IRS Puts Employers on Notice Regarding Reimbursement Arrangements That Don't Qualify as Accountable Plans (Parker's Federal Tax Bulletin: September 13, 2012)

This week, the IRS issued a ruling that provides important guidance for employers that issue reimbursements to employees and other workers. In Rev. Rul. 2012-25, the IRS clarifies that an arrangement that recharacterizes taxable wages as nontaxable reimbursements or allowances does not satisfy the business connection requirement of the accountable plan rules. The IRS refers to this as wage recharacterization because the amount being paid is not an expense reimbursement but rather a substitute for an amount that would otherwise be paid as wages.

Rev. Rul. 2012-25 includes four situations three of which illustrate arrangements that impermissibly recharacterize wages. The fourth situation illustrates an arrangement that does not impermissibly recharacterize wages, where an employer prospectively alters its compensation structure to include a reimbursement arrangement.

Background

In determining adjusted gross income, Code Sec. 62(a)(2)(A) provides that an employee can deduct certain business expenses paid in connection with the performance of services as an employee under a reimbursement or other expense allowance arrangement. Code Sec. 62(c) provides that, for this purpose, an arrangement is not treated as a reimbursement or other expense allowance arrangement if (1) the arrangement does not require the employee to substantiate the expenses covered by the arrangement to the person providing the reimbursement, or (2) the arrangement provides the employee the right to retain any amount in excess of the substantiated expenses covered under the arrangement.

Under Reg. Sec. 1.62-2(c), if a reimbursement or other expense allowance arrangement meets the requirements of business connection, substantiation, and returning amounts in excess of substantiated expenses, all amounts paid under the arrangement are treated as paid under an accountable plan.

COMPLIANCE TIP: Amounts treated as paid under an accountable plan are excluded from an employee's gross income, are exempt from withholding and payment of employment taxes, and are not reported as wages on the employee's Form W-2. If the arrangement fails any one of the accountable plan requirements, amounts paid under the arrangement are treated as paid under a nonaccountable plan, must be included in the employee's gross income for the tax year, are subject to withholding and payment of employment taxes, and must be reported as wages or other compensation on the employee's Form W-2.

An arrangement satisfies the business connection requirement if it provides advances, allowances, or reimbursements only for business expenses that are allowable as deductions and that are paid or incurred by the employee in connection with the performance of services as an employee of the employer. Thus, not only must an employee actually pay or incur a deductible business expense, but also the expense must arise in connection with the employment for that employer.

The regulations provide that the business connection requirement is not satisfied if a payor pays an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur deductible business expenses.

Tax Treatment of Employee Business Expenses

The Tax Reform Act of 1986 significantly changed the rules for deducting employee business expenses by converting most of these expenses into itemized deductions that an employee can deduct only to the extent the aggregate of such expenses exceeded 2 percent of adjusted gross income (the 2-percent floor). However, the 1986 Act left in place a taxpayer's ability to deduct from gross income and without regard to the 2-percent floor, employee business expenses incurred by the taxpayer as part of a reimbursement or other expense allowance arrangement with his or her employer.

After enactment of the 1986 Act, tax practitioners proposed that employers could use reimbursement and expense allowance arrangements to (1) eliminate the effect of the 2-percent floor on deductible employee expenses, and (2) save both employer and employee employment taxes, by restructuring their compensation packages to convert a portion of an employee's compensation into a nontaxable reimbursement. This restructuring would permit employers to pay a lesser total amount while increasing employees' after-tax compensation.

Code Sec. 62(c) was enacted to prevent such restructuring of compensation arrangements and permit an above-the-line deduction only for expenses reimbursed under what legislative history referred to as an accountable plan.

In issuing regulations under Code Sec. 62(c), the IRS noted that, while an employer may establish or modify its compensation structure to include nontaxable reimbursement under an accountable plan, recharacterizing as nontaxable reimbursements amounts that would otherwise be paid as wages violates the business connection requirement, and more specifically, the reimbursement requirement. This is true even if an employee actually incurs a deductible expense in connection with employment with the employer.

