The Tax Cuts and Jobs Act took away a tax-saving deduction for employees who have out-of-pocket expenses for their jobs. Under the old law, many employees got a tax break for their work-related expenses for mileage, travel, supplies, tools and continuing education. If those expenses were greater than 2% of their income, they could deduct them as a miscellaneous itemized deduction on Schedule A. This also applied to shareholders of S-corporations and remote workers.
However, the new law took that deduction away for the next few years. All miscellaneous itemized deductions are suspended until 2026. This means employees are out of luck if they have work-related expenses and their employer doesn’t reimburse them.
Accountable plans to the rescue
But, if an employer establishes an accountable plan, both sides win: the employer gets a deduction, and the employee receives a tax-free reimbursement. Under an accountable plan, employees are reimbursed for the work-related expenses they “account” for (hence the name) by filing an expense report with their employer. Those expenses are then deductible by the employer.
To satisfy the IRS, an accountable plan must meet these three criteria:
- The expenses must have a business connection. The expenses must be incurred while the employee is performing work for the company and must be ordinary and necessary expenses. These can include meals with clients, travel expenses, business-related mileage and home office expenses.
- There must be substantiation to support the deduction. This is done by submitting a detailed monthly or quarterly expense report with the relevant documentation attached. Apps like Expensify make this simple to do with a smartphone.
- Any excess reimbursements over actual expenses must be repaid promptly. If the employer provides an advance for travel expenses, any unused funds must be repaid within 120 days.
Setting up an accountable plan is easy. Here’s a sample agreement that can be used to set one up. When all three criteria are met, the employee gets a tax-free reimbursement and the employer gets a deduction for the employee’s expenses. If these criteria are not met, those reimbursements become taxable income for the employee.
Home office expenses can also be reimbursed through an accountable plan. Sales professionals, remote workers, S-corporation shareholders and other employees who (1) have a space they use regularly and exclusively to conduct business, and (2) use that space as their principal place of business can deduct home office expenses.
Salary reductions in exchange for additional reimbursements
In some situations, it may make sense to reduce salaries by the amount of the reimbursements. Both sides can benefit under such an arrangement.
The employee receives the same amount of cash or even a bit more since payroll taxes aren’t taken out. Because those reimbursements aren’t taxable, their taxable income goes down, as does their tax bill. The employer gets a deduction for the reimbursed amount, but since these reimbursements aren’t being paid out as wages, employers will see their payroll taxes decrease.
However, if the reimbursed expenses include lots of expenses for meals and entertainment, employers may see their taxable income increase because those deductions are limited under the new law. Meals in travel status remain 50% deductible, but entertainment expenses are no longer deductible. The status of deductions for meals for meetings with clients is not yet clear.
Setting up an accountable plan for your business is easy, and can cut taxes for both business owners and their employees.
Does an accountable plan sound like a great idea for your business? Contact us and we’ll help you set one up!