If you permit or require employees to purchase their own small tools and then reimburse them for the expense, and the arrangement qualifies as an “accountable plan” under IRS rules, you — and your employees — can gain valuable tax benefits.
A significant tax difference
When a plan isn’t accountable, expense reimbursements are included in employees’ gross wages for tax purposes, and both the company and employees must pay employment taxes on those amounts. Although employees may be able to write off these expenses as miscellaneous itemized deductions, they’ll benefit only if they itemize and only to the extent that their total miscellaneous deductions exceed 2% of their adjusted gross income.
Under an accountable plan, on the other hand, expense reimbursements are tax-free to employees and exempt from withholding and employment taxes. Plus, the company can still deduct them as business expenses (provided they otherwise qualify).
Making it accountable
A reimbursement plan is accountable if it:
- Requires reimbursed expenses to have a business connection — that is, expenses must be related to an employee’s work for the company and must otherwise be deductible by the employee,
- Requires employees to substantiate expenses in writing within a reasonable time (60 days is a good rule of thumb), and
- Requires employees to return any excess reimbursements or allowances within a reasonable time (120 days is a good rule of thumb).
Although accountable plans aren’t required to be in writing, it’s a good idea to document reimbursement policies and procedures. This can help ensure that the plan will pass muster with the IRS.
Employees should substantiate their expenses with expense statements or similar records that establish their business purpose, together with documentary evidence, such as receipts, canceled checks or bills. Many construction companies require receipts because they generally provide the best evidence of actual expense amounts.
Keep in mind that, even when these requirements are met, the IRS may reject a reimbursement plan if it finds that the employer is recharacterizing wages as expense reimbursements or allowances in order to gain a tax advantage. In a 2012 Revenue Ruling, for example, the IRS found that a company’s reimbursement plan wasn’t accountable when it reduced employees’ hourly wages and made up the difference with a nontaxable “hourly tool rate.” Once an employee’s tool expenses were covered, his or her wages were returned to their previous hourly rate.
Easy and inexpensive
If you reimburse employees’ tool expenses, be sure you have an accountable plan. These plans are relatively easy and inexpensive to establish, and they provide tax benefits for employers and employees alike.