Wage Recharacterization

According to the IRS, the presence of wage recharacterization is based on all the facts and circumstances. Generally, wage recharacterization is present when an 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.

Wage recharacterization may occur in different situations. For example, an employer recharacterizes wages if it temporarily reduces taxable wages, substituting the reduction in wages with a payment that is treated as a nontaxable reimbursement and then, after total expenses have been reimbursed, increases taxable wages to the prior wage level. Similarly, an employer recharacterizes wages if it pays a higher amount as wages to an employee only when the employee does not receive an amount treated as nontaxable reimbursement and pays a lower amount as wages to an employee only when the employee also receives an amount treated as nontaxable reimbursement. An employer also recharacterizes wages if it routinely pays an amount treated as a nontaxable reimbursement to an employee who has not incurred bona fide business expenses.

Three of the four scenarios in Rev. Rul. 2012-25 illustrate situations in which there is wage recharacterization.

Situation 1

In Situation 1, a company contracts with cable providers and employs technicians to install cable television systems at residential locations on behalf of different cable providers. Employee technicians are required to provide the tools and equipment necessary to complete the various installation jobs to which they are assigned. The company compensates its employees on an hourly basis, which takes into account the fact that technicians are required to provide their own tools and equipment.

The company decides to begin reimbursing its technicians for their tool and equipment expenses through a tool reimbursement arrangement (i.e., a tool plan). Under the company's tool plan, a technician provides the company with an amount equivalent to the technician's tool and equipment expenses incurred in connection with providing services to the company. The company takes the technician's total expenses for the year and divides the total amount by the number of hours a technician is expected to work over the course of a year to arrive at an hourly tool rate. Once the company has determined the hourly tool rate amount for a technician, it pays the technician a reduced hourly compensation rate and an hourly tool rate. The company treats the reduced hourly compensation as taxable wages and treats the hourly tool rate as a nontaxable reimbursement. The hourly tool rate plus the reduced hourly compensation rate approximately equal the pre-tool plan compensation rate. The tool plan tracks the hourly tool rate up to the amount of substantiated tool and equipment expenses. Once a technician has received tool plan payments for the total amount of his or her tool and equipment expenses, the company stops paying the technician an hourly tool rate but increases the technician's hourly compensation to the pre-tool plan hourly compensation rate.

According to the IRS, the company's tool plan in Situation 1 does not satisfy the business connection requirement of the accountable plan rules because the employer pays the same gross amount to a technician regardless of whether the technician incurs (or is reasonably expected to incur) expenses related to the company's business. Specifically, the tool plan ensures that a technician receives approximately the same gross hourly amount by substituting a portion of what was paid as taxable wages with a tool rate amount that is treated as nontaxable reimbursement, and then increasing the wages again once all tool expenses have been reimbursed. Accordingly, the purported tool reimbursements are merely a recharacterization of wages because approximately the same amount is paid in all circumstances. The fact that a technician actually incurs a deductible expense in connection with employment does not cure the incidence of wage recharacterization. The arrangement fails to satisfy the business connection requirement. Therefore, without regard to whether it meets the other requirements of an accountable plan, the company's tool plan is not an accountable plan.

Situation 2

In Situation 2, an employer is a staffing contractor that employs nurses and provides their services to hospitals throughout the country for short-term assignments. The employer compensates all the nurses on an hourly basis and the hourly compensation amount does not vary depending on whether the hospital is located away from the assigned nurse's tax home.

When the employer sends nurses on assignment to hospitals that require them to travel away from their tax home and incur deductible expenses in connection with the employer's business, the employer treats a portion of the nurses' hourly compensation as a nontaxable per diem allowance for lodging, meals, and incidental expenses under a per diem plan; the employer treats the remaining portion of the nurses' hourly compensation as taxable wages. When the employer sends the nurses on assignment to hospitals within commuting distance of their tax home, the employer treats all the nurses' compensation as taxable wages. In each case, the nurses receive the same total compensation per hour.

