Executives often incur business-related expenses when furthering their company’s interests off-premises. For instance, an executive might be required to take a client out to lunch or might be required to drive his or her own car somewhere for business purposes. Companies will often reimburse executives subsequently for these business expenses. When an employer reimburses an employee for travel, meal, and entertainment expenses, the entire amount of the reimbursement will be excluded from the employee’s income if certain conditions are met. In particular, whether business expense reimbursements will be tax free to the executive depends on whether or not the company’s expense reimbursement arrangement constitutes an accountable plan.
What is an Accountable Plan?
An expense reimbursement plan is accountable if it requires the executive to:
- Prove a business connection
- Substantiate expenses being reimbursed
- Return excess advances within a reasonable amount of time. If the company’s plan meets the requirements for an accountable plan, expense reimbursements to executives are excluded from the executives’ income
The plan can pay reimbursements only for otherwise deductible business expenses (such as travel, lodging, or meal expenses incurred while away overnight on business). The reimbursements must be clearly identified as such when the executive is paid.
Substantiation
The plan must require substantiation of the expenses reimbursed. Two items are necessary to substantiate travel, meal, and entertainment expenses:
- Adequate records, including a summary of expenses, such as an account book or log, showing the expense’s time, place, amount, and business purpose
- Documentary evidence (such as itemized receipts for payments, or paid invoices) substantiating the amount and place
Tip: Executives must submit documentary evidence, such as a written receipt, for any lodging expense (regardless of amount) and for other travel and entertainment expenses of $75 or more.
Example: Joe is told by his employer to take a client out for drinks and dinner after a business meeting. The bar tab and the dinner total $65, and the tip is an additional $9. Joe pays for everything with his own money and expects to be reimbursed by his employer. Because the total expenditure (bar tab, dinner, and tip) is under $75, a receipt for the expense is not necessary.
Return Excess Amounts
The plan must require the executive to return any advance that exceeds substantiated business expenses within a reasonable period of time. Any excess not actually returned is treated as compensation to the executive, subject to payroll tax withholding like any other compensation.
Example:
Widget Company has an employee expense reimbursement plan that reimburses travel, entertainment, and transportation expenses for company employees. The plan reimburses only deductible business-related expenses, requires employees to adequately and timely substantiate expenses, and requires employees to timely return any excess (unsubstantiated) advances.
Jennifer, an executive, is advanced $3,000 for travel expenses she estimates will be incurred on a company business trip. She actually spends $2,000, substantiates the $2,000, and never returns the remaining $1,000. The company’s arrangement still meets the criteria of an accountable plan. However, Jennifer’s failure to return the $1,000 causes the $1,000 to be treated as paid under a nonaccountable plan. Thus, the $1,000 is treated as taxable compensation income, subject to withholding and payroll taxes.
What if the Company does not Maintain an Accountable Plan?
If the company fails to comply with the accountable plan rules, business expense reimbursements are reported as compensation to the executive and are subject to withholding. These expenses are deductible by the executive only as miscellaneous itemized deductions on his or her personal income tax return, subject to the 2 percent of adjusted gross income (AGI) floor.
Obviously, this leaves many executives who do not itemize deductions (or whose deductions are limited under the 2 percent of AGI floor) with a diminished or no opportunity to exclude legitimate business expense reimbursements from income.
What About Travel or Mileage Allowances?
Instead of receiving a reimbursement for actual expenses, some executives receive a travel or mileage allowance (a flat or stated rate without regard to the amount of expenses the executive actually incurs). A travel or mileage allowance paid under an accountable plan (e.g., a per diem arrangement) and not exceeding the federal rate is excluded from the executive’s income.
The primary advantage of these allowances is that they eliminate the need for executives to gather documentation and receipts supporting the actual amount spent while on company business. Additionally, the executive can, in some instances, keep excess advances under a per diem or mileage allowance plan.
Tip: IRS Publication 1542—Per Diem Rates (for Travel within Continental United States) contains current federal per diem rates for lodging, meals, and incidental expenses paid for business travel. These federal rates will vary depending on your travel location. For more information, consult this source.
Tip: Whenever an employee uses his or her personal car for business purposes and wants to deduct the business expenses related to use of the car, there is a choice between determining the actual expenses incurred (including such items as gas and oil), and using the simpler standard mileage rate. The standard mileage rate is 55.5 cents per business mile for 2012.
To use the standard mileage rate, the taxpayer must choose the rate for the first year in which the car was placed in service for business. If actual expenses are used in the first year, the mileage rate cannot be used in later years. But if the mileage rate is used in the first year, the taxpayer can change to actual expenses in later years.
If you have questions or need assistance, contact the Business Experts at Henssler Financial: 770-429-9166 orexperts@henssler.com.
Disclosures:
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing.
