Coordinated Issue - Motor Vehicle Industry
Revision Date: July 2, 2008
Motor Vehicle Industry
Employee Tool & Equipment Plans
Previously – Service Technicians’ Tool Reimbursement Plans
Whether amounts paid to employees under Employee Tool and Equipment Plans for the use of their tools and equipment are paid under an accountable plan so that the payments are excluded from the employees’ gross income and are exempt from the withholding and payment of employment taxes.
As the Internal Revenue Service (Service) has seen them to date, Employee Tool and Equipment Plans (Tool Plans), under which amounts are paid to employees for the use of their tools and equipment, do not meet the accountable plan requirements. Therefore, the amounts are treated as paid under a nonaccountable plan and must be included in the employee’s gross income, must be reported as wages or other compensation on the employee’s Form W-2, and are subject to withholding and payment of federal employment taxes.
Each plan alleging to reimburse expenses should be reviewed to determine whether the accountable plan rules are met. This paper discusses Tool Plans as encountered by the Service to date and analyzes such facts under the accountable plan requirements.
Employees in automobile, truck, and equipment dealerships, repair and body shops, and various other enterprises in several industries including aviation, agriculture, and construction, are hired to perform repair and maintenance services. As a condition of employment, the employees are required to provide and maintain their own tools and equipment, which may be kept on-site at the business locations or possibly even stored at home. Generally, the tools and equipment are used exclusively by the employee to whom they belong and may range from simple tools to sophisticated electronic and computer equipment.
Many Tool Plans are being marketed to employers in these industries. The Tool Plans are administered either by a third party for a fee or by the employer. These Tool Plans purport to operate as accountable plans as described in Internal Revenue Code (Code) § 62(c) and § 1.62-2 of the Income Tax Regulations. Under § 62(c) and the regulations, reimbursements for employee business expenses meeting certain requirements are not wages includible in income or subject to the withholding and payment of employment taxes.
Prior to the implementation of the Tool Plan, the employee’s compensation is typically determined using an hourly rate and is paid in one check per employee per pay period, with no specific amount attributed to the provision of tools or equipment or other factors related to their employment qualifications, and with no amount identified as reimbursement for specific expenses. After implementation of the Tool Plan, the employee’s compensation is divided into two components, one treated as taxable and one treated as nontaxable, the sum of which generally equals the employee’s previous hourly compensation. The employee usually receives two separate checks—(1) one from the employer computed at the reduced hourly wage rate, which the employer treats as wages and as subject to Federal Insurance Contributions Act (FICA) tax (both the employer and employee shares of social security and Medicare) and income tax withholding, and (2) one from the employer or Tool Plan administrator that is characterized as “tool and equipment reimbursement” or “tool allowance,” which the employer or administrator treats as nontaxable and not subject to FICA tax and income tax withholding. Because the Tool Plan treats the payments as nontaxable, the Tool Plan payments are not reported on Form W-2 or Form 1099.
Employers and Tool Plan administrators use various methods to determine what amount will be paid as purported reimbursement for the employee’s tool and equipment expenses and how the amount will be paid. With respect to what total amount will be paid as a tool allowance, the Tool Plans vary in the details, but generally base the total amount paid on some version of the value or cost of the complete inventory of tools and equipment each employee owns. Some plans also take into account “other expenses” such as tool maintenance or insurance when determining the total amount to be paid as purported reimbursement.
To determine the total amount to be paid, some Tool Plans may ask each employee for a list of their tool and equipment inventory and for any available receipts at the time the Plan is being implemented. In many cases, the inventory includes tools or equipment purchased while the employee was employed by a prior employer or perhaps tools acquired as part of the education or schooling process. When the employee does not have receipts to establish cost, either an estimate of the cost (produced by the employee or the Tool Plan administrator) or the current replacement value of the tools or equipment (or category of tools or equipment) may be used. The Tool Plans may use catalogs from various tool and equipment vendors to determine the current replacement value. The estimated cost may be based on factors such as the type of tool or equipment, its useful life, and the geographic location of the worker. Some Tool Plans ask questions or request certification regarding any prior depreciation taken by the employee for tools in inventory, but the Tool Plans do not appear to follow through on obtaining the information, including when the tools were acquired or whether the initial cost was deducted by the employee, necessary to determine the expenses actually incurred by the employee in performing services for that employer. Accordingly, none of the methods for determining the amount to be paid as a tool allowance appear to be directly correlated with or based exclusively on the actual expenses paid or incurred, or reasonably expected to be incurred, by the employee for tools and equipment in performing services for that employer.
