I’ve been getting a lot of questions from small business owners recently about two related topics: 1. how to reimburse employees for business expenses, and 2. how to claim the home office deduction. Both of these questions can be answered by using something called an accountable plan. A recent article in the AICPA’s Journal of Accountancy says that “accountable plans are a flexible tool to incentivize employees to pursue business goals and to facilitate employee-owners’ deductions of expenses they incur in running their businesses.” The need for accountable plans in small business has increased since the passage of the Tax Cuts and Jobs Act did away with miscellaneous itemized deductions on personal tax returns, which is where unreimbursed employee expenses were typically claimed.
In basic terms, an employer can establish an accountable plan and then reimburse an employee for business related expenses incurred in the course of their employment. The expenses are carried onto the books of the company, where they are deductible. The employee is not subject to any income recognition from the reimbursements (i.e. reimbursements are tax-free to the employee).
Standards of compliance
There are three standards that accountable plans must comply with:
- The expenses must have a business connection
- The expenses must be substantiated within a reasonable period, and
- The employee must return any money not spent to the employer, also within a reasonable period
If any of these standards are not met, then any reimbursements made to employees are considered taxable income to the employee and included as income on his/her W-2.
Before a reimbursement can be made, the employer must authorize the purchase for a legitimate business purpose. A purchase for a legitimate business purpose is anything that is deductible under Regs. Sec. 1.62-2, including:
- Travel expenses
- Auto expenses (Gas or mileage)
- Tools and supplies
- Home office expenses
- Cellphone (business use)
- Training & continuing education
- Dues, subscriptions, and professional licenses
Reimbursing an expense does not change the deductibility of the expense itself. For instance, meals may be reimbursed at 100% of the cost, even though the expense is only 50% deductible by the company. Entertainment expenses are no longer deductible as such at all under the TCJA (Sec. 274(a)(1)).
“Substantiated” means the employer must collect documentation that shows the amount, time, place, and business purpose of the expense. This generally entails an account book, log, receipt, bill, or credit card statement. It doesn’t have to be the original, but the proof must be specific enough to differentiate the types of expenses. For instance, a credit card statement for a hotel expense would not be enough unless it clearly separated meals and entertainment from an overnight stay expense. A list of categorized expenses is also not enough, unless the individual purchases are detailed and supported. The required documentation is covered under two different sections of the Code.