A recent IRS ruling addresses compensation arrangements that purport to provide employees with tax-free expense reimbursements but, in fact, merely recharacterize taxable wages as tax-free income. The IRS treats these arrangements as failing to satisfy the requirements of an "accountable plan," making the expense reimbursements taxable to the employees.
The ruling describes three examples of invalid accountable plans:
- Tool Expense. A cable installation company requires its installers to purchase their own tools. Each year the installers tell the employer how much they expect to spend on tools for the year. The employer divides this amount over the total number of hours the installers are expected to work and then treats a portion of the wages paid for each hour worked as a tax-free reimbursement of this tool expense. For example, if the installers would otherwise make $10 per hour and are treated as incurring $1 of tool expense for every hour worked, the installers are paid $9 in taxable wages and $1 in tax-free tool reimbursement for every hour worked.
- Meals and Lodging. A staffing service that places temporary nurses in hospitals pays those nurses a set hourly wage, regardless of where the nurses are working. But for nurses who must travel away from home for an assignment, the contractor treats a portion of the hourly wages they would otherwise receive as a tax-free per diem allowance for food and lodging.
- Mileage Allowance. A construction contractor that builds commercial buildings in various locations throughout a large metropolitan area requires some (but not all) employees to use their personal vehicles for travel between work sites each day. In addition to base hourly wages, the contractor pays every employee a fixed amount per pay period as a tax-free mileage reimbursement, regardless of whether the employee actually incurred any mileage expense during that period.
In all of these cases, the expense-reimbursement portions of the employees' compensation are treated as a recharacterization of otherwise-taxable wages and so are treated as taxable wages instead of tax-free expense reimbursements.
"While an employer may establish or modify its compensation structure to include nontaxable reimbursement under an accountable plan, recharacterizing as nontaxable reimbursement amounts that would otherwise be paid as wages violates the [accountable plan requirements]. This is true even if an employee actually incurs a deductible expense in connection with employment with the employer."
"The presence of wage recharacterization is based on the totality of facts and circumstances. Generally, wage recharacterization is present when the employer structures compensation so that the employee receives the same or a substantially similar amount whether or not the employee has incurred deductible business expenses related to the employer's business."