Know the Rules for Reimbursing Employees

Businesses can reimburse employees for eligible out-of-pocket, work-related expenses through either an accountable or a nonaccountable employee reimbursement plan. The key difference lies in how the payments are treated for tax purposes.

In an accountable plan, employers can reimburse employees for business expenses without classifying the payment as taxable income. Conversely, under a nonaccountable plan, reimbursements are treated as taxable wages and must be reported on an employee's W-2. Choosing the appropriate structure and applying it correctly can help both you and your employees avoid unexpected tax liabilities.

Boss paying employee in cash

What's the difference?

Accountable plans must comply with the following IRS conditions:

The expense must have a direct connection to the business and the employee's job responsibilities.
The employee must provide documentation, such as receipts or an expense report, that accurately reflects how the money was spent.
Any excess advance or reimbursement must be returned within a "reasonable period."

If these conditions are met, the reimbursement is excluded from the employee's income and is not subject to payroll taxes.

By contrast, nonaccountable plans fail to meet one or more of these requirements. When this occurs, the reimbursement is treated as regular wages: It's reported on the employee's Form W-2 and taxed accordingly. Additionally, it is subject to federal income tax withholding, Social Security, Medicare or the Federal Unemployment Tax Act. While this option requires less documentation, it results in higher tax costs for both the employee and the employer.

IRS-compliant procedures

The IRS provides two methods to determine whether expenses were substantiated and excess funds were returned within a "reasonable period."

Fixed-date method: An advance is given no more than 30 days before the expense is incurred. The employee must substantiate the expense within 60 days and return any excess within 120 days.
Periodic statement method: At least quarterly, the employer issues a statement listing reimbursements that haven't been substantiated. The employee then has 120 days to return or document the excess.

Whichever method you choose, accurate recordkeeping is essential. For example, receipts are generally required for any expense over $75, as well as for all lodging.

Why it matters

Accountable plans offer a clear tax advantage: Employees avoid tax on the reimbursement, and employers avoid additional payroll tax liability. However, to maintain these benefits, it is crucial to adhere strictly to the documentation and timing rules.

If an accountable plan is mishandled — such as when an employee fails to return an overpayment — the IRS may reclassify the reimbursement as nonaccountable. This can lead to unexpected tax exposure for both the business and the employee.

For full details on what qualifies, see IRS Publication 463.