Every business needs an expense reimbursement plan (also called an accountability plan). And your plan needs to meet specific Internal Revenue Service (IRS) and Department of Labor (DOL) standards to be official.
What is expense reimbursement? Key details you need to know
A reimbursement is a sum that you return to someone for expenses incurred. The expense reimbursement process allows employers to pay back their employees who spent their own money on business-related expenses.
If a business doesn’t supply its employees with credit cards or per diem, reimbursements are the most common method for addressing out-of-pocket employee expenses.
So, what constitutes reimbursable expenses?
Usually, when an employee travels for work, a business will reimburse all their meals, gas, and lodging expenses. Office supplies, work tools, and training costs are other types of reimbursable expenses.
Anytime an employee uses their own money to pay for business-related expenses, your finance department might need to reimburse them and keep track of the reimbursement.
Take note of this important point about expense reimbursements: The IRS says that expense reimbursements don’t have to be included in an employee’s wages if that business has an accountable plan. As long as you have an accountable plan in place, reimbursements are not taxable.
If you plan on reimbursing employee business expenses for their out-of-pocket purchases, it’s a good idea to set up your accountable plan right away. This will make accounting and tax filing easier and more efficient.
How to justify your business’s accountable plan
An accountable plan follows the IRS regulations for reimbursing employees for business expenses. Following your plan ensures a reimbursable expense is not counted as income and therefore isn’t taxable.
When creating a business plan, you have to meet these three standards:
#1: Business connection
The expenses incurred must be related to the business in some capacity.
Under Regs. Sec. 1.62-2, any legitimately used purchase for a business is considered a business connection. A business connection includes travel expenses, tools and supplies, home office expenses, training costs, dues, subscriptions, and licensing costs.
However, if the employee needs to be reimbursed for entertainment expenses, then it must be treated as wages, which are taxable and non-deductible.
#2: Substantiation
The employee should supply receipts documenting the amount submitted for reimbursement. The receipt should include proof of the expense, including the amount, time, place, and business purpose. Employees must also submit their receipts for money paid within a reasonable amount of time.
Keep in mind that statements like credit card bills are unacceptable because they don’t detail the amount of money spent on each item. For example, they don’t itemize meals vs. entertainment and, instead, show the total amount of the transaction as a line item.
In instances where employees use credit or debit cards, they should hold onto receipts for each separate expense (meals, entertainment, lodging, and gas expenses) and provide them to the manager in charge of reviewing and issuing reimbursements.
#3: Return excess amounts
The employee must return any excess amounts of money not spent as part of per diem within a reasonable time period.
A “reasonable amount of time” can be decided under Regs. Sec. 1.62-2(g)(2) in one of two ways: The fixed-date method or the periodic-statement method.
The fixed-date method says that employees must repay excess amounts within 60 days after the expense occurred. The period-statement way is ideal for those who use quarterly statements. It says that the employee must return any extra charges within 120 days of the statement.
Ensure your expense reimbursement policy is DOL-Compliant
Your accountability plan must also be compliant with the Department of Labor (DOL) standards. The DOL advises that businesses and unions ask “The Five Ws,” which are:
- Who was there?
- What was the cost?
- When did it happen?
- Where did it occur?
- Why is the expense considered business-related?
Learn more about creating your employee reimbursement plan.
The difference between an expense reimbursement and a per diem
All companies can opt for one of two common methods to reimburse expenses: a per diem or actual expense reimbursement.
With out-of-pocket expenses, the employee must provide receipts to report the actual cost and then request reimbursement. Items reimbursed under this method include travel expenses such as airline tickets, car rentals, and gas.
A per diem is a fixed amount of money that an employee receives to pay for items like meals. used in place of the expense reimbursement method. So instead of paying back the money an employee spends on a business trip, the employer provides them with a certain amount of money to spend upfront.
Learn more about per diems and if they’re the best method for your business.
Types of deductible (and non-deductible) reimbursements
Many businesses choose to reimburse employees for their out-of-pocket expenses since these payments can be deductible come tax season. So, what exactly qualifies as a deductible business expense?
