Tax Researcher. BUSINESS EXPENSE REIMBURSEMENTS BY EMPLOYERS: How To Avoid Payroll Taxability. Volume XXII Issue 9 September, 2005

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1 Volume XXII Issue 9 September, 2005 BUSINESS EXPENSE REIMBURSEMENTS BY EMPLOYERS: How To Avoid Payroll Taxability Employers normally do not expect their employees to bear the expense of outside meals or overnight lodging related to their business activities. Generally, the employer will make an advance or pay a reimbursement to the employee to cover such business expenses. The taxability of these employer payments will depend on what the employer requires and what the employee actually does, with respect to: 1. return of any unused funds, and 2. substantiation of how the funds actually were expended for business purposes. Basically, there are three ways the employer can make the employee whole. First, the employer s payments can be made under an accountable business expense reimbursement plan. Secondly, the employer may pay based on a per diem allowance that is within the per diem rates of the Federal government. Or, thirdly, the employer may pay the employee but not require the refund of unused amounts or substantiation of the expenses paid. Each of these methods has its own taxability rules. Regardless of the method used to make the employee whole, the employer s payment should be paid or identified separately from wages. If combined in a single payment along with wages, the amount reimbursed by the employer will be treated as TAXABLE WAGES to the employee. Accountable Plans Advances or business expense reimbursements made under an accountable plan generally are non-taxable and are not reported by the employer on the employee s Form W-2.

2 To be an accountable plan, the IRS requires that three conditions be satisfied: a. BUSINESS CONNECTION The expenses paid by the employer must be for work-related expenses that would be deductible by the employee if claimed as a deductible business expense on the employee s personal tax return (Form 1040). b. SUBSTANTIATION The employee must provide evidence of the amount, time, use and business purpose of the advance or expense reimbursement. The substantiation must be provided within a reasonable time. c. RETURN OF EXCESS PAYMENTS Employees must be required to return, within a reasonable period of time, any reimbursements or advances in excess of their substantiated expenses. Importantly, even under an accountable plan, Federal income tax withholding and Social Security, Medicare and FUTA taxes apply to any advance or reimbursement for which the employee fails to substantiate the use or to return any excess amount, within a reasonable period of time. Federal income tax withholding may be computed as if the payment were supplemental wages, provided that the reimbursements were paid separately from regular wages, or were separately identified if combined with regular wages. Per Diem Allowances An alternative method for making the employee whole, which may be easier for both the employer and the employee, is to use a per diem allowance which does not exceed the per diem rates of the Federal government. Using this method, the IRS will ASSUME that the amounts for lodging, meals and incidental expenses are substantiated WITHOUT ANY FURTHER PROOF. Employees need only account for the time, place and business purpose of the travel. Interestingly, employees whose ACTUAL expenses are less than their per diem are NOT required to return the excess. However, amounts advanced for days not actually traveled, must be returned to the employer or they will be taxable as wages. The business travel must be away from home for the per diem allowance to apply to the lodging, meals and incidental expenses. Incidental expenses means laundry, dry cleaning fees, and tips for service. It does not include such expenses as transportation costs, telephone calls and taxi fares, which are too variable from person to person to be measured on a standardized basis. However, employees may be reimbursed for the latter expenses by the substantiation method, and thereby prevent the employer s reimbursement from being taxable as wages. Because the Federal per diem rate is the IRS standard for determining taxability, it is necessary to examine it more closely. The Federal government publishes its own per diem rates for Federal employees traveling on government business. The rates are revised annually, and follow the government s fiscal year, which starts October 1, rather than the calendar year. The Federal per diem rate usually is shown by component: a.) lodging expense rate, and b.) the meal and incidental expense (M&IE) rate, for the locality of travel. To enable the respective rate to be specific to a locality, the Federal government uses three rate tables: a.) localities in the continental United States (CONUS); b.) non-foreign localities outside the U.S. (OCONUS), including Alaska, Hawaii, Puerto Rico, Northern Mariana Islands and U.S. possessions; and c.) foreign locations. Locality of travel is the place where the employee stops for sleep or rest.

