While the increase in the standard deduction (nearly double the 2017 amounts for tax years 2018 thru 2025) means that fewer taxpayers overall will itemize deductions, employees with out-of-pocket work-related expenses may not have realized that the TCJA eliminated all possible means of tax relief for “ordinary and necessary” business-related expenses they incurred on behalf of their employers.
Examples of workers most likely affected include sales employees not reimbursed for their vehicle or mileage expenses and licensed professionals not reimbursed for maintaining their licenses and fulfilling continuing education requirements. While many individual taxpayers did not have enough miscellaneous items to exceed the 2% adjusted gross income (AGI) threshold for deducting unreimbursed business expenses, the deduction was very important to others. In short, as part of an eight-year suspension of miscellaneous deductions limited by 2% of AGI [defined in Internal Revenue Code (IRC) section 67(b)], deductions for all such expenses—including those for home office, business travel, tools and supplies, professional license fees and dues, and continuing professional education—were abruptly halted on January 1, 2018.
There remains, however, a path to tax parity for these affected employees (in cooperation with their employers), known as an accountable plan (Treasury Regulations section 1.62-2). Under an accountable plan, businesses can claim a deduction for employee reimbursements of legitimate business expenses that are not included in the employee’s taxable income. Businesses should, however, weigh the pros and cons of implementing an accountable plan. Examples of the pros of an accountable plan include the following:
- Increased employee morale, as workers do not feel they are paying out-of-pocket for business expenses on behalf of their employer
- Higher overall pay (net of tax) for employees
- A smaller employment tax bill for both employers and employees (i.e., withholding taxes, FICA, federal and state unemployment taxes).
Examples of the cons of an accountable plan include the following:
- More cost to employers, if reimbursing costs previously paid by employees
- Increased administrative costs to keep track of documentation required under an accountable plan
- Potential circumstances under which employees would prefer their income to be higher despite the related increase in taxes (e.g., if applying for a home mortgage).
Overall, compared to prior TCJA periods, employers may find that the scales have tipped to where the benefits of an accountable reimbursement plan may now outweigh the costs.
IRC section 162(a) permits deductions for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” In general, to be deductible as an expense of a trade or business, the expense must—
- be ordinary and necessary, and
- be an expense of the payer’s trade or business during the taxable year.
IRC section 162 does not require that all business expenses be reasonable in amount—only compensation. The courts, however, have held that an expense must not only be ordinary and necessary in order to be deductible, but also reasonable in amount and in relation to its purpose [U.S. v. Haskel Engineering & Supply Co., 20 AFTR 2d 5077 (CA-9,1967); Comm’r v. Lincoln Electric Co, supra note 3; Fuhrman, Daniel E., TC Memo 2011-236; Edwards, David J., TC Memo 2002-169; South Salina Corp., TC Memo 470].
Employers and employees can both benefit when the reinmbursement for business expenses is made pursuant to an accountable plan.
Use of an Accountable Plan
Employers and employees can both benefit when the reimbursement for business expenses is made pursuant to an accountable plan. Expenses reimbursed to employees under this type of plan are generally not considered income to the employee for federal income tax purposes and, therefore, are exempt from all employment taxes and withholding for federal and state income taxes, FICA, and Medicare (including the employer payroll taxes). In addition, not having additional taxable income means the employee’s AGI is minimized, potentially increasing that individual’s eligibility for certain tax credits or minimization of additional taxes.
Expenses reimbursed under an accountable plan are also deductible as business expenses by the employer, subject to any federal income tax limitations pertaining to a particular expense (i.e., meals, gifts, listed property). If tracking an employee’s actual expenses is too burdensome or unpredictable, employers should also consider the incorporation of federally approved per diem rates for lodging, meals, and incidental expenses as a part of the company’s expense reimbursement plan. (Increased per diem rates for 2020 are available on several web-sites, including http://www.gsa.gov.) Paying more than the per diem amount while using this method, however, can result in heavy IRS penalties.
There is no IRS form necessary to adopt an accountable plan. Although it is not required, it is advisable to set the terms of the company’s reimbursement plan in writing and to establish a standardized expense reporting form (e.g., outlining types of expenses to be reimbursed, time frame for substantiation).
