Are Your Expense Reimbursement Legal?

By Harvey J. Berger and Jocelyne C. Miller

     Who reviews your organization’s expense accounts? Does that person allow exceptions to your ordinary requirements? It is not just the terms of your accountable plan that matter. How you administer the plan also impacts whether the Internal Revenue Service (IRS) considers reimbursements taxable wages to your employees.
     If set up and managed correctly, an accountable plan keeps reimbursements or advances for business expenses out of your employee’s taxable wages. If managed incorrectly, penalties may accrue and employee tax liability may grow, long before anyone realizes that they have made errors.
     Most employers have established what they believe to be a solid accountable plan. They routinely exclude expense reimbursements and advances from employee wages on their employees’ W-2 Forms.
     A recent 8th Circuit Court of Appeals case demonstrates some of the consequences that can follow when a plan designed as an accountable plan is not tightly administered, and the reimbursements become wages as a result. For Section 501(c)(3) and Section 501(c)(4) organizations, these consequences could also include the potentially onerous sanctions for excess benefit transactions under Code Section 4958.
     In Namyst v. Commissioner, 97 AFTR 2d 2006-709, January 27, 2006, an employee occasionally received checks from his employer in whole dollar amounts for his business expenses. The employee did not produce receipts or other appropriate written substantiation totaling the full amount of these checks. Additionally, the employee did not return the money that exceeded his expenses.
     The court concluded that with respect to this employee the employer’s reimbursement plan was a non-accountable plan. This meant that none of the employee’s reimbursements or advances from that plan could be treated as though they were from an accountable plan, including those reimbursements for which the employee produced receipts matching to the penny.
     The employee in the Namyst case had taxable wages when his employer gave him money for his business expenses because that money came from a non-accountable plan. All the reimbursements and advances under a non-accountable plan are wages and they must be reported on the employee’s W-2 and have income and employment taxes withheld. Employees who itemize deductions can claim the business expenses on their federal income tax returns, but the deduction probably will not fully offset the wage income. Employee business expenses and other miscellaneous deductions must exceed 2 percent of adjusted gross income for there to be any deduction. Employees who claim the standard deduction will owe tax on all of the reimbursements.
     In the Namyst case, the court determined that the reimbursement plan was not an accountable plan because the employer failed to require adherence to one of the three accountable plan requirements. For a reimbursement plan to be an accountable plan, each reimbursed employee expense must (1) have a business connection and (2) be substantiated with a receipt or similar written documentation.
     The third requirement kicks in if the plan allows for money to be advanced to employees for future expenses. In such cases, you must make the advances no earlier than is reasonable for paying the expense and you must calculate it so as not to exceed the amount of anticipated expense.
     In addition, employees must return excess money, for which there is no substantiated expense, within a reasonable time.
     Although in the Namyst case the court determined the plan was non-accountable because excess money was not returned, the same determination would have resulted if the employee had returned the excess money but received reimbursement for expenses that were personal in nature or if the employee was unable to substantiate his reimbursed expenses. Each of the three requirements is equally important and the lack of any one could turn an otherwise accountable plan into a non-accountable one.
     Absent gross administrative lapses involving many employees, or inadequate provisions in the plan as a whole, the accountability of these plans is determined on an employee-by-employee basis. This means that despite a court’s determination that the Namyst employee received wages from a non-accountable plan, the other employees who had turned in receipts for their business expenses equaling the amount they received still received their reimbursements from an accountable plan. In other words, a single reimbursement plan may be considered an accountable plan for some employees and a nonaccountable plan for others.
     The Namyst case involved a for-profit corporation, but the rules discussed above apply equally to all employers. It is even more important for Section 501(c)(3) and Section 501(c)(4) organizations to look carefully at how accountable plans are administered because of Intermediate Sanctions under Internal Revenue Code Section 4958.
     Although administrative lapses in reimbursing any employee’s expenses might turn those reimbursements into wages in the eyes of the IRS, Section 501(c)(3) and Section 501(c)(4) organizations should be especially vigilant in administering executives’ expenses. For these and certain other employees, the ramifications of imperfect handling of expense reimbursements go beyond the added paperwork to capture taxes that should have been withheld.
     The Internal Revenue Code imposes excise taxes on certain transactions deemed to provide “disqualified persons” with benefits in excess of reasonable compensation for services rendered. These Intermediate Sanctions, so called because they are a middle step the IRS can take instead of revoking a organization’s tax exemption, must be explained on the organization’s Form 990 which is available to the public.
     Disqualified persons include anyone who was, at any time during the five-year period ending on the date of the transaction, in a position to exercise substantial influence over the affairs of the organization. Generally, the officers and directors of an organization are considered disqualified persons. Family members of these influential people are also personally disqualified.
     The federal income tax regulations specifically exclude accountable plan expense reimbursements from the definition of excess benefit transactions. However, the IRS treats reimbursements from a non-accountable plan as “automatic” excess benefit transactions unless they are caught quickly by the plan administrator and included as wages on the employee’s W-2 or the disqualified person includes them as income on his or her tax return.
     If the W-2 does not reflect the non-accountable plan reimbursements in wages and the disqualified person does not include them as wages on a tax return, the organization must show “reasonable cause” to avoid excise taxes of 10 percent of the excess benefit on management and 25 percent of the excess benefit on the disqualified person.
     In addition, the disqualified person must repay the excess benefit transaction amount to avoid a 200 percent excise tax. For each party, reasonable cause means they need to show that despite the fact they did not report the money as wages, they exercised “ordinary business care and prudence.”
     The IRS can find excess benefits even if the non-accountable reimbursements are included on a disqualified person’s W-2, if the reimbursements cause the person’s wages to exceed the limits of reasonable compensation.
     Waiting for the IRS to determine that excise taxes are due might not be prudent. The IRS expects organizations and employees that owe these taxes to determine their own liability and submit that amount with a Form 4720. Failure to file the Form 4720 and remit the tax triggers further penalties, up to 25 percent of the tax due, long before an audit is scheduled.
Harvey Berger, CPA, is a partner and national director of not-for-profit tax services in Vienna, Va., for the accounting and management consulting firm Grant Thornton LLP. His email address is: hberger@gt.com. Jocelyne C. Miller, JD, is an associate in the Washington, D.C. area not-for-profit tax practice of Grant Thornton. Her email address is Jocelyne.Miller@gt.com