With respect to how the amount is paid, one Tool Plan variation breaks down the total amount to be paid into a fixed hourly “tool allowance” rate. The “tool allowance” rate is initially based on a set percentage (e.g., 30%, 35%) of the employee’s original hourly wage rate, but may be modified so that when the “tool allowance” rate is subtracted from the original hourly wage rate, the revised hourly wage rate remains at or above minimum wage. The hourly “tool allowance” rate is then multiplied by the number of hours actually worked during a pay period to result in a periodic tool allowance payment (often paid at the same time as payroll) until the total periodic tool allowance payments equal the total amount to be “reimbursed” under the plan. During pay periods when an employee is receiving a periodic tool allowance, the employee also receives the reduced hourly wage rate for his/her actual hours worked.
Another Tool Plan variation determines a fixed “tool allowance” amount by multiplying a set percentage (e.g., 30%, 35%) of each employee’s hourly wage rate by a set number of hours that the employee is expected to work during a payroll period that require the use of tools and equipment (such as 80 hours during a two-week payroll period). This fixed amount is then deducted as a lump sum from the employee’s pretax compensation each payroll period and is paid separately to the employee on a periodic basis as the tool allowance (often paid at the same time as payroll) until the total periodic tool allowance payments equal the total amount to be “reimbursed” under the plan.
As indicated, employees receive tool allowance payments, however determined and paid, until they have received an amount equal to the total amount to be “reimbursed” under the plan, i.e., the value or estimated cost of the employee’s inventory, however calculated. Once an employee has received periodic tool allowance payments equal to the total amount to be “reimbursed”, the employee stops receiving tool allowance payments and returns to his/her regular pay at the hourly wage rate earned prior to implementation of the Tool Plan. However, most Tool Plans permit employees to increase their total amount to be “reimbursed” under the Tool Plan or again participate in the Tool Plan with respect to new inventory by having the employees submit information regarding expenses incurred for any new or additional tools or equipment. The Tool Plans generally require receipts for new purchases.
In general, wages are defined for Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA) and income tax withholding purposes as all remuneration for employment unless otherwise excluded. I.R.C. §§ 3121(a), 3306(b), and 3401(a). There is no statutory exception from wages for amounts paid by employers to employees for employee business expenses. However, § 1.62-2(c)(4) provides that amounts an employer pays to an employee to reimburse for employee business expenses under an "accountable plan" are excluded from the employee's gross income, are not required to be reported on the employee's Form W-2, and are exempt from the withholding and payment of employment taxes. See also §§ 31.3121 (a)-3, 31.3306(b)-2, and 31.3401(a)-4 of the Employment Tax Regulations, and § 1.6041-3(h)(1) of the Income Tax Regulations.
Section 61 of the Internal Revenue Code defines gross income as all income, from whatever source derived. Section 62 defines adjusted gross income as gross income minus certain “above-the-line” deductions. Section 62(a)(2)(A) allows an employee an above-the-line deduction by providing that, for purposes of determining adjusted gross income, an employee may deduct certain business expenses paid by the employee in connection with the performance of services as an employee of the employer under a reimbursement or other expense allowance arrangement. Section 62(c) provides that, for purposes of § 62(a)(2)(A), an arrangement will not be treated as a reimbursement or other expense allowance arrangement if (1) the arrangement does not require the employee to substantiate the expense covered by the arrangement to the person providing the reimbursement, or (2) the arrangement provides the employee the right to retain any amount in excess of the substantiated expense covered under the arrangement.
Section 1.62-2(c)(1) of the Income Tax Regulations provides that a reimbursement or other expense allowance arrangement satisfies the requirements of § 62(c) if it meets the requirements of business connection, substantiation, and returning amounts in excess of substantiated expenses. If an arrangement meets these requirements, all amounts paid under the arrangement are treated as paid under an accountable plan. Amounts treated as paid under an accountable plan are excluded from the employee’s gross income, are not reported as wages on the employee’s Form W-2, and are exempt from withholding and payment of employment taxes. In contrast, if the arrangement fails any one of these requirements, amounts paid under the arrangement are treated as paid under a nonaccountable plan and are included in the employee’s gross income, must be reported as wages or other compensation on the employee’s Form W-2 and are subject to withholding and payment of employment taxes. See §1.62-2(c)(3) and (5).
