It's generally understood that business expenses incurred by owners and employees are tax-deductible. But business expenses aren't always simple, especially once your business grows. Buying office supplies with the company credit card, and having a receipt to back it up is a simple transaction unlikely to garner attention from the IRS. When you send an employee to a sales meeting on the other side of the country, and they use their personal credit cards to pay for meals and other incidentals, additional layers of tax compliance for employers arise.
Here's what every business owner needs to know about IRS business expense reimbursements and how employers can comply with IRS regulations.
Why Compliance Matters
Compliance with IRS regulations is integral to staying operational. If the IRS suspects that records are being improperly kept and deductions willfully falsified, it can lead to costly penalties, business disruptions, and even imprisonment. Making a mistake on your tax return in good faith will not have major legal implications, but addressing that mistake can have a high price tag and distract you from other business priorities.
Willful noncompliance can shatter your business reputation and show distrust among current and potential employees. Financial institutions, investors, and service providers may not want to do business with your firm if they feel that leadership can't be trusted. Staying compliant with tax laws and business expense reimbursement rules is of the utmost importance, proving to the public and private sectors that your firm is trustworthy.
Overview of IRS Regulations on Business Expense Reimbursements
A nearly century-old court case, Welch v. Helvering, is still cited today for what constitutes a business expense and what separates it from a personal expense. The outcome of this case defined business expenses as "necessary and helpful" to operations. Rent, insurance, and salaries are necessary. The company pizza party may not be, but it is helpful for team-building and morale.
Reimbursement of business expenses to employees is the act of paying them directly from company funds if the employee used their personal funds. If an employee uses a company financial account to make an authorized purchase, such as office furniture or travel arrangements, then they do not require reimbursement or additional accounting of these expenses. However, if they use personal funds to pay for business expenses and request reimbursement on an expense report, some of these expenses can create compliance hurdles.
Sometimes, expense reimbursement may be taxable if it goes beyond the normal scope of operations or what is necessary for their trade (such as tools and professional license renewal). Ultimately, this depends on whether the firm has established an accountable plan or not.
Business expense reimbursement does not include personal expenses that employers frequently pay for to obtain tax benefits, such as relocation assistance and medical expense reimbursement.
Accountable vs. Non-Accountable Plans
Employer policies for IRS business expense reimbursements are defined as an accountable plan or non-accountable plan. An accountable plan must meet all of these conditions:
- Expense is paid or incurred while the employee is performing services for their employer
- Reimbursements are for expenses only, not wages
- Employee must submit proof to substantiate the business expense, including the amount, date, location, and purpose, within a reasonable timeframe
- Employee must repay any excess amounts within a reasonable timeframe
Reimbursed expenses under an accountable plan are not taxable wages to the employee. However, if the business expense reimbursement structure is looser or nonexistent, employee reimbursements can become taxable.
Policies with one or more of the criteria below are considered non-accountable plans:
- Employee does not provide receipts or other substantiation
- Employer advances money for these expenses, employee doesn't return excess funds
- Employer doesn't have a reasonable expectation that non-wage payments will be used for business expenses
- Employer pays for reimbursements that would've otherwise been wages
Common Types of Reimbursable Expenses
Common expenses eligible for tax-free reimbursement to the employee include:
- Travel and transportation
- Meals
- Entertainment for clients and prospects
- Supplies and equipment purchases
- Tools and supplies used at work
- Business gifts
Documentation and Record-Keeping Requirements
To meet business expense reimbursement guidelines under an accountable plan, documentation should include:
- Amount
- Date and time
- Location
- Mileage logs, if reimbursing car expenses
- Purpose of the expense (and trip, if travel)
- Parties involved and whose expenses were paid, if a meal or entertainment expense
This is because certain deductions require more substantiation than the date and amount.
It is best to create a uniform expense report for employees to fill out within a reasonable timeframe, such as 30 days from the date paid or incurred. For certain categories that require more substantiation than a receipt alone, the employee should answer questions pertaining to the business purpose of these expenses. Management should review these reports to determine their veracity and then reimburse employees accordingly.
Common Pitfalls and How to Avoid Them
Inadequate Documentation
Employees must include as many details as possible. An easily comprehensible policy on expense reports can solve the issue of inadequate documentation. Missing receipts, dates, and other crucial information would mean that the employee's expenses aren't eligible for reimbursement.
Misclassification of Expenses
Many deductible expenses can fall into a gray area, with clothing and makeup being common culprits for expense misclassification. Employees may want reimbursement for new clothes and personal care, particularly in public-facing jobs.
If these expenses are reimbursed, they are actually taxable to the employee as wages. Only bona fide occupational clothing and gear are deductible. While travel and transportation reimbursements are generally tax-free, commuting does not count unless it is part of a tax-free transit benefit program.
To avoid these pitfalls, discuss your firm's operations and job types with an outside CPA. They can help identify common areas of misclassification and assist in developing clear, IRS-compliant reimbursement policies.
Failure to Return Excess Reimbursements
If an employee receives more funds than they were due for their eligible expenses, it might not be returned because they were busy or assumed it was theirs to keep. While technically not illegal, unclear policies regarding the return of excess funds can cause compliance issues. Create clear policies regarding the return of excess funds and include this language in expense reports and other employee documents.
Best Practices for Ensuring Compliance
- Ensure your policies and procedures are crystal clear. The root of most IRS business expense reimbursement compliance issues is a lack of clear policies that are easy for all employees to understand. Create procedures that are easily comprehensible regarding the creation of expense reports and how they move through the chain of command. Policies that satisfy IRS requirements for accountable plans are a must.
- Include business expenses in employee training. When employees are hired or promoted, they should be trained to submit business expenses for reimbursement. Guide them through the procedures and eligible expenses, and then ensure they can access these documents at any time.
- Conduct regular audits and reviews. Periodically review expense records for discrepancies. Get outside help assessing your current employee reimbursement policy to see which areas need improvement.
- Implement expense management software. Leveraging expense management technologies can shorten the expense reimbursement process, reduce errors, and save hours of productivity. These technologies can scale with your firm while ensuring compliance with business expense reimbursement regulations.
Expense management can become difficult to manage as your firm grows. However, whether you have ten employees or 10,000, it is crucial to stay compliant with business expense reimbursement regulations and form clear policies so that employees understand their responsibilities.
Ensure your business stays compliant with Payday's expense management solutions. Learn more today.