The best way to understand what counts as a deductible reimbursable business expense is to refer to what the IRS states:
- Must be ordinary and necessary
- An ordinary expense is common and accepted in your industry
- A necessary expense is helpful and appropriate for your business
- It does not have to be indispensable to be considered necessary
In short, most reimbursable expenses include transportation, accommodation, tools and supplies, training and education, and incidental expenses.
Which business expenses aren’t covered?
As of 2018, entertainment expenses were no longer deductible per the IRS’s rules of Revenue Procedure 2019-48. However, on November 16, 2021, the IRS issued Notice 2021-63 TCJA (Sec. 274(a)(1)), which allows for 100% deductions for entertainment including food and beverages from restaurants. This exception is in place until the end of 2022, and can work for backdated expenses which were incurred in 2021. Prior to this change, they were 50% deductible.
Now, if an employer does reimburse an employee for entertainment expenses, the amount must be treated as wages (Regs. Secs. 1.62-2(c)(5) and 1.62-2(d)).
Non-deductible entertainment employee expenses include:
- Nightclubs
- Cocktail lounges
- Theaters
- Country clubs
- Golf and athletic clubs
- Sporting events
- Hunting and fishing
Of course, this isn’t to say that you can’t reimburse your employees for their entertainment expenses.
If your employee takes a client out for golf and lunch at a country club, that’s an excellent way to gain some face-to-face time, which could improve sales-client relationships. (Temporary tax relief for business meals provided by restaurants could apply here—for 2021 and 2022 only, businesses can deduct 100% of the cost.)
However, if you do reimburse such expenses yourself, you’ll want to keep in mind that these are part of your employee’s wages, which your employee will have to pay taxes on.
#1: Transportation
Transportation costs include auto mileage and travel reimbursement.
This could occur when employees travel for business trips. Or it can be an agreed-upon amount for the employee to be reimbursed per mile when traveling to multiple worksites, for example, if a social care worker travels to different locations during the work-day or a delivery person drives around delivering your products.
Business owners will offer an employee the IRS’ standard mileage rates, where they reimburse employees for gas and wear-and-tear. Another option is a per diem allowance for travel expenses, although there are different per diem rates according to the General Services Administration (GSA) that depend on where you live.
Other transportation reimbursements may include train tickets, plane tickets, baggage costs, and inflight purchases such as internet or meals.
#2: Accommodation
Accommodation includes lodging, hotel, and meal costs, but these costs must be reasonable and fall within certain circumstances to be deductible. For example, an employee booking a luxurious hotel and attending spa appointments likely won’t be covered because receiving a massage isn’t a business expense.
#3: Tools and supplies
Tools and expenses are expected reimbursements among employers and employees. The employee must prove that the tools and supplies are necessary to perform the job and must be kept on-site at all times.
Even workplaces that host holiday parties may be able to reimburse employees for food, drink, and decoration and use it as a tax-deductible expense—especially since parties are a way to boost employee morale!
#4: Training and education
Many businesses reimburse their employees who gain further training or who attain the job under an educational assistance policy.
Policies like these reimburse employees who pursue training, certification, or a degree. Employers may refund expenses like tuition, course materials, fees, taxes, textbooks, and supplies.
So, for example, if an employee at a daycare center decides to get a degree in Early Childhood Education to further their expertise for the job, the daycare may reimburse their college expenses through an education assistance program.
For businesses, education assistance is considered non-taxable income up to $5,250.
#5: Incidental expenses
Incidental expenses are nominal fees, costs, or gratuities incurred in addition to the primary service. According to the IRS, miscellaneous and incidental expenses that are reimbursable include:
- Meals while traveling for business trips, room service, and fees and tips
- Laundry, dry cleaning, and pressing
- Transportation between lodging, businesses, and places where employees eat meals
- Mailing and shipping costs
Keep track of your business-related expenses with the right software
For businesses that don’t use per diem to pay their employees for out-of-pocket costs, reimbursements are the best option for keeping track of approved expenses incurred by employees.
At the end of each fiscal period, finance and account managers can review and analyze the expense reimbursements issued in reports. They can then identify all tax-deductible costs since reimbursements are not employee wages—which is a win-win for everybody.