The business connection, substantiation, and return of excess requirements under § 1.62-2(d), (e), and (f) apply on an employee-by-employee basis.
Business Connection Requirement
An arrangement meets the business connection requirement of § 1.62-2(d) if it provides advances, allowances (including per diem allowances, allowances for meals and incidental expenses, and mileage allowances), or reimbursements for business expenses that are allowable as deductions by Part VI (section 161 and the following), subchapter B, Chapter 1 of the Code, and that are paid or incurred by the employee in connection with the performance of services as an employee of the employer. Thus, not only must an employee pay or incur a deductible business expense, but the expense must arise in connection with performing services for that employer. If an employer reimburses deductible business expenses that the employee incurred prior to employment, the plan does not meet the business connection requirement. “Paid or incurred” requires that there be an actual expense. If an arrangement is making payments to compensate for the fair rental value or use of tools or equipment rather than expenses incurred, it will not meet the business connection requirement.
Section 1.62-2(d)(3)(i) provides that the business connection requirement will not be satisfied if the payor arranges to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) deductible business expenses or other bona fide expenses related to the employer’s business. A payor arranges to pay an amount to an employee regardless of whether the employee is reasonably expected to incur bona fide business expenses by supplementing the wages of those employees not receiving the reimbursement (so that the same gross amount is paid regardless of the reasonable expectation to incur expenses), by routinely paying a reimbursement allowance to an employee who has not incurred bona fide business expenses, or by reducing the wage payment in light of expenses incurred or reasonably expected to be incurred only to then increase the wage payment again after the expenses have been reimbursed.
Section 1.62-2(j) example 1 illustrates a violation of the § 1.62-2(d)(3)(i) requirement that a reimbursement be paid only when expenses are incurred. The example provides that Employer S pays its engineers $200 a day. On those days that an engineer travels away from home on business for Employer S, Employer S designates $50 of the $200 as nontaxable reimbursement for the engineer’s travel expenses. On all other days, the engineer receives the full $200 as taxable wages. Because Employer S pays an engineer $200 a day regardless of whether the engineer is traveling away from home, the arrangement does not satisfy the reimbursement requirement of § 1.62-2(d)(3)(i). Thus, no part of the $50 Employer S designated as reimbursement is treated as paid under an accountable plan. Rather, all payments under the arrangement are treated as paid under a nonaccountable plan. Employer S must report the entire $200 as wages or other compensation on the employee’s Form W-2 and must withhold and pay employment taxes on the entire $200 when paid.
Where a plan serves to recharacterize amounts as a reimbursement allowance that would otherwise be paid as wages if there were no expenses reasonably expected to be incurred for the employer, amounts paid under the plan will not be treated as paid under an accountable plan. Such recharacterization violates the business connection requirement of § 1.62-2(c) because the employee receives the same amount regardless of whether expenses were incurred or reasonably expected to be incurred. Consequently, all amounts paid under the plan must be treated as paid under a nonaccountable plan, must be included in the employee's gross income, and must be reported as wages for FICA tax and income tax withholding purposes.
The prohibition against wage recharacterization does not preclude an employer’s prospective alteration of its compensation structure to include reimbursement of substantiated expenses under an accountable plan, as long as such amount, however identified or denominated, is only paid if bona fide expenses are incurred or reasonably expected to be incurred for the employer, and the employer does not use an alternate method to get the same amount of gross pay to employees when qualifying expenses are not incurred or reasonably expected to be incurred and subsequently substantiated (e.g., increased compensation, bonus, reduction in wages for the reimbursement “amount” with subsequent increase once the “reimbursement” is complete). The presence of wage recharacterization is based on the totality of facts and circumstances. Furthermore, an employer may convert from a nonaccountable plan to an accountable plan only if the employer keeps track of the expenses that have been reimbursed under the nonaccountable plan to ensure they are not reimbursed a second time under the accountable plan.
