Not all of your employees are chained to a desk. Many employees nowadays spend their time out in the world, working with customers, conducting meetings, and traveling on behalf of your business.
You may also use a mix of staffing strategies, from mobile employees to contract employees to home-based employees, each on their own schedule.
A smart business will include an expense reimbursement plan so that employees aren't losing money to work for you. But if you aren't paying attention to the rules, you could get in trouble with the IRS. Here's what you need to know to set up your own plan.
What is Expense Reimbursement?
The expense reimbursement process allows employers to pay back employees when they spend their own money as part of conducting business. This typically does not need to be reported as income because employees are simply making up money they've already spent on your behalf.
What expenses should a business cover?
Most reimbursable expenses occur when employees travel for work, but they can cover a wide variety of activities related to employment.
For example, if an employee purchased a tool for the exclusive purpose of using it for work, that expense could be reimbursed by the business.
The IRS Publication 15, Circular E, Employer's Tax Guide addresses expense reimbursements on page 15. Specifically, the guide states that employers do not need to list reimbursements as employee wages if the business has an accountable plan.
Hint: That's good news because it means reimbursements are exempt from payroll taxes.
What is an accountable Expense Reimbursement plan?
There are three things you must consider while making an accountable expense reimbursement plan:
- The plan must state that employees will only be reimbursed for ordinary and necessary business expenses. The employee must incur these expenses as part of performing their job duties.
- It must require that expenses be substantiated within a reasonable period, typically 60 days. This will require the employee to provide documentation of the business expenses.
- If the employer advances an amount to the employee to cover the costs which are not later substantiated, the employee must return that advance within a reasonable period, typically within 120 days.
This is all part of spelling out your plan to simplify the expense process for employees. It will also make it easier to differentiate between types of reimbursements for your taxes later in the year.
That's important to know because reimbursements are either taxable or non-taxable.
What are taxable reimbursements in an expense reimbursement policy
To reiterate our earlier point: reimbursements are not taxable income. However, some business expenses are taxable.
For example, an employee using a company car for personal use, such as picking up their kids from school or going to the grocery store. The IRS knows that if an employee drives a company car, you cannot reasonably state that the employee uses it for business 100% of the time.
This means that part of the associated expense is subject to taxation.
Also, if you give your employees prizes in the form of goods or services, the prize must be reported as income by the employee at the prize's fair market value. An excellent example of this is a trip awarded based on job performance.
If your company provides certain services to employees like accounting or legal advising, those must be reported as salary or wages. This is part of taxable employee benefits.
What are non-taxable reimbursements in an expense reimbursement policy
There are several non-taxable reimbursements that companies and employees can take advantage of.
However, we will add this caveat: Many categories have specific guidelines governing taxability. Hence, we suggest you consult a tax lawyer and an experienced accountant before you include them in your plan.
Here are a few (generally) non-taxable reimbursements:
- Educational reimbursements up to $5,250 per year
- Specific insurance premiums up to $5,000, including health benefits, group life insurance, and accident benefits
- Gifts with minimal value, such as plaques or trophies
- Retirement planning services offered as part of a qualified retirement plan
- Discounts of up to 20% on employer-provided services
- Meals or lodging provided on the worksite (on meeting specific guidelines)
- Using a company car for commuting (on meeting specific guidelines)
- Other approved business expense reimbursements
These should not be confused with fringe benefits. These benefits are part of an employee's gross income and are subject to employment taxes and income tax withholding. However, some fringe benefits are tax-free (just to make it confusing!)
Here's a guide on how fringe benefits are taxed to help clarify the matter.
Pro-tip:Consult a tax lawyer and an accountant when you write up your plan. Your employees (and your bottom line) will be endlessly grateful.
What are deductible expenses in an expense reimbursement policy?
To make things confusing, some expenses are eligible for employees to write off their taxes, though they are not subject to income tax.
However, to simplify matters, this only applies to tax years before 2018. For tax years 2018 and on, unreimbursed expenses are no longer deductible.
This falls under miscellaneous itemized deductions, which are subject to the 2% adjusted gross income limitation.
Note: To be clear, these expenses are only deductible if an employer has not reimbursed them. If your employees have been reimbursed, they can't deduct those expenses.
IRS Publication 535, Business Expenses, states,
"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."
SUGGESTED READ: Expense reimbursement policy best practices for your business
The law and your expense reimbursement policy
Knowing the law is essential to keeping your business out of trouble with the IRS.