Three Key Requirements of Accountable Plans
Each employee must furnish adequate substantiation of all reimbursed expenses. In general, the substantiation (proof) is adequate if it identifies the specific nature of each expense and confirms that the expense is attributable to the company’s business activities (i.e., detailing who, what, when, where, and why). Evidence of expenditures generally includes receipts, canceled checks, or paid bills. Certain types of expenditures, such as travel, meals, and lodging while away from home, require specific documentation (see IRS Topic 11, Business Travel Expenses.)
The expenses must satisfy the requirements for deduction as “ordinary and necessary” business expenses (per IRC section 162) and must be paid or incurred by the employee in connection with the performance of services as an employee. An ordinary expense is one that is common and accepted in the industry; a necessary expense is one that is appropriate and helpful to a business.
Return of excess payments.
The plan must require the employee to return, within a reasonable period of time (typically 120 days), any amount that exceeds the employee’s properly substantiated expenses.
It is important to ensure that the accountable plan is properly structured, as the IRS has been diligent in challenging arrangements that it suspects are merely attempts to conceal compensation and, thereby, avoid taxation. If the IRS determines a plan is nonaccountable, all reimbursements will be transformed into taxable wages and will be subject to income tax for the employee, as well as to employment tax for the employee and employer.
Any reimbursement plan that does not satisfy the requirements of an accountable plan is a nonaccountable plan. For example, employers who give employees a set amount for monthly business expenses and do not request any proof of business-related expenses nor request a refund for unspent funds are operating nonaccountable plans. Employee business expenses reimbursed under a nonac-countable plan are to be reported as wages on Form W-2 and are not currently deductible to any extent from the employee’s tax return [see IRS Publication 15, Circular E, Employer’s Tax Guide (2019), page 15, for reporting guidance]. It is possible to have an accountable plan for some items and a nonaccountable plan for others, if this best suits the situation, but in such cases employers should clearly communicate to employees how this will affect their taxable wages.
Reviewing Unreimbursed Employee Expenses
Many employees may be paying outof-pocket expenses that are not being reimbursed with either an accountable or a nonaccountable plan. Now that employees are no longer able to take a tax deduction for these expenses under the TCJA, they may either stop paying for these items (if optional) or become more resentful that they are not being reimbursed. Employers should discuss with their employees just which business-related expenses the employees may have paid in the course of doing their jobs but not requested (or been offered) reimbursement for. Some employers may have little idea how many of their employees annually claimed itemized deductions for unreimbursed business expenses on prior years’ individual tax returns—nor the monetary magnitude of these claims. Some employers may be able to make an educated guess, but not a true accounting. These expenses may have been paid directly out-of-pocket by employees in an effort to further their careers, and the company’s success.
Examples of pre-2018 unreimbursed business expenses claimed as itemized deductions include the following:
- Uniforms and safety clothing not suitable for ordinary wear
- Professional associations, publications, and training conferences
- Required continuing education to maintain job or credentials
- Chamber of commerce dues (if membership benefited job)
- Professional license fees
- Required medical or physical exams
- Travel and transportation expenses related to the job, including business use of a car
- Tools and supplies used on the job
- Home office expenses incurred by an employee required to work at home, such as allocated space and utilities, office supplies, and office equipment.
Employees with substantial unreimbursed work-related expenses, or who are partially or fully reimbursed under a nonaccountable plan, will be negatively affected by the TCJA.
Taking Care of Business
CPAs should understand that employees with substantial unreimbursed work-related expenses, or who are partially or fully reimbursed under a nonaccountable plan, will be negatively affected by the TCJA, despite the increase in the standard deduction, even as employers will be positively affected. Employees will most likely fully recognize the negative aspects of losing important deductions as the tax filing season progresses. CPAs should remember that the TCJA not only limited the deduction for employee business expenses; it also eliminated all other miscellaneous itemized deductions subject to the 2% AGI floor as well (see Form 2016 for a short list of individual exceptions).
Employers can improve employee relationships by recognizing, and funding, the justifiably important and fully deductible (for the employer) business expenses in a way that does not burden their employees. Employers should consider taking advantage of the accountable plan option, as employers and employees both benefit when employee-paid business expenses are reimbursed under such plans.