In Shotgun Delivery v. United States, 269 F.3d 969 (October 16, 2001), the United States Court of Appeals for the Ninth Circuit affirmed in part and reversed in part the District Court’s decision which upheld the Internal Revenue Service’s assessment of more than $450,000 in delinquent employment taxes, plus interest and penalties. The Court agreed with the district court’s determination that Shotgun’s expense reimbursement arrangement with its employees was not an accountable plan within the meaning of § 1.62-2 and that the contested payments should have been treated as wages and taxed as such. In Shotgun, the plaintiff provided courier services. It charged customers an amount called a tag rate that was based on distance, time required for delivery, waiting time, and weight. The employees used their own vehicles for deliveries and were paid 40% of the tag rate. The couriers were compensated with two separate checks. The first check was a “wage check,” which paid the couriers an hourly amount. The second check was for “reimbursement of expenses/lease fee” and equaled 40% of the tag rate minus the amount paid on the wage check. Thus, couriers were always paid 40% of the tag rate. The court found the arrangement was not an accountable plan because it failed to meet the business connection requirement. The court stated that “the evidence suggests that the plan’s primary purpose was to treat the least amount possible of the driver’s commission as taxable wages” and concluded that "as Shotgun’s reimbursement arrangement had no logical correlation to actual expenses incurred it was an abuse of section 62(c) and was therefore a nonaccountable plan."
Section 1.62-2(e)(1) provides that the substantiation requirement is met if the arrangement requires each business expense to be substantiated in accordance with paragraph (e)(2) or (e)(3) of that section, whichever is applicable, to the payor (the employer, its agent or a third party) within a reasonable period of time. Section 1.62-2(g)(1) provides that what constitutes a reasonable period of time depends on the facts and circumstances of each arrangement. However, § 1.62-2(g)(2) provides a safe harbor for substantiation under which the substantiation requirement is met if an expense is substantiated within 60 days after the expense is paid or incurred.
Section 1.62-2(e)(2) provides that an arrangement that reimburses expenses governed by § 274(d) meets the requirements of § 1.62-2(e)(2) if information sufficient to satisfy the substantiation requirements of § 274(d) and the regulations is submitted to the payor. Section 274(d) applies to “listed property” under § 280F(d)(4). Most tools are not listed in § 280F(d)(4). The list is limited to items such as property used for transportation including an automobile, computer or peripheral equipment as defined in §168(i)(2)(B), and cellular telephone or similar telecommunications equipment. No deduction is allowed for an expense associated with such listed property under § 274(d)(4), and any “reimbursement” of the expense must be treated as wages subject to withholding and payment of employment taxes, unless the employee establishes by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of each expenditure, (B) the amount of each business or investment use of the listed property and its total use, (C) the date of the expenditure or use, and (D) the business purpose for an expenditure or use of any listed property. Section 1.274-5T(b)(6).
Section 1.62-2(e)(3) provides that an arrangement that reimburses business expenses not governed by section 274(d) meets the requirements of § 1.62-2(e)(3) if information is submitted to the payor sufficient to enable the payor to identify the specific nature of each expense and to conclude that the expense is attributable to the payor’s business activities. Each of the elements of an expenditure or use must be substantiated to the payor, and it is not sufficient for an employee to merely aggregate expenses into broad categories or to report individual expenses through the use of vague, non-descriptive terms.
Section 1.62-2(e)(3) references §1.162-17(b) which provides substantiation rules for employee business expenses. Section 1.162-17(b)(1) provides that an employee need not report on his/her tax return expenses for travel, transportation, entertainment, and similar purposes paid or incurred by him/her solely for the benefit of his/her employer for which he/she is required to account and does account to his/her employer and which are charged directly or indirectly to the employer, or for which the employee is paid through advances, reimbursements, or otherwise, provided the total amount of the advances, reimbursements, and charges is equal to the expenses. Section 1.162-17(b)(4) requires an employee to submit an expense account or other required written statement to the employer showing the business nature and the amount of all the employee’s expenses.
Return of Excess Requirement
Section 1.62-2(f) provides that, in general, an arrangement meets the requirement of returning amounts in excess of expenses if it requires the employee to return to the payor within a reasonable period of time any amount paid under the arrangement in excess of the expenses substantiated. Section 1.62-2(f) further provides that an arrangement whereby money is advanced to an employee to defray expenses will be treated as satisfying the return of excess requirement only if the amount of money advanced is reasonably calculated not to exceed the amount of anticipated expenditures, the advance of money is made on a day within a reasonable period of the day that the anticipated expenditures are paid or incurred, and any amounts in excess of the expenses substantiated are required to be returned to the payor within a reasonable period of time after the advance is received. Furthermore, an arrangement will not meet the return of excess requirement if it fails to satisfy the substantiation requirement under § 1.62-2(e) since any amounts paid under the arrangement that are not substantiated are treated as excess and must be returned.