According to the IRS, the employer's per diem plan in Situation 2 does not satisfy the business connection requirement of the accountable plan rules because it pays the same gross amount to nurses regardless of whether the nurses incur (or are reasonably expected to incur) travel expenses related to the employer's business. The purported per diem payments are merely recharacterized wages because nurses receive the same gross compensation per hour regardless of whether travel expenses are incurred (or are reasonably expected to be incurred). The fact that a nurse traveling away from his or her tax home actually incurs a deductible expense in connection with employment does not cure the incidence of wage recharacterization. The arrangement fails to satisfy the business connection requirement and, thus, without regard to whether it meets the other requirements of an accountable plan, the employer's per diem plan is not an accountable plan.

Situation 3

In Situation 3, the employer is a construction firm that employs workers to build commercial buildings throughout a major metropolitan area. As part of their duties, some of workers are required to travel between construction sites or otherwise use their personal vehicles for business purposes. These workers incur deductible business expenses in operating their personal vehicles in connection with their employment. The employer compensates all its workers for their services on an hourly basis, which the employer treats as taxable wages. The employer also pays all its workers, including those who are not required to travel or otherwise use their personal vehicles for business, a flat amount per pay period that the employer treats as a nontaxable mileage reimbursement.

The IRS ruled that employer's mileage reimbursement plan in Situation 3 does not satisfy the business connection requirement of the accountable plan rules because it operates to routinely pay an amount as a mileage reimbursement to workers who have not incurred (and are not reasonably expected to incur) deductible business expenses in connection with the employer's business. The purported mileage reimbursement is merely recharacterized wages because all workers receive an amount as a mileage reimbursement regardless of whether they incur (or are reasonably expected to incur) mileage expenses. The arrangement fails to satisfy the business connection requirement. Therefore, without regard to whether it meets the other requirements of an accountable plan, the employer's mileage reimbursement plan is not an accountable plan.

Situation 4

In Situation 4, an employer operates a cleaning services company that employs cleaning professionals to perform house cleaning services for the employer's clients. Employee cleaning professionals are required to provide the cleaning products and equipment necessary to complete the cleaning service jobs to which they are assigned. The employer pays the employees on an hourly basis, which takes into account that employees are required to provide their own cleaning products and equipment. The employer decides to begin reimbursing employees for their cleaning and equipment expenses through a reimbursement arrangement. The employer prospectively alters its compensation structure by reducing the hourly compensation paid to all employees. Under the employer's new reimbursement arrangement, employees can substantiate to the employer the actual amount of deductible expenses incurred in purchasing their cleaning products and equipment in connection with performing services for the employer. The employer reimburses its employees for substantiated expenses incurred in performing services for the employer. Any reimbursement paid under the employer's reimbursement arrangement is paid in addition to the hourly compensation paid for the employees' services. Employees who do not incur expenses for cleaning products and equipment in connection with their jobs or who do not properly substantiate such expenses, continue to receive the lower hourly rate and do not receive any reimbursement and are not compensated in another way (for example, with a bonus) to substitute for the reduction in the hourly compensation. The employer treats the hourly compensation as taxable wages and treats reimbursements for cleaning and equipment expenses as nontaxable reimbursements.

The IRS ruled that, in Situation 4, the employer's reimbursement arrangement satisfies the business connection requirement of the accountable plan rules. This is because the employer's plan reimburses employees only when a deductible business expense has been incurred in connection with performing services for the employer, and the reimbursement is not in lieu of wages that the employees would otherwise receive. Although the employer has reduced the amount of compensation it pays all its employees, the reduction in compensation is a substantive change in the employer's compensation structure. Under the arrangement, reimbursement amounts are not guaranteed and employees who do not incur expenses in connection with the employer's business, or who do not properly substantiate such expenses, continue to receive the reduced hourly compensation amount. These employees do not receive any reimbursement and are not compensated in another way to make up for the reduction in the hourly rate. The employer's reimbursement arrangement does not operate to pay the same or a substantially similar gross amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) expenses related to the employer's business. The reimbursement is paid in addition to the employees' wages rather than as a substitute for wages that would otherwise be paid. Thus, the employer's reimbursement arrangement satisfies the business connection requirement. Therefore, as long as the substantiation and return of excess amounts requirements are also met, the employer's reimbursement arrangement is an accountable plan.

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