Did you know that the Tax Cuts and Jobs Act (TCJA) eliminated itemized deductions for employees who incur unreimbursed expenses for company business for 2018 through 2025?
Fortunately, you can set up a so-called "accountable plan" to minimize the adverse effects of this TCJA provision. Here's how the accountable plan deal works.
Playing by a New Set of Rules
Before the TCJA, an employee could claim an itemized deduction for unreimbursed business expenses to the extent they exceeded 2% of the employee's adjusted gross income (AGI) when combined with other miscellaneous expenses subject to the 2%-of-AGI deduction threshold. Examples of unreimbursed business expenses subject to the 2% threshold included union dues, fees to belong to professional associations, work clothes and cleaning expenses for work clothes. Examples of other miscellaneous expenses included investment expenses and fees for tax advice and preparation.
After the TCJA, deductions for all of these miscellaneous itemized expenses and unreimbursed business expenses subject to the 2% floor are repealed through 2025.
If employees will continue to pay business expenses out of pocket on behalf of your company, consider setting up a so-called "accountable plan" to reimburse them. That way, the company can deduct the reimbursements (subject to the 50% deduction disallowance rule for reimbursed meal expenses). Plus, the reimbursements will be tax-free to recipient employees.
Without an accountable plan, reimbursements count as additional taxable wages. For your employees, that would result in income taxes and withheld FICA taxes on the reimbursements. And your company would have to pay the employer's share of Social Security and Medicare taxes on the reimbursements.
Following the Rules for Accountable Plans
An accountable plan is an expense reimbursement or allowance arrangement that requires employees to substantiate expenses and return unsubstantiated advances. In general, employers maintain employee expense reimbursement plans on a company-wide basis. But the tax rules are applied on an employee-by-employee basis. So, one employee's reimbursements could fall under the favorable accountable plan rules, while another employee's reimbursements fall outside those rules because the accountable plan requirements weren't met.
Specifically, an accountable plan must satisfy the following four requirements:
- The business connection requirement. The plan must provide reimbursements or allowances only for otherwise deductible business expenses (subject to the 50% deduction disallowance rule for meals). These amounts must be paid or incurred by the employee in connection with performing services for the company.
The reimbursements or allowances must be clearly identified as such when the employee is paid. For example, they could be paid with separate checks. If wages and expense reimbursements or allowances are paid together, the reimbursement or allowance amount should be shown on the employee's check stub.
Be aware that the TCJA permanently disallows deductions for business entertainment expenses, so you shouldn't cover them with an accountable plan. Instead, set up a way for employees to charge those expenses directly to a company account. Although that won't change the fact that entertainment expenses are nondeductible, it simplifies matters by removing your employees from the loop of tricky tax rules.
- The adequate substantiation requirement. The plan must require substantiation of reimbursed expenses via an expense report, diary, log, trip sheet, detailed receipt or similar record within a reasonable period after the expenses are paid or incurred. A receipt or other documentation is generally required for any lodging expense of $75 or more.
The documentation should show:
– The amount and business purpose of the expense,
– The time and place of any travel,
– The date and description of any business gifts, and
– The business relationship to the company of each person receiving a gift.
For travel expenses, an accountable plan can base reimbursements on the federal per diem rates for meals, lodging and incidentals. If federal per diems are used, no substantiation of actual amounts is required. Your PDR tax advisor can provide a list of federal per diem rates in the continental United States, which may vary by location and date.
If an employer's per diem allowance exceeds the applicable federal per diem rate, the employee can keep the excess. However, any excess is treated as additional wages subject to income taxes and federal employment taxes.
- The return of excess advances requirement. The plan must require employees to return any advance that exceeds substantiated business expenses. Any unreturned excess amount is treated as additional wages subject to income taxes and federal employment taxes.
If the company pays a per diem travel allowance that doesn't exceed the federal per diem rate, employees can retain any excess of the per diem allowance over actual expenses (in other words, "keep the change"). Doing so won't disqualify the accountable nature of the plan or require any excess to be treated as additional taxable wages. In contrast, a plan that reimburses for actual expenses must require employees to return all excess advances to qualify as an accountable plan.
- The reasonable time period requirement. Both the substantiation of expenses incurred by employees and the return of any excess (unsubstantiated) advances must happen within a reasonable time period. Facts and circumstances dictate what's reasonable. For example, an employee on an extended out-of-town assignment would have more time to substantiate expenses and return any excess amounts.
Simplifying Matters with Safe Harbors
If you want certainty in meeting the reasonable time period requirement, IRS regulations offer two safe harbors.
Fixed-date method. Under this safe harbor, the reasonable time period requirement is automatically met if the plan stipulates that:
- Advances will be made no more than 30 days before the employee pays or incurs the anticipated expense for which the advance is made.
- Expenses must be substantiated within 60 days after they're paid or incurred.
- Advances for unsubstantiated amounts must be returned to the company within 120 days.
Periodic-statement method. Under this safe harbor, the reasonable time period requirement is automatically met if the plan stipulates that the company will:
- Provide affected employees with statements, no less than quarterly, of the amount of advances that haven't yet been substantiated, and
- Request that any such advances either be substantiated or returned to the company within 120 days after the statement is issued.
Time to Switch?
Under the current tax rules, accountable plans are clearly beneficial to employees with unreimbursed business expenses and to their employers (because the employer's share of federal employment taxes is avoided). If your employees pay out of pocket for business-related expenses, contact your PDR tax advisor to see if an accountable plan is right for your company.
Alternatives to Accountable Plans
What can you do if you don't want to establish an accountable plan? Your company can simply give employees reimbursements or advances with no strings. Those amounts will be treated as additional wages subject to income taxes and federal employment taxes.
Alternatively, your company can begin or continue a policy of not reimbursing employees for paying your business's expenses. As explained in the main article, employees can't claim any deductions for such unreimbursed expenses for 2018 through 2025. To compensate for that change in the tax law, the company could make "tax adjustment" payments to affected employees. Those payments would be treated as additional wages subject to income taxes and federal employment taxes. But they could help affected employees cover the tax detriment caused by the TCJA's disallowance of itemized deductions for unreimbursed company business expenses.