Section 1.62-2(g)(2)(ii) provides a safe harbor under which periodic statements may be used. The section provides that if a payor provides employees with periodic statements (no less frequently than quarterly) stating the amount, if any, paid under the arrangement in excess of the expenses the employee has substantiated in accordance with §1.62-2(e), and requesting the employee to substantiate any additional business expenses that have not yet been substantiated (whether or not such expenses relate to the expenses with respect to which the original advance was paid) and/or return any amounts remaining unsubstantiated within 120 days of the statement, an expense substantiated or an amount returned within that period will be treated as being substantiated or returned within a reasonable period of time.
Revenue Ruling 2005-52
In Rev. Rul. 2005-52, 2005-2 C.B. 423, the Service addressed the tax consequences of a tool allowance plan. In the revenue ruling, the employer paid each employee an hourly wage plus a set amount for each hour worked as a “tool allowance” to cover costs the employee incurred for acquiring and maintaining tools. The employer set each employee’s tool allowance annually by using a combination of data from a national survey of average tool expenses for automobile service technicians and specific information concerning tool-related expenses provided by the employee in response to an annual questionnaire completed by all service technicians who work for the employer. The employer then used a projection of the total number of hours the employee was expected to work during the year that would require the use of tools to convert the employee’s estimated annual tool expenses into an hourly rate for the tool allowance. The tool allowance, therefore, was an estimate of the tool expense projected to be incurred per hour by the employee over the course of the coming year.
At the end of each pay period, each employee reported the number of hours worked requiring the use of tools. The employer then multiplied the number of hours reported as worked requiring the use of tools by the employee’s hourly rate for the tool allowance and paid the resulting amount to the employee in addition to compensation for services performed during the pay period. The employer furnished each employee with a quarterly statement that reported the amount paid to the employee as a tool allowance during the quarter, and the tool expenses estimated to be incurred in the quarter. Employees were not required to provide any substantiation of expenses actually incurred for tools either before or after the quarterly reports were issued. The employer did not require employees to return any portion of the tool allowance that exceeded the expenses they actually incurred either before or after the quarterly reports were issued, and in the absence of substantiation, had no means of knowing whether it had made any excess payments.
The revenue ruling concludes that the arrangement fails to meet both the substantiation and return of excess requirements because it does not require employees to substantiate the actual expenses they incur; rather, the employees report their hours worked in which the use of tools was required, and the employer reimburses them per hour at their tool allowance rate, which is based on estimated annual tool expenses and statistical data. The ruling provides that although reasonable expectations for expenses can be used to establish that a plan meets the business connection requirement, satisfaction of the substantiation and return of excess requirements must be based on actual expenses. The ruling emphasizes that employers may not substitute a reasonable estimate of expenses to be incurred based on statistical data and hours worked for the substantiation of actual expenses as required by §1.62-2(e)(3), absent explicit guidance permitting the use of such “deemed” substantiation.
The ruling provides that the employer does not cure the absence of substantiation or return of excess by providing the employees with the quarterly statements, since the employer does not require the employees to provide substantiation of expenses actually incurred, nor does the employer require employees to return any excess received within a reasonable period of time after receiving the quarterly statement. Therefore, the revenue ruling concludes that the employer does not provide a periodic statement within the meaning of §1.62-2(g)(2)(ii).
The revenue ruling goes on to provide that, even if the employer required its employees to substantiate the actual amount of expenses incurred and treated any excess amount as additional wages, the arrangement would still fail to qualify as an accountable plan. To qualify as an accountable plan, an arrangement must require that amounts paid in excess of substantiated expenses be returned. Simply including excess amounts in wages does not satisfy the requirement of returning amounts in excess of expenses, the exception being where employee expenses are covered through a mileage or per diem allowance pursuant to §1.62-2(f)(2).
Consequently, the ruling holds that the arrangement described is not an accountable plan and all tool allowances paid under the arrangement must be included in the employees’ gross income, reported as wages on the employees’ Forms W-2, and subject to withholding and payment of federal employment taxes.
