Small Tools, Big Deal: Accountable Reimbursement Plans

by: Smith and Howard

June 26, 2014

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Small tools are an unavoidable expense for many construction workers and the companies that employ them. Like many contractors, you have likely considered creating an “accountable” plan for reimbursing employees for their small tools purchases. Although the dollar amounts of these items may be relatively miniscule, getting an accountable plan right is a big deal come tax time.

Mind the criteria

The IRS has set three primary criteria for establishing an accountable plan. First, there’s the “business connection” requirement. It says that any expenses you reimburse must be business-related and otherwise deductible by the employee. So the tool purchases in question must be for your construction projects, and the worker who buys them must already be your employee. The other two criteria are that employees should:

  • Substantiate their tool expenses in expense accounts or other written records, and
  • Repay any tool allowance they receive that exceeds the cost of the tools.

Ensuring that your tool reimbursement plan meets these three primary criteria is a good start toward garnering the tax benefits of an accountable plan. But you still need to maintain proper documentation pinpointing the amounts you remit to employees as either wages or allowances when you pay them. In addition, you must make these payouts on the basis of realistic cost expectations.

Be reasonable

The IRS requires something else as well: reasonableness. It wants expenses to be substantiated within a reasonable period, and it requires employees to repay any employer-provided tool allowances exceeding their expenses within a reasonable period.

There are a couple of approaches companies have long used to support reasonableness. One is establishing a fixed-date system that, for example, specifies that tool reimbursements will occur within 30 days of when a worker incurs an expense, and the expense will be substantiated within 60 days. Further, any advances or allowances that can’t be substantiated will be repaid within 120 days.

The other traditional approach is to issue periodic statements reflecting tool expenses and reimbursements. Here, your construction business would remit the statements at least quarterly and highlight payments that exceed substantiated expenses, which workers would need to either substantiate or repay within a set period (generally 120 days).

A word of warning: The IRS won’t always accept periodic statements alone. So, if you opt for this method, mandate that employees submit bona fide receipts for tool purchases.

Heed the reminder

Not long ago, the IRS released Revenue Ruling 2012-25, which provides a relatively gentle reminder of the rules to employers whose reimbursement plans may have fallen out of compliance of late. The guidance largely focuses on the “business connection” requirement.

Specifically, the IRS wishes to clarify that an arrangement that recharacterizes taxable wages as nontaxable reimbursements or allowances does not satisfy the business connection requirement. According to the agency, an employer recharacterizes wages if it:

  1. Temporarily reduces taxable wages and substitutes nontaxable reimbursements until total expenses have been reimbursed and then increases wages to the previous level,
  2. Pays a higher amount as wages to an employee when he or she doesn’t receive a nontaxable reimbursement, and a lower amount as wages when the employee also receives a nontaxable reimbursement, or
  3. Routinely pays a nontaxable reimbursement to an employee who hasn’t incurred bona fide business expenses.

The guidance also illustrates how Rev. Rul. 2012-25 may be applied to various types of employers. (Ask a Smith and Howard tax advisor for help fully interpreting it.)

Fear not the complications

Despite their apparent complications, accountable plans are indeed a good thing. Reimbursements aren’t reported as income, so you should be able to avoid payroll taxes and W-2 reporting while claiming deductions for these expenses. Meanwhile, employees don’t have to report reimbursements as income or claim the expenses as miscellaneous itemized deductions. The tricky part, of course, is following the rules. To make sure you are doing so, call Smith and Howard at 404-874-6244 to speak with a tax advisor.

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