3 Sometimes an employer will pay the per diem allowance only for meals and incidental expenses (M&IE). For example, an M&IE only per diem allowance would be paid if the employer: provides the lodging in-kind, pays the cost of the lodging directly to the lodging provider, does not expect lodging expenses to be incurred, or pays the employee for actual lodging expenses, separately substantiated. Attempting to simplify the extensive Federal per diem rate tables, the IRS has authorized a high-low substantiation method for travel within the continental United States. Under this method, a short list of high-cost localities is identified. The applicable per diem rate for travel to any one of these high-cost localities is $204 per day ($158 for lodging and $46 for M&IE), effective January 1, Typically, the high-cost localities of travel are large cities like Boston or New York, or resort areas (for example: Aspen, CO; Martha s Vineyard, MA; Park City, UT). At the same time, the rate for ALL OTHER locations within the continental United States is $129 per day ($93 for lodging and $36 for M&IE). The high-low substantiation method may not be used for travel outside the continental United States. Also, if the employer s per diem covers only meals and incidental expenses (M&IE), the high-low substantiation method does not apply. Furthermore, employers who begin using the high-low substantiation method for a particular employee s travel within the continental United States, must continue to do so for the calendar year. However, the employer is permitted to switch to reimbursement for actual expenses, or to an M&IE per diem for the specific locality, BEFORE the end of that calendar year. Also, the employer may apply the per diem substantiation method for travel outside the continental United States during the same year. Finally, the M&IE portion of the Federal per diem must be pro-rated for partial days. For example, perhaps only a portion of the first or last days of a business trip will be spent away from home. The employee is allowed one-fourth of the applicable M&IE per diem for each quarter of the day spent traveling or away from home. The IRS defines the daily quarters to be: midnight to 6 AM, 6 AM to noon, noon to 6 PM, and 6 PM to midnight. Non-Accountable Plans When the employer advances money to an employee in anticipation of business trip expenses, but does not require substantiation of the expenditure of those funds and the return of any unused amount, the employer is said to be using a non-accountable plan. Indeed, whenever an employer s plan does not meet one or more of the three requirements (see above) for an accountable plan, it is a non-accountable plan. The consequence of a non-accountable plan is that any employer payments under the plan are considered taxable income to the employee, subject to all Federal employment taxes, and reportable as wages on the employee s Form W-2.

4 Furthermore, an employee under an accountable plan who fails to substantiate any expenses or return an excess reimbursement within a reasonable time, must treat the unsubstantiated amount as though it was paid under a nonaccountable plan for purposes of taxability. Thus, if a single reimbursement or advance payment has both accountable and non-accountable elements, the payment is treated as made proportionately under two separate plans. However, the employer s reporting and withholding requirements apply only to the non-accountable element. HOW THE FICA INCOME TAX CREDIT RE-PAYS RESTAURANT EMPLOYERS Before 1988, restaurant operators with tipped employees paid Social Security and Medicare (FICA) tax on ONLY those tip amounts deemed to be wages since they were being used to support a tip credit. Generally, these employers claimed a tip credit for part of the minimum wage rate they were required to pay. So, if NO tip credit were claimed, there would have been NO FICA tax on the employee s reported tips. However, effective January 1, 1988, the law was changed to make ALL reported tips subject to FICA tax. The tax was paid by the employee (subject to the taxable wage limit for Social Security tax, but not limited for Medicare tax), and matched by the employer. In 1993, Congress changed the law again, to reduce the FICA tax burden on employers operating food and beverage establishments ( restaurants ). However, Congress did not simply repeal the employer-paid FICA tax on tips. Instead, an INCOME TAX CREDIT was established to offset the employer s already-paid FICA tax on any reported tips in excess of tips used to support a tip credit. The change became effective for taxes paid after December 31, 1993, and provided potential tax relief for 1994 and in subsequent years. How the Employer s FICA Income Tax Credit Works The Internal Revenue Code already allows business tax credits for various purposes, which reduce Federal income tax liability. The amount of the FICA Income Tax Credit is the employer s FICA tax rate (currently 7.65%) multiplied times any employee-reported tip income which was not used to support tip credit for minimum wage purposes. For example, under current Federal minimum wage requirements, if an employee is paid a cash wage of $2.13 per hour, and he or she reports tips of $6.02 (on average) per hour, the first $3.02 per hour of reported tips may be considered wages to bring the employee to the required Federal minimum wage rate of $5.15 per hour ($2.13 cash wage + $3.02 tip credit = $5.15). In this example, the remaining $3.00 per hour of reported tips ($ $3.02) is not considered wages under the Fair Labor Standards Act, and the FICA tax paid by the employer on this portion of reported tips is eligible for the FICA Income Tax Credit. Like other general business tax credits under the Internal Revenue Code, this tax credit is not refundable. An employer must have Federal income tax liability (present, past or future) to use the credit. If there is no Federal income tax liability in a particular year or if the available credits exceed the Federal income tax liability, the unused credit can be carried back one year or forward up to twenty years, to years in which there is a Federal tax liability against which the credit can be applied.

