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The tax rules surrounding travel reimbursement policies can have a major impact on overhead costs and employee morale. A contractor can choose to either reimburse its employees for actual travel and entertainment expenses or pay the employee an expense allowance. The taxable treatment for both the employer and the employee depends on what type of reimbursement plan the contractor has in place.

Accountable Plan Rules
Generally, any expenses reimbursed to the employee are deductible by the employer. The difference is in how the reimbursement affects the employee. If the employer has a written “accountable” plan, then the reimbursement is non-taxable to the employee, and none of the reimbursement is included in the employee’s income. Some contractors erroneously include the entire reimbursement in the employee’s W-2 or on a separate 1099. Employees also do not deduct any of their expenses on their own personal return. The reimbursement for any meals and entertainment expenses by the employer is limited to 50 percent of the amount incurred.

Under IRS regulations, a plan is accountable if it meets the requirements for business connection and substantiation, and requires that any allowances in excess of the actual expenses be returned. The business connection requirement is satisfied when the employees are reimbursed for travel expenses paid in connection with performing services for the employer. The substantiation standard is met when the plan requires employees to submit information to the employer to substantiate the time, place, business purpose and amount of the expense. Any unused allowances not paid back to the employer within a reasonable period of time are considered paid under the non-accountable plan rules and treated as additional employee wages. 

One way to cut down on the required paperwork for substantiation is to issue a credit card to each employee. The employer can then pay the direct reimbursement to the credit card company. Employees can maintain their credit card receipts and submit reports electronically to their employer.

Non-Accountable Plan Rules
The other option is to treat all employee travel reimbursements as employee wages under a non-accountable plan. The most common example of a non-accountable plan is a simple allowance arrangement in which the contractor pays the employee a flat amount periodically for expenses and the employee is not required to provide any accounting of these expenses to the employer.

At first glance, the adoption of a simple allowance arrangement might seem appealing to an employer because the deduction is 100 percent deductible with no 50 percent limitation for meals and entertainment expenses. However, any tax savings from the increased deduction likely will be offset by increased payroll taxes and other payroll costs associated with treating the reimbursed expenses as wages.

With a non-accountable plan, employees can try to offset the additional income in their W-2 by deducting their expenses incurred on their individual returns. However, these deductions will rarely offset 100 percent of the income because they are treated as itemized deductions and must exceed 2 percent of the employee’s adjusted gross income to be deductible. In addition, the deductions for meals and entertainment expenses are subject to the 50 percent limitation.  

Employers that have a hybrid reimbursement arrangement (an accountable plan for some expenses and non-accountable for others) should treat the arrangements as two separate plans accordingly.

Per Diem Method
In lieu of accounting for and deducting the actual amount of travel costs incurred by employees, contractors can elect to pay a fixed daily reimbursement or per diem. If the per diem paid does not exceed IRS-approved maximums, the reimbursement is treated as made under an accountable plan, and the employee does not need to gather travel receipts to substantiate the actual amounts paid (although the time, place and purpose must still be substantiated through adequate documentation). Employees might consider this a perk because the per diem allowance is generally tax-free, regardless of whether they spend it all.

The IRS issues notices each year to announce the annual per diem rates; they can also be found at gsa.gov/perdiem. There are two separate rates per locality: one for lodging and another for meals and incidental expenses (M&IE).

Employers can pay a combined per diem to cover both lodging and M&IE or just for M&IE if, for instance, the employer either provides lodging, pays the lodging directly to the provider or reimburses the actual lodging costs to the employee.

Instead of having to look up each locality, employers can use a simplified per diem method known as the “high/low method,” which uses only two sets of rates—one for designated high-cost locations and another for all other localities. The locations and high/low rates are issued annually in a notice from the IRS. Currently, the daily rate is $259 for travel to a high-cost locality and $172 for travel to any other locality within the continental United States. The M&IE portion of those rates is $65 and $52, respectfully.

The employer’s per diem allowance can be paid at or below the applicable federal rates. If the contractor’s per diem rate exceeds the applicable federal rate, the excess is treated as paid under a non-accountable plan and is therefore taxable to the employee, subject to payroll withholding and included in the employee’s W-2.

Contractors often overlook that even though these travel expenses are generally allocated to job costs, the M&IE portion of the per diem is still subject to the 50 percent limitation. The 50 percent disallowance applies to the entire M&IE per diem even though such amount includes incidental expenses. For example, if the M&IE rate paid is $46 (common for most areas), the contractor would only get to deduct $23.

Employers that pay less than the applicable federal rate for both lodging and M&IE can choose to treat 40 percent of the allowance paid to be attributable to the M&IE portion and therefore subject that amount to the 50 percent limitation. Under this formula, effectively 80 percent of the total per diem paid is deductible. 

A few employers were unsuccessful in past tax court cases in claiming they were paying for lodging as well as M&IE in order to deduct 80 percent of the per diems, where the courts found no evidence that lodging expenses were actually being incurred. For example, if the stated full combined per diem rate is $129 per day and the contractor only pays $46 (compared to the example above without lodging), the employer would be able to deduct $37 instead of $23. In choosing this option, employers should be ready to prove that they did not also pay lodging for the employee directly and that the employee actually incurred lodging expenses.

Some employers have argued that 100 percent of their per diem is for lodging only and should be fully deductible, but to date the IRS has consistently not allowed lodging- only per diems. 

Another option contractors have to deduct 100 percent of the per diem is to pass the 50 percent limitation on to their customers. This is permissible under IRS regulations issued in 2013 regarding reimbursement arrangements among three or more parties. Under this arrangement, the contractor and customer agree in writing that, in addition to the contracted fee, the contractor will be reimbursed for the workers’ per diem expenses. The contractor provides the customer with the appropriate substantiation for the expenses and can deduct the expenses in full. The customer ultimately bears the meals and entertainment expense and is subject to the 50 percent limitation. This would work best on projects for governmental or not-for-profit customers that are not subject to income tax, so the 50 percent limitation would not affect them.

Cord D. Armstrong is managing director of CBIZ’s tax division in Phoenix. For more information, email carmstrong@cbiz.com.

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