Obtaining accountable plan status for tool reimbursement plans.

• Author: Schell, Wayne M.

The tax treatment of tool reimbursement plans has long been a point of contention for businesses that require employees to provide their own tools. In many instances, motor service technicians who work for dealerships or auto repair or body shops must supply their own tools and keep them on site at their employer's business location. As a result, many employers split the employee's compensation into two parts--wages and tool reimbursements. Without much success, automobile repair shops and other businesses have long sought to have such plans classified as accountable plans. Now, in Letter Ruling 200930029, the IRS has shown a pathway for obtaining that tax-favored status. Those hoping for a little relief from the burdensome substantiation requirements, however, will be disappointed.

Typical Tool Reimbursement Plans

Tool reimbursement plans are not a new phenomenon. They are commonly used in car and truck repair and body shops, but they are also found in other types of businesses that combine skilled labor and tools. The employer can administer these plans, but they are often run by a third party.

In many tool reimbursement plans, an employee's compensation is divided into two parts: one part treated and taxable as wage compensation, and the second part treated as a nontaxable reimbursement for the cost of tools used. The employee may (or may not) receive two checks for the two parts of the compensation. When a tool reimbursement plan is adopted, there is often no change in the employee's total compensation--just a recharacterization of part of the payment.

Employers (or third-party administrators) use a variety of methods to determine the amounts to be paid to employees under tool reimbursement plans. Sometimes they will try to determine the actual cost of employees' existing tools when they begin the plan; sometimes they will estimate the replacement cost of employees' tools; and sometimes they will rely on surveys to determine the expected cost and replacement interval for tools used by employees in the industry. Other costs such as insurance and tool maintenance costs may be considered.

When employees start the plan, their regular pay is reduced by the amount paid as a tool allowance. If the total annual tool allowance is paid before the end of the year, the employees' regular pay is then increased until the end of the year, so their total gross compensation remains the same. The only difference is that amounts identified as tool reimbursement allowances are purported to be nontaxable and not subject to payroll taxes, while the regular pay is fully taxable. Treating tool reimbursements in this way attempts to save taxes for both...