The most common examples of reimbursable expenses fall into four categories:
- Meals and entertainment
These are covered in detail under IRS Publication 463, Travel, Gift, and Car Expenses.
Types of business expenses in an expense reimbursement policy
For IRS purposes, travel expenses are considered ordinary and necessary expenses incurred while traveling away from home for your job.
Typically, employers will reimburse employees for their use of a personal or company vehicle under the standard mileage rate as part of a travel and expense policy. This typically will not include commuting expenses between an employee's home and workplace.
Meals and Entertainment
Let's say that your employee takes a client to dinner as part of business negotiations. This would fall under the realm of meal and entertainment expenses, but only if it is shown to have a clear business purpose.
Note: Keep in mind that employees must be reimbursed at 100% of the cost, even though employers can only deduct 50% of the cost.
Also, employers cannot deduct meals that are "lavish and extravagant." Whether or not a meal is lavish or extravagant is based on the circumstances -- it must be reasonable based on the situation. A specific dollar amount won't disqualify you if that meal is a fair price at a deluxe resort, for example.
If you give gifts as part of conducting business, the cost of those gifts can be deducted (and employees can be reimbursed for them) based on the dollar amount of the gift.
You can deduct no more than $25 given directly or indirectly to each person in the course of a single business year.
Incidental costs, such as engraving a piece of jewelry, are not included in determining the cost of the gift.
Any item that is either gift or entertainment comes under the entertainment category.
Packaged food intended for use at a later date is still a gift.
Finally, there are transportation expenses, which are not to be confused with travel expenses incurred while traveling away from home. This is where it gets messy because day-to-day commuting expenses typically are not deductible.
However, daily transportation expenses may be deductible if you're going to a temporary work station.
When are your travel expenses from your residence to another work location reimbursable?
- If you have one or more regular work locations apart from your residence
- If your residence is your principal place of business
How to create an expense reimbursement policy?
With all of that in mind, let's talk about how your business can create an expense reimbursement policy.
For the sake of your tax lawyer, your accountant, and the sanity of your employees, it's best to iron out every small detail of this policy before you put it into action. You'll avoid many headaches down the road.
Clearly define your expense reimbursement policy
First, you need to set transparent budgets and spending categories for your expense policy.
This is because an expense reimbursement policy serves two purposes for your business:
- Clarifying expenses
- Avoiding unnecessary spending
The categories will vary depending on your business and what expenses you typically deal with. Travel, food, and supplies expenses are standard business expenses incurred on a business trip. Generally, travel expenses are the most expensive category. Hence, it should be broken into subcategories such as flights, rental cars, hotel stays, etc.
Flights are the most expensive, so it's easy to want to save money here and there. That said, don't fall for false savings -- a flight may cost $50 less, but you may lose three hours of productivity during a layover.
Determining your budget depends on your business and how much you reasonably expect to spend. Look at the previous years' spending trends and estimate how you can accommodate additional growth.
Set clear, fair, and consistent processes
Regardless of your budgets, your processes should always be clear, fair, and consistent.
We're talking plain English wordings, specific use cases, clearly articulated spending limits, and well-defined applicable scenarios.
The key here is to balance restrictiveness with the legroom. Set hard and soft limits and be clear about what does and does not work. Lastly, you must be willing to trust that your employees will follow the rules.
Find an Expense Management Software to address your needs
Finally, make sure to invest in an Expense Management Software. Trust us: it's the best investment you'll make all year.
Think about all the receipts an employee could generate in a single business trip. Hotel bills, travel expenses, meal receipts, other purchases are just some of the things your employees incur while on a business trip. All of these have to be captured, categorised, and reimbursed.
Unless your finance team is superhuman (they're not) or has nothing better to do (they often have something better to do) manually sifting through receipts for reimbursements is a waste of their time. You're also gambling that your employee will remember every receipt from the trip, which is unlikely.
Instead, invest in a software that makes it easy for employees to record business expenses. These softwares also allow your finance department to sort through incoming expenses for reimbursement quickly. This dramatically improves your reporting and reduces the risk that you'll run into trouble with your filing.
An expense tracking and reporting app, for example, is a godsend for employees. You can automatically capture receipts, record mileage on the go, and track spending on credit cards.
Streamline Expense Reimbursement processes with Fyle
If you're thinking about expense reimbursement but haven't quite figured out the last step, that's where we come in.
Want to find out how we can make your tax season easier than ever? Schedule a demo today!