IRS illustrates employee reimbursement plans.

• Author: Spyker, Deborah

The IRS and the Tax Court have historically resisted the characterization of concurrent salary reduction and expense allowance or reimbursement arrangements as accountable expense reimbursement arrangements for purposes of Sec. 62, on the basis that such transactions improperly reduce wages subject to income and payroll taxes and allow employees to escape the deduction limitation on nonreimbursed employee business expenses (see, e.g., Lickiss, T.C. Memo. 1994-103).

Now, in Rev. Rul. 2012-25, the IRS has described four situations where employers have recharacterized taxable wages as nontaxable business expense reimbursements and has ruled on whether these arrangements satisfy the business connection requirement of the accountable plan rules.

Background

Sec. 62(a)(2)(A) allows a deduction for certain business expenses paid by an employee in connection with the performance of services for an employer under a reimbursement or other expense allowance arrangement. However, under Sec. 62(c), an arrangement is not treated as a reimbursement if (1) the arrangement does not require the employee to substantiate the expenses, or (2) the arrangement provides the employee the right to retain any amount in excess of the substantiated expenses.

Regs. Sec. 1.62-2(c) states that if a reimbursement arrangement meets the requirements of business connection (described below), substantiation, and returning amounts in excess of substantiated expenses, all amounts paid under the arrangement are treated as paid under an accountable plan. As such, the amounts are excluded from the 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, Wage and Tax Statement. However, if the arrangement fails any of the three requirements, the arrangement is treated as a nonaccountable plan. Accordingly, the amounts are included in gross income, are subject to employment tax, and must be reported on the employee's Form W-2.

Under the business connection requirement, the employee must pay or incur a deductible expense, and the expense must arise in connection with the employee's performance of services for the employer (Regs. Sec. 1.62-2(d)(1)). In addition, the business connection requirement is not satisfied if an employer pays an amount to an employee regardless of whether the employee actually incurs or is reasonably expected to incur deductible business expenses (Regs. Sec. 1.62-2(d)(3)(i))...