Rev. Rul. 2005-52 did not address how an arrangement intending to reimburse tool expenses can satisfy the business connection requirement. Accordingly, Rev. Rul. 2005-52 did not address the prohibition against wage recharacterization nor the necessity of establishing that expenses being reimbursed are incurred in the course of performing services for the employer. Such analysis was not necessary in light of the tool allowance’s failure to satisfy the equally fundamental requirements of substantiation and return of excess.
Section 1.62-2(k) provides that if a payor's reimbursement or other expense allowance arrangement evidences a pattern of abuse of the rules of § 62(c) and the regulations, all payments made under the arrangement will be treated as made under a nonaccountable plan. See discussion of Shotgun Delivery above.
DISCUSSION AND ANALYSIS
Under current law, amounts paid to employees for the use of their tools and equipment can be excluded from wages only if paid under an accountable plan. A plan must satisfy the accountable plan requirements of business connection, substantiation, and return of excess under § 62(c) and § 1.62-2 in order for payments made under it to be excludable from wages. A purported reimbursement arrangement that merely allocates compensation between wages and tool and equipment payments will not satisfy the requirements of § 62(c) and §1.62-2.
Based on the arrangements the Service has seen, amounts paid to employees under Tool Plans with the aspects described herein do not satisfy the requirements of an accountable plan. However, the facts of each arrangement should be reviewed to determine whether they differ from the Tool Plans described in this document and whether they satisfy the accountable plan rules.
Business Connection Requirement
Tool Plans fail the business connection requirement. The amounts being paid under the Tool Plans are paid routinely in the absence of information necessary to establish a reasonable expectation of the expenses to be incurred and are not true reimbursements or advances of expenses incurred or reasonably expected to be incurred in performing services for the employer. Rather, the Tool Plans designate a portion of an employee’s existing compensation and label it as a “nontaxable reimbursement” only until the employee’s total amount of tool inventory has been paid out, at which point the portion is again designated as taxable wages. The employee continues to be paid the same gross pay, including the portion temporarily designated as a tool allowance, without regard to whether expenses are incurred or reasonably expected to be incurred. Employees receive the same gross pay before, during, and after they are “reimbursed” for expenses. In fact, it is our understanding that the Tool Plans assure employers and employees that there is no out-of-pocket cost for either of them in implementing a Tool Plan and that the only difference is tax savings and more take-home pay. If the employee incurs any future expenses for the employer after the total amount of tool inventory has been paid, the employee’s wage portion again will be reduced and a periodic tool allowance will be paid until the expenses have been reimbursed, at which time the wage portion will again be increased. Where an employer arranges to pay an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur deductible business expenses, the arrangement fails to meet the business connection requirement.
The same reasoning applies here that was used by the court in Shotgun Delivery Service, where a portion of the employee’s commission was designated as an expense reimbursement, but the amount had no logical connection to the expenses incurred. In the case, two drivers following identical routes and incurring the same expenses received the same total amount for the delivery. However, if one took longer to drive the route, the employer treated a larger proportion of his payment for that delivery as taxable hourly wages, and a smaller proportion as a nontaxable expense reimbursement. Thus, the expense reimbursements paid to the two drivers were not the same even though the expenses incurred should have been the same.
Tool Plans suffer from the same problem. In Tool Plans, two employees who have the same inventory of tools but who pay or incur very different expenses for that employer, because of their different history of purchases, past reimbursements and/or depreciation, would nonetheless receive the same total amount through tool allowance payments. Tool allowance payments made in this fashion lack a logical connection to expenses incurred or reasonably expected to be incurred during employment for the current employer and, therefore, fail to meet the business connection requirement. Continuing to pay as part of the hourly wage the amount previously designated and paid as tool reimbursement even though all purported expenses have been “reimbursed” illustrates that the amount is being paid without regard to whether the employee incurs or is reasonably expected to incur expenses for the employer.
While an analysis of a Tool Plan under the substantiation and return of excess requirements is not necessary once the Tool Plan fails the business connection requirement, the following sections evaluate Tool Plans under the other accountable plan requirements as well.
Tool Plans also fail the substantiation requirement. The majority of the tools covered under Tool Plans are not “listed property.” The general substantiation requirement under § 1.62-2(e)(3) requires the substantiation of the elements of the expense, which includes providing an expense account or other written statement showing the amount and business nature of each expense.
