If your business has employees then you likely have to reimburse them for out-of-pocket expenses they incur periodically. Reminder: If your business is a S or a C Corporation then you are considered an employee of the corporation, and are subject to the same reimbursement policies as any other employee. When accounted for properly, employee expense reimbursements are deductible to you as the employer, and tax-free to the employee. However, when these reimbursements are not accounted for correctly the IRS can reclassify them as wages, making the full amount subject to both employer and employee payroll taxes as well as income taxes for the employee. To avoid paying taxes on the expense reimbursements you pay to your employees follow these guidelines.
There are four requirements that must be met in order to reimburse your employee’s expenses without creating taxable wages for them:
Legitimate business expense. You can only reimburse your employees for expenses that serve a legitimate business purpose. Reimbursing your employees for meals from an out of town business trip is a legitimate business expense but reimbursing your employee for a night out with their spouse over the weekend would be considered taxable wages to them. To maintain the tax advantaged status of your employee expense reimbursements you should document the business purpose of each expense.
Proof of expense. Before you can reimburse your employee’s expenses you must receive proof from them that the expenses were paid. The substantiation requirements for reimbursed expenses are the same as your ordinary business expenses. Receipts for purchases and mileage logs are the best way to substantiate your business expenses.
Refund excess reimbursements. If you reimburse your employee for an amount greater than the expenses they incurred the excess amount will become taxable wages to the employee if not returned within 120 days.
Reimburse expenses in a timely fashion. Expenses must be reimbursed in a timely fashion to avoid being reclassified as wages. The IRS states that timeliness is determined by the facts and circumstances of each situation. However, to provide additional guidance the IRS lays out circumstances in which reimbursements will always be considered timely:
Reimbursements paid in advance within 30 days before the expense in incurred
Substantiation of expenses provided to the employer within 60 days of payment
Returns of excess payments within 120 days of receipt
While a formalized expense report is not required by the IRS to reimburse employee expenses, it is the best way to ensure that you are meeting the four criteria outlined above. If you have employees or if you are the owner of an S or C corporation we would encourage you to have your employees or yourself fill out expenses reports on a regular basis to reimburse out-of-pocket expenses.