Tool allowances must be based on actual cost.

• Author: O'Driscoll, David

Tool allowances based on hours worked and on statistical data were subject to withholding and included in employees' income. The IRS determined that such estimates could not be used as substitutes for actual substantiation of the tool expenses. The arrangement also failed return-of-excess criteria, because employees were not required to return amounts exceeding their actual expenses.

Facts

E operates an automobile repair and maintenance business. As a condition of employment, E requires service technician employees to provide and maintain various tools needed to perform repair and maintenance services. E pays each employee an hourly wage and a set amount for each hour worked as a "tool allowance," to cover the employee's costs of acquiring and maintaining his or her tools.

E sets each employee's tool allowance annually by using a combination of data from a national survey of average tool expenses for automobile service technicians and specific information on tool-related expenses provided by the employee in response to an annual questionnaire. E uses the data to project the employee's total annual tool expenses.

To convert the employee's estimated annual tool expenses into an hourly rate for the tool allowance, E projects the total number of work hours that will require the use of tools. Thus, the hourly allowance is an estimate of the tool expense projected to be incurred per hour by the employee during the coming year.

Each employee reports his or her hours worked requiring the use of tools, to E at the end of each pay period. On a quarterly statement furnished to each employee, E reports the (1) amount paid to the employee as a tool allowance during the quarter and (2) tool expenses estimated to be incurred in the quarter (i.e., the hours reported worked requiring the use of tools multiplied by the tool allowance).

Employees are not required to (1) provide substantiation of expenses actually incurred for tools or (2) return any portion of the tool allowances that exceeds the expenses they actually incur, either before or after the quarterly reports are issued.

Law and Analysis

For purposes of determining adjusted gross income, Sec. 62(a)(2)(A) and Regs. Sec. 1.62-2(b) provide that an employee may deduct employee business expenses paid under a reimbursement or other expense allowance arrangement with his or her employer.

Under Sec. 62(c), an arrangement will not be treated as a reimbursement or other expense allowance arrangement if it...