While the Tool Plans vary on the level of information requested, Tool Plans fail the substantiation requirement because they fail to require substantiation of each element of an expenditure or use, including its business nature and proper reimbursable amount, in accordance with §§ 1.62-2(e)(3) and 1.162-17(b)(4). Substantiation of these elements may require determining, in addition to original cost, information such as purchase dates, whether the tools have been used for any purpose other than the current employer’s business, and whether any of the cost has been recovered through reimbursement or depreciation, or has otherwise been fully deducted or depreciated. The Tool Plans do not appear to require that the employee supply this information.
To the extent the Tool Plans rely only on current value of inventory, expenses have not been substantiated because current value (rather than the unrecovered cost attributable to use of the tools in the employer’s business) is not a proper reimbursable amount that satisfies the business connection requirement, as discussed above.
To the extent the Tool Plans rely on cost estimates or totals for categories of tools without attempting to obtain information from the employee (such as cost, acquisition date, prior deduction, depreciation, or reimbursement ) that would establish whether the employee has an expense and, if so, the amount of the expense, the Tool Plans do not determine the proper reimbursable amount of expenses attributable to an employer’s business activities. All the elements (i.e., amount, time, place, and business purpose) of the expenses incurred in performing services for the employer must be established, as required by § 1.62-2(e)(3). Some of this information is essential to establish that the employee incurred an expense at all. An employee may have a tool or piece of equipment in inventory, but if the expense for the tool or equipment has previously been reimbursed or has been fully depreciated, then the expenses paid for the tool or equipment cannot be reimbursed through the current employer’s accountable plan.
If the employer cannot obtain accurate information from the employee to establish all the elements of the expenses paid or incurred in performing services for the employer, the employer may argue it may rely on a reasonable estimate to substantiate the expenses for tools not subject to § 274(d). Cohan v. Commissioner, 39 F.2d 540 (2nd Cir. 1930). However, there must be a reasonable evidentiary basis for the estimate. Namyst v. Commissioner, T.C. Memo. 2004-263, affd 435 F.3d 910 (8th Cir. 2006). Of course, to the extent any of the tools or equipment constitute “listed property” requiring substantiation that satisfies § 274(d) and the regulations, the Tool Plans do not appear to satisfy the more rigorous and specific requirements of that section.
Substantiation must be made on a timely basis, and must establish what expenses were incurred for the employer. Fair tool and equipment rental or replacement value, without more, does not satisfy the substantiation requirement, as it does not take into account any information about the acquisition date and amount of, or the specific nature of, any expenses paid or incurred by the employee for the employer and not previously reimbursed. Furthermore, by taking into account the employee’s entire existing inventory, whether determined by reference to value or cost, without taking into account the employee’s prior history of depreciation or reimbursement for the expenses incurred for the tools listed, the Tool Plans fail to even reasonably estimate expenses actually incurred. Rev. Rul. 2005-52 emphasizes that there must be substantiation and provides that although reasonable expectations for expenses can be used to satisfy the business connection requirement, satisfaction of the substantiation and return of excess requirements must be based on expenses actually incurred.
The Tool Plan’s requirement for receipts for new expenses, while satisfying substantiation for those particular expenses, does not salvage the substantiation failures in the design or operation of the remainder of the Tool Plan.
Return of Excess Requirement
Tool Plans also fail the return of excess requirement. All amounts paid under the Tool Plans that are not properly substantiated are treated as excess reimbursements. Even if the Tool Plans make reference to a requirement to return “excess” tool allowances, since the Tool Plans do not substantiate the expenses, they also do not require employees to return any amounts paid in excess of substantiated expenses.
Employees must be required to return to the payor within a reasonable period of time any amount paid in excess of expenses substantiated. Section 1.62-2(h)(2)(i)(B) and Rev. Rul. 2005-52 make clear that excess must be returned and cannot simply be reclassified as wages and taxed as such. The regulation and the ruling both provide that, with the exception of circumstances where the employee expenses are covered through a mileage or per diem allowance, an arrangement is not an accountable plan if it includes amounts paid in excess of substantiated expenses in wages rather than requiring that they be returned.
