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The end of one calendar year and the beginning of the next is a good time to revisit topics related to wages, W-2 reporting and expense reimbursements. Contractors frequently reimburse employees for travel, lodging, meals and other incidental expenses, and it is important to be aware of the requirements in this area.

Reimbursed Business Expenses of the Employee

An employer may reimburse an employee for travel, meals and entertainment expenses incurred while performing services for the employer. This reimbursement can and is done in many ways. At one end of the spectrum, employees are required to turn in receipts and other documentation in order to be reimbursed. At the other end, the employer may just give the employee an amount of money the employer believes is adequate to cover any expenses the employee may incur and not require the employee to report back on actual expenses incurred. In between, there are nearly as many separate methods as there are employers.

As far as the IRS is concerned, all these reimbursement plans fit into two categories. Either the plan is an accountable plan or a non-accountable plan. The tax treatment of the reimbursement, for both the employer and the employee, depends on whether the employer has an accountable plan or a non-accountable plan.

In an accountable plan, the employee is required to provide certain required documentation (see discussion below) to the employer. All other plans are considered non-accountable plans.

If expenses are reimbursed under an accountable plan, the employer deducts the amount allowable as travel, meals and entertainment expense. The amounts are not treated as income to the employee; therefore, no amounts are required to be included on the employee’s W-2, no employment taxes need to be paid, etc. The 50 percent limitation on the deduction for meals and entertainment applies to the employer’s deduction of meals and entertainment expenses that are reimbursed. The employee excludes the reimbursement from income.

Under a non-accountable plan, the IRS rules require the employer to report the reimbursement as taxable wages to the employee on Form W-2. The employer receives a deduction for compensation expense but also is required to withhold income and Social Security taxes. The employer also is responsible for the employment taxes on the payment. The employee is allowed to deduct business expenses that are reimbursed under a non-accountable plan, as well as expenses that are not reimbursed, as miscellaneous itemized deductions. The portion of the expenses representing meals and entertainment is subject to the 50 percent limit on deductions for meals and entertainment. As miscellaneous itemized deductions, these expenses also are subject to the 2 percent of Adjusted Gross Income limitation. These limitations result in the employee paying tax on a portion of the payment.

Accountable Plan

To qualify as an accountable plan, employees must:

1) Have paid or incurred deductible expenses while performing services as an employee;
2) Adequately account to the employer for these expenses within a reasonable period of time; and
3) Return any excess reimbursement or allowance within a reasonable period of time.

An arrangement under which the employer advances money to the employees is treated as meeting the third requirement above only if the following requirements also are met:

a) The advance is reasonably calculated not to exceed the amount of anticipated expenses.
b) The employer makes the advance within a reasonable period of time. 

Adequate Accounting

Employees must adequately account to the employer for their travel, meals and entertainment expenses. They must give the employer documentary evidence of their travel, mileage and other employee business expenses. This evidence should include items such as receipts, along with a statement of expenses, an account book, a day planner or similar record in which the employee has entered each expense at or near the time the expense was incurred. To minimize the administrative effort required to meet these rules, the employer may use a per diem plan. The rules of per diem plans are discussed below.

Excess Reimbursement

Any amount advanced to the employee that exceeds the amount adequately accounted for by the employee must be returned to the employer within a reasonable period of time.

Reasonable Period of Time

Interpretation of a “reasonable period of time” depends upon the facts and circumstances of the situation. Actions that take place within the periods listed below will be treated as occurring within a reasonable period of time.

• The employer reimburses an expense within 30 days of the time the employee incurred the expense.
• The employee adequately accounts for the expense within 60 days after the expense was paid or incurred.
• The employee returns any excess reimbursement within 120 days after the expense was paid or incurred.
• The employer gives the employee a periodic statement, at least quarterly, that asks the employee to either return or adequately account for outstanding advances, and the employee complies within 120 days of the date of the statement.

Use of Per Diems

A per diem is an allowance for travel, lodging, meals and incidental expenses that is calculated based on the number of days of an employee’s travel. An employer can reimburse employees under an accountable plan based on travel days, miles or some other fixed allowance. The employee is considered to have accounted to the employer the amount of the expense that does not exceed the rates established by the federal government. By using a per diem allowance, the employee is not required to submit receipts to the employer to meet the accountable plan rules. However, employees are still required to substantiate the time, place and business purpose of the trip.

Federal Per Diem Rates:

The federal rate can be figured using one of the following:

• The regular federal per diem rate is defined as the highest amount the federal government will pay to its employees while away from home on travel. Rates differ depending upon the travel location. The federal government publishes the rates for each location annually. The published rates are effective for the period from Oct. 1 of one year to Sept. 30 of the next. The rules allow employers to use the same rates for the entire calendar year. The rates for 2008 can be found in IRS Revenue Procedure 2007-63.
• The standard meal allowance is the meals and incidental expenses portion of the regular federal per diem rate. The standard meal allowance is the only per diem allowed if the employer pays for or reimburses actual lodging expenses or the employee is not reasonably believed to have incurred any lodging expenses. Whether the employer uses the regular federal per diem rate to cover all expenses (including lodging) or the standard meal allowance, the amount of the reimbursement that represents the meals and incidental expenses is subject to the 50 percent disallowance of meal and entertainment expenses.
• The high-low method is a simplified method of computing the federal per diem rate for lodging and meal expenses. It eliminates the need to keep a current list of the per diem rate in effect for each city. Instead, each travel location is considered either a high-cost or low-cost destination, and there are two levels of per diems depending on the travel destination. The 2008 high and low per diems are:

Allowance Not Equal to Federal Rate

If the allowance for an employee is less than or equal to the appropriate federal rate, the allowance is treated as reimbursed under an accountable plan and is not included in the employee’s taxable wages. If the allowance is greater than the federal rate, the amount up to the federal rate is excluded from the employee’s taxable wage under an accountable plan but reported to the employee in box 12 (code L), Form W-2.

Incidental Expenses

Expenses included in the rate for meals and incidental expenses are:

• Fees and tips given to porters, baggage carriers, bellhops, hotel maids and others.
• Transportation between places of lodging or business and places where meals are taken, if suitable meals cannot be obtained at the temporary duty site.
• Mailing costs associated with filing travel vouchers and payment of government charge card billings.

No Standard Deduction for Lodging

The per diem rates for meals can be used as a standard meal allowance by both employees and self-employed taxpayers for determining a deduction for unreimbursed meal expenses. However, the per diem rates for lodging are only used for purposes of determining the amount of an employer reimbursement that meets the accountable plan rules. Employees who are not reimbursed by their employer and self-employed taxpayers cannot use the per diem rates for lodging as a means to determine a deduction for lodging. They must use the actual expense method for this purpose.

Travel on First and Last Days of Trip

The per diem rate for meals must be prorated (a reduced rate) on the first and last days of a trip. A taxpayer can either claim three-fourths of the standard meal allowance for each day or prorate the amount using any method that is consistent and within reasonable business practice.

Employee Related to Employer

If the employee is related to the employer, the employee must still be able to prove expenses to the IRS even if the expenses have been adequately accounted to the employer under a per diem or car allowance plan and any excess reimbursement is returned. For this rule, an employee who directly or indirectly owns more than 10 percent of the stock in a corporation is considered related to the employer.

Non-Accountable Plan

Any form of reimbursement that does not meet the accountable plan rules discussed above is a nonaccountable plan. All amounts paid, or treated as paid, under a non-accountable plan are reported as wages on Form W-2. The payments are subject to income tax withholding, Social Security, Medicare and federal unemployment taxes.