Employee Expense Reimbursement

How do employee expense reimbursements work?

Employee expense reimbursement is when employers pay funds back to employees who have used their own money to pay for business-related expenses. Employees are usually not required to report expense reimbursements as either income or wages. According to the IRS Employer’s Tax Guide (Publication 15), if the business has an “accountable plan,” it doesn’t have to count expense reimbursements as part of its employees’ wages.

To qualify as an accountable plan, an expense reimbursement policy must meet the following conditions:

• The employee must pay or incur the allowable expense while performing services for their employer. The reimbursement must apply specifically to the expenses and cannot be an amount that would have been considered the employee’s wages.
• The employee must provide evidence to substantiate the business expenses. The evidence must outline the amount of the expense, when and where the employee incurred the expense, and the purpose of the expense. Business expenses must be submitted within a reasonable amount of time after the expenses were incurred.
• The employee must pay back any excess amount of reimbursement (if the employer paid the employee more than the employee spent) within a reasonable time frame.

Employee reimbursements paid under an accountable plan are not considered wages, so these payments are not subject to any taxation. However, if the expenses do not meet the above criteria, the employee reimbursement is treated as paid under a nonaccountable plan. This amount becomes subject to taxation in the next payroll period.

Reasonable time period

There is no fixed definition for a “reasonable” amount of time, as the time period depends on the circumstances. The IRS considers it reasonable to:

• Give employees an advance within 30 days before they’ll pay the expenses.
• Have employees provide the necessary details of their expenses within 60 days after they paid the expenses.
• Have employees return any amounts the employer paid them above their expenses within 120 days after paying those expenses.
• Provide employees with a periodic statement to either return or explain any outstanding amounts, which they must do within 120 days.

Nonaccountable plan

Any payments made to employees for necessary business expenses under a nonaccountable plan count as supplemental wages, which means they are subject to all applicable income and payroll taxes. Payments qualify as part of a nonaccountable plan if they meet one or more of the following criteria:

• The employee does not provide receipts or other documentation to substantiate their expenses in a timely manner.
• The employer advances an amount to cover the employee’s business-related expenses, and the employee does not return the unspent amount in a timely manner.
• The employer advances an amount to the employee with no reasonable expectation that the employee will use the amount for business expenses.
• The employer pays reimbursement expenses that would have otherwise been paid as wages.

Work-from-home reimbursement

The pandemic increased the amount of employees engaging in remote work, and it is a trend that continues. Employers can use work-from-home reimbursements to cover some of the expenses that employees incur from remote work. A remote work reimbursement may cover:

• Internet service
• Telephone service
• Desks and chairs
• Computers
• Equipment

According to the Fair Labor Standards Act, employers must provide work-from-home reimbursement to cover expenses that would lower the employee’s hourly wage rate below the minimum wage.

What qualifies as an employee expense?

Employee expenses that the employer must reimburse are subject to the rules of deductible business expenses. As IRS Publication 535 says, “To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”

These are some examples of ordinary and necessary expenses:

• Work clothes and uniforms
• Tools and supplies used at work
• Licenses and regulatory fees
• Professional society dues
• Educator expenses
• Medical exams required by employers
• Work-related education
• Job-related legal fees
• Laboratory breakage fees
• Home office
• Passport fee for business trips

Expenses that could qualify for employer reimbursement typically fall into one of these categories:

• Work-related supplies
• Travel and transportation
• Meals and entertainment
• Gifts

Work-related supplies

If an employee purchases supplies for business purposes, the employer can reimburse the expenses at cost.

Travel and transportation

According to the IRS, travel expenses are ordinary and necessary expenses when an employee has to travel to do their job. Employees can be reimbursed for using their personal vehicle for business. The IRS sets the standard mileage rate for reimbursing an employee’s business-related use of their vehicle. (The commute from home to work is not usually a reimbursable expense.)

Transportation expenses are separate from travel expenses that the employee incurs while traveling away from their home area. The employer may reimburse transportation expenses if the employee is traveling to a temporary workstation under one of the following circumstances:

• The employee travels to one or more regular work locations (not including the employee’s residence).
• The residence is the employee’s principal place of business.

Meals and entertainment

You can reimburse employees for meal and entertainment costs that they incur within the employee’s tax home if those expenses have a clear business purpose. Employees can be reimbursed for 100 percent of meal and entertainment costs, although employers can deduct only 50 percent of the cost.

You may reimburse employees with a fixed allowance (e.g., fixed travel days or miles). Under this arrangement, the employee has sufficiently accounted for their expenses as long as the reimbursement rates are in line with government-established rates. You can find details of the government per diem rates for meals and accommodations on the U.S. General Services Administration website. IRS Publication 15-B lists the standard mileage rates to cover driving expenses.

Gifts

If your employees give gifts as part of doing business, you can reimburse them for the cost of those gifts. You can deduct a maximum amount of $25 per person per year for gifts. If an item your employee gives a client could be considered either a gift or entertainment, it defaults to the entertainment category.

Other nontaxable reimbursements

These are some other expenses you can reimburse your employees for on a tax-free basis:

• Education
• Specific insurance premiums (e.g., health benefits, group life insurance, accident benefits)
• Gifts with minimal value (such as trophies)
• Retirement planning services under a qualified plan
• Discounts on employer-provided services

Each of these nontaxable reimbursements falls into its own category with specific guidelines on taxability.