Pattern of Abuse
In addition to violating the basic requirements of an accountable plan, namely business connection, substantiation, and return of excess, Tool Plans may also evidence a pattern of abuse under § 1.62-2(k), requiring the treatment of payments made under the plans as made under a nonaccountable plan. Generally, the failures are not isolated with regard to a particular employee or period of time. Rather, the failures appear to be routine and fundamental to the design of these Tool Plans, where the goals are to ensure that the gross pay of each employee remains the same, regardless of whether the employee incurs or is reasonably expected to incur expenses for the employer, while generating tax savings for both the employer and employee by “reimbursing” the employees with funds that would otherwise be payable to them as taxable wages and will again be paid to them as wages once the “reimbursements” are completed.
The accountable plan rules were not meant to allow taxpayers to avoid paying taxes on wages, even if for a short period of time, in the guise of expense reimbursement. The routine reimbursement of unsubstantiated expenses and the practice of recharacterizing wages as reimbursements until the employee’s tool inventory value is zeroed out, only to reinstate the original wage amount at that point, evidence a pattern of abuse of the accountable plan rules.
As the Service has seen them to date, Tool Plans do not satisfy the three requirements of an accountable plan, and possibly evidence a pattern of abuse. As a result, payments made to employees under these Tool Plans will be treated as paid under a nonaccountable plan. Therefore, amounts paid under these Tool Plans must be included in the employee’s gross income, reported as wages or other compensation on the employee’s Form W-2, and subject to withholding and payment of employment taxes.
The facts of each plan allegedly reimbursing employee tool and equipment expenses should be reviewed to determine whether they differ from the Tool Plans described in this document and whether they satisfy all of the accountable plan rules. For example, it is relevant to know when the employer implemented the arrangement and whether the hourly wage rate was reduced at such time only to be reinstated at the previous hourly wage rate after the tool expenses are reimbursed. It should be determined whether the arrangement is written, and, if so, the writing should be reviewed to determine if its terms comply with the requirements of an accountable plan. Whether the written terms of the arrangement are actually followed is equally important. For example, what substantiation is requested and required to establish the expenses incurred for the tools and when such expenses were incurred in relation to the employee’s employment with the employer?
The employee’s understanding of the arrangement also should be considered. For example, it would be relevant to know whether the employee was informed that he/she would always receive at least the same amount of gross pay as he/she received prior to implementation of the arrangement, regardless of the amount of tool expenses incurred or reasonably expected to be incurred for the employer. Statements in any marketing materials may demonstrate a clear expectation that the wage portion will be reduced for the tool allowance only to be reinstated once the tool inventory is “reimbursed.”
Employers frequently assert that it is industry practice to pay employees for the use of their tools and equipment. There is no "industry practice" exception to the accountable plan requirements. Employers may reimburse employees for the expenses attributable to the use of their tools and equipment; however, only if the accountable plan rules are followed may they treat those reimbursements as nontaxable.
After analyzing the arrangement, a determination can be made whether it meets the accountable plan requirements under the analysis outlined in this paper.
Private Letter Rulings
The Service will not issue a private letter ruling or determination letter in relation to whether amounts related to a salary reduction and paid under a purported reimbursement or other expense allowance arrangement will be treated as paid under an accountable plan in accordance with § 1.62-2(c)(2). See Revenue Procedure 2008-3, section 5.01.
- The sum may be slightly different if the employer allocates some of its tax savings to the employee by increasing the total amount paid to the employee.
- Since FUTA tax is usually not at issue with respect to the proper treatment of tool allowances because the taxpayers pay other wages in excess of the FUTA tax wage base, the remainder of this paper only addresses the income tax withholding and FICA tax consequences.
- See also Rev. Rul. 2004-1, 2004-1 C.B. 325. In Rev. Rul. 2004-1 the Service concluded, in relevant part, that a reimbursement arrangement that subtracted a mileage allowance (calculated at the standard business mileage rate for the miles traveled) from the driver’s set commission rate and treated only the remaining commission as wages failed the business connection requirement. The variable allocation between commission and mileage allowance essentially recharacterized as a mileage allowance amount otherwise payable as commission, thereby ensuring that each driver received the same total amount regardless of the amount of deductible employee business expenses actually incurred.
- Whether or not there is wage recharacterization is a separate determination from whether a compensation structure raises additional issues, such as constructive receipt.
- Information regarding the acquisition date of tools or equipment is especially important both in establishing that there has been an expense incurred in performing services for that employer and in determining whether the employee has depreciation expenses that an employer could reimburse.
Index for Coordinated Issue Papers - LMSB