5 Also, the matching FICA tax payments an employer makes are a business expense deduction against Federal taxable income. To the extent that the employer claims the FICA Income Tax Credit, the employer will not be able to receive a business expense deduction for that amount of FICA tax. However, the value of a tax CREDIT for Federal income tax purposes may be several times the value of the FICA tax as a business expense DEDUCTION. Computing the Credit Importantly, if state minimum wage rate laws were applied when the payroll calculations were made, and the state wage rate and maximum tip credit differ from Federal, then the payroll tip credit must be re-calculated using FEDERAL standards, if the FICA Income Tax Credit is to be calculated correctly. Regardless of how the payroll was calculated, the employer must compute the reported tips which qualify by using Federal minimum wage and tip credit standards --- that is, a minimum wage rate of $5.15 per hour and maximum tip credit of $3.02 per hour. Here is an illustration: STEP I Assume a cash wage of $3.00 per hour paid by the employer, totaling $120 ($3.00 X 40 hours), and tips reported by the employee of $320 ($8.00 tips per hour X 40 hours). Therefore, with total earnings of $440 ($120 + $320), the employer-paid FICA tax is $33.66 ($440 X 7.65%). STEP II Assume the same cash wages of $3.00 per hour paid by the employer, or $120 ($3.00 X 40 hours), and reported tips used to reach the Federal minimum wage rate ($5.15), of $86 ($ $3.00 cash wage = $2.15 tip credit X 40 hours). Therefore, the tips deemed wages (tip credit) under the Fair Labor Standards Act is $86. STEP III The reported tips in EXCESS of tips deemed wages is $234 (using $5.15 as the Federal minimum wage rate), derived by subtracting tips deemed wages ($86) from total reported tips of $320. STEP IV The amount eligible to be claimed as income tax credit is $17.90 ($234 X 7.65%). Potential ANNUAL employer savings from the tipped employee described above would be $ ($17.90 X 52 weeks). The FICA Income Tax Credit is computed the same way whether the employer is an individual, a partnership, an S corporation or a C corporation. The employer claims the income tax credit by completing Form 8846 (Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips) and attaching it to the annual business income tax return. TAX RESEARCHER is distributed with the understanding that the publisher is not rendering legal, accounting or other professional services. If such advice or assistance is required, an attorney or accountant should be consulted. This newsletter is published monthly by Statutory Research, a department of the Employer Services Division. Address comments to: ADP, Inc., Statutory Research Department, One ADP Boulevard (M/S 364), Roseland, New Jersey Copyright 2005 ADP, Inc. For more information, contact your local ADP representative Go to or call CALL ADP ( ) The ADP Logo is a registered trademark of ADP of North America, Inc. All other trademarks and service marks are the property of their respective owners.