Fringe benefits

According to the IRS Employer’s Tax Guide to Fringe Benefits (Publication 15-B), a fringe benefit is “a form of pay for the performance of services.” Therefore, fringe benefits are taxable. Even if a third party actually provides the benefit (e.g., a gym provides the workout equipment and classes), the employer pays to provide the fringe benefit. The employee receives the fringe benefit in exchange for providing their services to the employer, even if another person receives the benefit without performing services in exchange for money (e.g., the employee’s spouse uses the gym membership).

These are some examples of fringe benefits:

• Employee stock options
• Health savings accounts
• Transportation benefits
• Meals
• Tuition reduction
• Gym memberships
• Adoption assistance
• Achievement awards

While the value of a fringe benefit is taxable (e.g., federal income tax, Social Security tax, Medicare tax, FUTA tax), the taxable portion of a fringe benefit may be reduced by the amount legally excluded from compensation or paid for by the recipient.

How to record and reimburse employee expenses

As the employer, you must create an accountable plan to reimburse your employees for expenses; otherwise, this expense will be subject to payroll taxes. According to IRS Publication 15, “Payments to your employee for travel and other necessary expenses of your business under a nonaccountable plan are wages and are treated as supplemental wages and subject to the withholding and payment of income, Social Security, Medicare and FUTA taxes.”

If you have an accountable plan, the business expenses you reimburse to an employee are not treated as wages and not taxed.  You do not report this amount with the employee’s wages on Form W-2; you should record the amount in box 12 of Form W-2, with code L.

Create an expense reimbursement report form.

Create a spreadsheet with the expense report format you prefer. Distribute this blank form to all employees who need to be reimbursed for business expenses. The form should include space for:

• The employee’s name
• The period covered by the expense report (monthly or weekly)
• A listing all of the possible reimbursable expenses, such as airline tickets, hotel rooms, gifts, trade shows, etc., with some blank lines so employees can type in other approved expenditure
• The amount of each expense
• The business purpose for each expense (this can be general, such as “marketing,” or specific to a customer account)
• A total amount due for the period 

Set rules for expense reimbursement.

Not every expense that an employee puts on the expense report necessarily ought to be paid. Companies  universally will not want to reimburse the employee’s personal expenses. You may have a rule that you reimburse expenses for corporate gifts, but only up to a set amount. Corporate gift expenses above that amount would not be approved. 

In addition, you may have a general rule for certain expense categories. For example, your company rule may be that work-from-home employees can have the cost of their internet service reimbursed, but they cannot be reimbursed for buying a new computer. Clearly communicate these rules to all employees so there is no frustration or disappointment later.

Decide who will be responsible for approving or denying expense reimbursement.

Once the employee has filled out an expense report, he or she needs to know where and how to submit it. This may be the employee’s direct supervisor, a department head, an executive or someone in your accounting department. This responsible party needs to let employees know the expected time frame to submit expense reports once the expense has been incurred.

The person in charge of approving expense reports should let the employee know about any expenses that have not been approved and the reasons for that. Approved expense reports should then be passed along to accounts payable to be paid.

Pay employee approved reimbursable expenses. 

You should keep detailed payroll records, including records of employee reimbursements. You can reimburse employee expenses in one of two ways:

• Integrate employee reimbursements directly into the payroll system.
• Pay employees separately for expenses through check or direct deposit.

Make sure you reimburse employees in a timely fashion since they have laid out their own money to pay company expenses.

The best accounting software and payroll services for tracking expenses and reimbursing employees

While you can track reimbursable expenses in a spreadsheet or a ledger, it is much easier and more accurate to use a combination of accounting software and payroll service. We have reviewed the most popular ones, picking the best accounting software solutions and top payroll services. Here are some of the top ones for keeping track of and paying reimbursable expenses.

QuickBooks Online

QuickBooks is the most popular accounting software for small businesses. Its least expensive plan, the Self-Employed plan, includes expense tracking, helps you manage receipts and tracks mileage. QuickBooks Online allows you to track all of your expenses and bring them into an accounts payable system. Another benefit is that since QuickBooks is so widely used, nearly all accountants and bookkeepers already are familiar with it and know how to use it. Read the full QuickBooks Online review for more details.

FreshBooks

FreshBooks is another great choice of accounting software for tracking and paying reimbursable employee expenses. It has the capability to create professional invoices and track and bill expenses. So if you have reimbursable employee expenses that can be passed along to the client, you can easily do that, a feature that is not common among accounting software solutions. FreshBooks connects to your business checking account and credit card accounts, automatically importing your expenses each day. If you have corporate credit cards that you issue to employees for expenses, this simplifies the expense report reconciliation process immensely. Find out more in our complete FreshBooks review.

ADP

ADP Workforce incorporates automated expense tracking by taking expense data from bank feeds, credit cards and OCR receipt capture. Employees can use the ADP mobile app to capture receipts while in the field and submit them without delay. In addition, ADP’s TripLog Drive GPS device automatically tracks employee business miles, tolls, parking, lodging and other expenses for business-related trips. To learn more, read the full ADP review.

Paychex

Like ADP, Paychex has a mobile app that allows employees in the field to upload receipts. In addition, the app incorporates the company’s expense reimbursement rules so that any expenses that do not conform will generate a notification to the employee that they will have to be reviewed for approval. Then the app notifies the appropriate manager of the questionable expenses for closer scrutiny and allows two-way communication so the manager can ask the employee questions about the expense. You can also use the app to communicate any changes in expense reimbursement policy to employees. This enhanced communication speeds up the approval process so employees can get reimbursed quicker. Discover more about Paychex in our full review. 

Both ADP and Paychex allow you to pay employee reimbursable expenses while keeping them separate from regular payroll for tax purposes.

David Gargaro contributed to this article.