Wednesday, October 3, 2012

I.R.S. Targets Re-characterized Wages as Non Taxable Reimbursements

The I.R.S. recently issued Internal Revenue Bulletin 2012-37 addressing re-characterization of wages to non-taxable expense reimbursements. This determination is important to every employer who reimburses employees for expenses. The non-taxable status of reimbursement could be jeopardized if the system is not in compliance with the I.R.C. code.

For years the I.R.S. has taken an interest in "tool allowances" found in any trade where the worker is expected to provide their own tools. The most common practice around "tool allowances" is the employer will calculate an annual tool expense the employee is expected to spend and divide that number by the number of hours the employee is projected to work arriving at an hourly tool rate. This tool rate is removed from the employee's hourly rate and paid to the employee as "tool expense reimbursement".  The employee provides no evidence of actual tool cost. When the "tool allowance" is reached for the year the employer then re-characterizes the monies paid as "tool allowance" as hourly wage.

A second scenario involves employers whose employee travel between worksites. Temporary agencies whose employees travel out of town fall in this category.  In this situation the employer re-characterizes part of the employee's hourly earnings as non-taxable expense reimbursement to cover the lodging, meals and incidentals of travel. The employee provides no evidence of travel expenses. When the employee is not traveling the employee is paid the same hourly wage with no re-characterization of part of the hourly rate.

Both of these scenarios bring to light the issue with expense reimbursement and when it is non-taxable and when it is taxable. The tax issues are apparent. Any monies designated as "expense reimbursement" are not subject to federal tax withholding, FICA or FUTA. In addition no state taxes would be due on these monies.

Code Section 62-2(c) clearly defines the difference between expense reimbursement a taxable wages.  To be treated as a non-taxable expense reimbursement there are three criteria that must be met.

1. Business related

2. Substantiated

3. Excess amounts must be returned

Because both scenarios above fall the substantiation requirement they cannot be treated as non-taxable expense reimbursement. You can read the entire Revenue Ruling at http://www.irs.gov/pub/irs-irbs/irb12-37.pdf