An employee tool and equipment reimbursement plan can be a good deal for contractors: Employees save money on tools they need on the job and the company saves on some payroll tax payments.
Third-party marketers offer businesses access to proprietary software for administering these plans, with some even processing the claims and reimbursements.
However, not all of these plans meet the guidelines for what the Internal Revenue Service (IRS) calls an “accountable plan.” Whether a firm creates its own plan or buys one from a third-party service, it’s crucial to follow the IRS guidelines. Failing to do so can result in misunderstandings with employees and, even worse, tax penalties.
Proper Plan Set-Up
The accountable plan gets its name from the requirement that employees account for every penny they’re seeking reimbursement for when they purchase tools and equipment. It’s not that hard to set up a plan properly, especially because a series of IRS revenue rulings and alerts have pinpointed the defects that caused some plans to run afoul.
To qualify tool and equipment reimbursement payments under an accountable plan, the following requirements must be satisfied.
- The reimbursed expense must be allowable as a deduction and must be paid in connection with performing services as the company’s employee. Tools must be purchased for use on the job—not at home or at another location—and while the worker is employed by the company.
- The employee must provide adequate documentation for each reimbursed expense within a reasonable period of time. No estimates will be allowed. (Two months from the date of purchase is considered a reasonable period.)
- If the employee receives an advance to purchase tools, any amounts in excess of expenses must be returned within a reasonable period of time. (The IRS considers four months from the date of the advance a reasonable period.)
By following these rules, reimbursements will be tax-free to employees and the contractor will not be subject to remitting withholding or payroll taxes on the amounts reimbursed.
The IRS does not require advance approval of plans, nor does it require that its rules be written down, but it’s wise to make the rules available to employees (e.g., in an employee handbook).
Following are other requirements a firm should consider for its plan:
- Keep tools on the company’s premises.
- Create a list of approved vendors from whom tools can be purchased.
- Create a list of approved tools.
- Require employees to sign a statement that certifies they have read and understand the plan, the information provided is complete and accurate, the expense will not be claimed as a deduction on their tax return and they will not seek additional reimbursement from other sources.
- Keep reimbursements separate from payroll and do not make any adjustments to compensation on account of the reimbursements.
Consequences of Not Following the Rules
If an employee doesn’t file a reimbursement claim at all, he will have the option of claiming a deduction for an unreimbursed business expense on his tax return. But that only works if he itemizes deductions, and he likely won’t recover the full amount of his purchase.
If an employee files a reimbursement claim later than the plan’s rules allow, any reimbursement made to him will count as taxable income. That hurts both the business and the employee—the employee because payroll and income taxes must be deducted from the reimbursement, and the business because it’s now responsible for the employer share of payroll taxes on the reimbursement.
Problems could multiply if the business makes policy exceptions (e.g., treating reimbursement requests filed post-deadlines as though they had been filed on time). Some plans offered by third-party marketers incorporate a more serious flaw: they re-characterize a portion of the employee’s regular earnings as tool reimbursements in order to generate tax savings for both the employer and employee.
If an IRS audit detects a pattern of improper reimbursements, it could determine the plan no longer qualifies as “accountable,” and the business could be held responsible for paying withholding taxes on all reimbursements, not to mention the penalties associated with any violations.
For general contractors that rely heavily on subcontractors, it is appropriate to reimburse them for tools they purchase to work on one of the firm’s projects. However, it’s recommended that contractors include reimbursements to subcontractors as income on the Form 1099 provided each tax year, and make it the subcontractor’s responsibility to deduct the tool purchase as a business expense on Schedule C of its tax return.
Tool and equipment reimbursement plans make good business sense for construction companies, and the savings employees realize in the process can build morale and loyalty. Whether starting from scratch or revising a current reimbursement program, make sure the policies follow the guidelines for accountable plans.