Tool reimbursement plans are typically seen in service contractors, home builders, or other businesses that require employees to use and maintain small tools. If your construction company has a tool reimbursement plan in place or are thinking about implementing one, certain considerations must be given to the details of the plan for the IRS to recognize the reimbursements and to not characterize the reimbursements as wages that would be taxable to the employee. If they are classified as wages they would also be subject to payroll tax and withholdings. There are advantages to both employer and employee when a qualified plan is in place. The IRS has three requirements in place for a plan to be qualified, all of which must be met.
Business Connection Requirement (Reg. 1.62-2(d)) – “Reimbursed expense must be allowable as a deduction and must be paid or incurred in connection with performing services as an employee of the employer.”
To meet the business connection requirement, an employer can only provide advances, allowances, or reimbursements for expenses that are regularly deductible. Expenses must also be “paid or incurred” by the employee in performing services as an employee of the employer. If the employer reimburses for expenses incurred prior to employment, it does not meet the business requirement. Reimbursements must be made for the expenses incurred only, and payments made to adjust for fair value would make the plan unallowable.
Substantiation Requirement (Reg. 1.62-2(e)) – “Each reimbursed expense must be adequately accounted for to the employer within a reasonable period of time.”
To meet the substantiation requirement, proper documentation of the expense and business purpose must be maintained, similar to meals and entertainment. Plans that use current value of inventory do not meet the substantiation requirement since they do not represent the expense incurred. Also, if plans rely on cost estimates or totals, the company must attempt to obtain information from the employee that would establish whether or not the employee has an expense and how much (i.e., cost, acquisition date, prior deduction, depreciation, or reimbursement).
Return of Excess Requirement (Reg. 1.62-2(f)) – “Any amounts in excess of expenses must be returned within a reasonable period of time. “
To meet the return of excess requirement, all amounts that are not properly substantiated are treated as excess reimbursement and must be returned in a “reasonable” period of time. The employer cannot reclassify the excess as wages, but must return all amounts in excess.
These three requirements must all be met for the IRS to consider a tool reimbursement plan as qualified. Other steps that could be taken include but are not limited to the following:
- Tools should be kept on the premises of the employer.
- Have employees purchase tools and equipment from an employer approved vendor list.
- Have employees submit a claim form that acknowledges that they have read and understood the plan; that they certify that the information provided is complete and accurate; that they won’t claim the expense as a deduction on their tax return/ and additional reimbursement will not be sought.
- Track the reimbursement expenses separately from payroll and ensure that they do not provide for any adjustments to compensation on account of the reimbursements.
Court rulings have proved that the regulations must meet all three requirements noted above to qualify as an accountable tool reimbursement plan. If your construction company has a tool reimbursement plan in place or have considered implementing a plan, contact Aronson for guidance so that your company is in full compliance with IRS regulations.