6 12-MONTH INDEX ADP s Tax Researcher (October, 2004 through September, 2005) TOPIC MONTHLY ISSUE Advance Payment of Earned Income Credit (SEE Earned Income Credit, advance payment of) Alien Workers (SEE Foreign Nationals Employed In the U.S.) Auto Mileage Rates (IRS) For 2004 and 2005 Jan. 05 Business Expense Reimbursements Generally Sept. 05 Non-accountable expenses Sept. 05 Per diem expense amounts Sept. 05 Travel expenses Sept. 05 Cafeteria Plan (SEE Section 125 plan) Catch-Up Contributions (SEE Pension Plan Contribution Limits) Child, payroll taxation of Apr. 05 Clergy, taxation of July. 05 Common Paymaster Nov 04 Corporation Dec. 04 Deferred Compensation Plans (SEE Pension Plan Contribution Limits) EFTPS Dec. 04 Electronic Federal Tax Payment System (SEE EFTPS) Employee, definition of Feb. 05 Family Members, payroll taxation of Apr. 05 FICA Income Tax Credit Sept. 05 Flexible Spending Accounts Apr. 05 Foreign Nationals Employed in the U.S. Aug. 05 Form W-4 Feb. 05 Jun. 05 Aug. 05 Fringe Benefits, taxable Jun. 05 Garnishment Orders May 05 Household Employee Mar. 05 Independent Contractor, definition of Feb. 05 Individual Taxpayer Identification Number Jun. 05 ITIN (SEE Individual Taxpayer Identification Number) Job Changes Jan. 05 Limited Liability Company (LLC) May 05 Maximum Tip Credit Changes District of Col. (eff. 1/1/05) Feb. 05 Florida (eff. 5/2/05) Apr. 05 Illinois (eff. 1/1/05) Dec. 04 Maine (eff. 10/1/04) Dec. 04 New Jersey (eff. 10/1/05) May 05 New Mexico (eff. 7/1/05) Jun. 05 New York (eff. 1/1/05) Jan. 05 Oregon (eff. 1/1/05) Dec. 04 Vermont (eff. 1/1/05) Dec. 04 Washington (eff. 1/1/05) Dec. 04 Wisconsin (eff. 6/1/05) July 05 Tip Credit Explained Aug. 05 TOPIC MONTHLY ISSUE Medicare Taxable Wages Nov. 04 Mergers Jan. 05 Minimum Wage Rates Changes District of Col. (eff. 1/1/05) Feb. 05 Florida (eff. 5/2/05) Apr. 05 Illinois (eff. 1/1/05) Dec. 04 Maine (eff. 10/1/04) Dec. 04 Minnesota (eff. 8/1/05) July 05 New Jersey (eff. 10/1/05) May 05 New York (eff. 1/1/05) Jan. 05 Oregon (eff. 1/1/05) Dec. 04 Vermont (eff. 1/1/05) Dec. 04 Washington (eff. 1/1/05) Dec. 04 Wisconsin (eff. 6/1/05) July 05 Because both Federal and state minimum wage rates may apply concurrently, which rate should the employer use? Mar. 05 Ministers (SEE Clergy) New Hire Reporting Oct. 04 Parent, payroll taxation of Apr. 05 Parking Benefit (SEE Qualified Parking Benefit) Partnership Oct. 04 Pension Plan Contribution Limits 2005/2004/2003 contribution limits Nov. 04 Pittsburgh Enacts New Payroll Tax Feb. 05 Predecessor Employer Jan. 05 Qualified Deferred Compensation Plans (SEE Pension Plan Contribution Limits) Reciprocity (SEE State income tax) Retirement (SEE Social Security Retirement Benefits) S Corporation Feb. 05 Section 125 Plan Apr. 05 Social Security Retirement Benefits May 05 Social Security Taxable Wages Nov. 04 Sole Proprietorship Jan. 05 Spouse, payroll taxation of Apr. 05 State Disability Insurance Jun 05 State Unemployment Insurance Multi-state workers Oct. 04 Taxable wage limits table for 2003, 2004 and 2005 Jan. 05 Statutory Employee Dec. 04 Statutory Non-Employee Dec. 04 Successor Employer Jan. 05 SUI (SEE State Unemployment Insurance) Taxable Fringe Benefits Jun. 05 Tip Credit (SEE Maximum Tip Credit) Transportation Fringe Benefits Jun. 05 Unclaimed Wages Oct. 04 Vacation Pay July 05

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