therefore, fringe benefits are taxable. Even if a third party actually provides the benefit (e.g., a gym provides the workout equipment and classes), the employer pays to provide the fringe benefit. The employee receives the fringe benefit in exchange for providing their services to the employer, even if another person receives the benefit without performing services in exchange for money (e.g., the employee's spouse uses the gym membership).
These are some examples of fringe benefits:
- Employee stock options
- Health savings accounts
- Transportation benefits
- Tuition reduction
- Gym and athletic facilities
- Adoption assistance
- Achievement awards
While the value of a fringe benefit is taxable (e.g., federal income tax, Social Security tax, Medicare tax, FUTA tax), the taxable portion of a fringe benefit may be reduced by the amount legally excluded from compensation or paid for by the recipient.
How to record and reimburse employee expenses
As the employer, you must create an accountable plan to reimburse your employees for expenses. According to IRS Publication 15, "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."
If you have an accountable plan, the business expenses you reimburse to an employee are not treated as wages and not taxed. You should keep detailed payroll records, including records of employee reimbursements. You do not report this amount with the employee's wages on Form W-2; you should record the amount in Form W-2, box 12, with code L.
You can reimburse employee expenses in one of two ways:
- Integrate employee reimbursements directly into the payroll system.
- Pay employees separately for expenses through check or direct deposit.
Can you write off reimbursed expenses?
If you reimburse your employees' expenses under an accountable plan, you may deduct them as business expenses. They are subject to federal income tax limitations for specific expenses (e.g., listed property, meals, gifts).