November 5, 2023

How to Reimburse Employees the Correct Way (With Free Templates)

Contents

The basic process for reimbursing employees is simple.

The employee incurs a business expense and they provide a receipt to their employer. The employer reimburses the employee and deducts the reimbursement on its tax return.

Easy, right?

Although simple, many reimbursement policies fail to consider IRS rules that, if not followed, could cause reimbursements to be taxable for both the employee and employer. 

The IRS differentiates between “accountable plan” and “nonaccountable plan” reimbursements. Accountable plan reimbursements are tax-free whereas nonaccountable plan reimbursements are taxable compensation for the employee.

It’s important to understand these rules so that your company’s policy avoids a tax pitfall for both itself and its employees. In this guide I’ll walk you through the accountable plan rules so that you can set up an IRS-compliant expense reimbursement policy for your business.

What is an Employee Reimbursement Policy?

An employee expense reimbursement policy is a formalized set of rules or guidelines that a company adopts to define how employees can get reimbursed for job-related expenses they pay for out-of-pocket.

Common Examples of Reimbursable Expenses

Here are common categories that you might include in your company’s reimbursement policy. Your policy might include additional categories or it could even exclude some of these categories. Do what makes sense for your company and its employees.

  1. Travel - This category includes the costs associated with going from one place to another for work purposes. Examples are mileage, if you use your own vehicle, airfare for business trips, or taxi fares for local travels.
  2. Meals - When an employee travels for work or meeting clients, the costs of meals can be covered.
  3. Home Office Expenses - For employees who work from home, certain expenses such as cell phone bills or internet charges can be reimbursed.
  4. Job Supplies - Employees might purchase supplies or tools for a project or job. These costs can be reimbursed under the policy.
  5. Training and Professional Development - The policy can also cover the costs associated with training programs or professional development courses that help in enhancing job skills.

The common theme for these categories is that the employee incurred a valid business expense on behalf of their employer, which is the number one rule for an IRS-compliant expense reimbursement. 

Differentiating from Fringe Benefits

Fringe benefits are compensation for services provided by employees beyond their base wage rate or salary. Reimbursements are payments to employees for expenses they incurred while on the job, which are not a part of their compensation plan.

Benefits of Setting Up an Employee Reimbursement Policy

Setting up an employee reimbursement  policy is beneficial to both the business owner and employees. Here’s why:

  • Tax Benefits for Business Owners - The policy allows business owners to get reimbursed for expenses they pay for out of pocket, reducing taxable income from their business.
  • Financial Stability for Employees - A clear policy that’s consistently enforced prevents employees from bearing the financial burden of work-related expenses, increasing their satisfaction and their tenure at your company.
  • Compliance with Tax Law - A policy that adheres to tax law prevents penalties, interest, and back taxes in the event of an IRS audit.

By implementing a reimbursement policy, a business provides a mutual benefit to both the employer and its employees.

IRS Rules: Accountable and Non-Accountable Plans

Before setting up your company’s reimbursement policy, you should first familiarize yourself with the IRS rules around employee expense reimbursements. These rules classify expense reimbursements into one of two categories:

  1. Accountable Plans
  2. Non-Accountable Plans

Let’s dig into the specific rules of both accountable and non-accountable plans.

Accountable Plan Rules

By crafting a reimbursement policy that adheres to IRS accountable plan rules, you’re building a systematized process through which employee reimbursements can be excluded from the employee’s taxable income and, by extension, from the employer’s wage base for payroll taxes.

An accountable plan reimbursement has three essential rules, all of which must be met:

  1. Business Connection - The reimbursable expense must be directly related to the business operations or the employee's job duties.
  2. Timely Substantiation - Employees must report their expenses, with documentary substantiation (i.e. receipts), within a reasonable period of time.
  3. Return of Excess Amounts - If the employee was advanced or reimbursed more money than they actually spent, then the employee needs to return the excess amount to the employer within a reasonable period of time.

If a particular reimbursement doesn’t satisfy all three rules, then the IRS would consider that reimbursement taxable compensation to the employee. See IRS Pub. 463 for additional information.

Non-Accountable Plan Examples

On the flip side, a non-accountable plan reimbursement comes into play when any of the aforementioned accountable plan rules aren’t met.

If reimbursements are non-accountable plan reimbursements, they must be classified as taxable income and reported on the employee's W-2 form at the end of the year. The employer must also pay payroll taxes on the taxable income.

Here are some common non-accountable plan reimbursements and their tax implications:

  1. Monthly Stipends to Employees - Some employers provide employees with a fixed monthly “stipend” for on the job expenses (a “gas stipend,” for example). The employee isn’t required to verify the actual amount that they spent. It’s OK to do this, but as a non-accountable plan reimbursement the stipend needs to be run through payroll so that it’s reported as taxable compensation.
  2. Not Collecting Receipts from Employees - When reimbursing employees, the employer must collect receipts or other substantiating documents. Otherwise the employer can’t confirm whether a reimbursement was more or less than the amount paid. If your reimbursement policy doesn’t require receipts then you need to reimburse employees through payroll. 
  3. Quarterly or Annual Expense Reports - Some employers might allow employees to submit one expense report for the entire year or one per quarter. That practice wouldn’t satisfy the IRS’ “reasonable period of time” requirement, making the reimbursements taxable compensation and reportable through payroll.

The key takeaway is that your company’s reimbursement policy should be designed with the three accountable plan rules in mind: business connection, timely substantiation, and return of excess amounts. Doing so helps create a harmonious workplace by safeguarding against tax pitfalls for both the employer and employee.

Some Expenses are Reimbursable but Not Deductible

Bear in mind that reimbursing an expense does not automatically make it deductible for the business, even if it’s not taxable compensation for the employee. For instance, although meals are reimbursable at their full cost to the employee, they remain only 50% deductible for the business. 

It’s therefore important to track reimbursements by expense category in the accounting system in order to accurately report these expenses on the tax return.

IRS Rules: Fringe Benefits vs. Reimbursements

It’s important that your company’s reimbursement policy differentiates between reimbursements for on-the-job expenses and reimbursements that qualify as fringe benefits. 

Reimbursements for business expenses aren’t taxable, if done under an accountable plan, whereas fringe benefit reimbursements are sometimes taxable. 

Let’s walk through the details.

What Is a Fringe Benefit?

A fringe benefit is compensation, such as a perk or a reward, that an employer might provide to its employees in addition to a regular salary. It's often used as a way to creatively compensate employees in ways other than a paycheck, like a cherry on top.

The key factor that determines whether a payment qualifies as fringe benefit is whether the underlying expense provides a personal benefit for the individual being reimbursed. Both accountable plan and non-accountable plan reimbursements are for business expenses, whereas a fringe benefit reimbursement is for a personal expense for the employee.

Because they’re compensation for services, fringe benefit payments are generally taxable to both the employee and employer unless the fringe benefit is specifically excluded from taxation.

Fringe benefits, regardless of whether they are taxable, should be run through payroll so that they’re reported on the employee’s Form W-2. 

Taxable Fringe Benefit Examples

Unlike non-taxable fringe benefits, which are specifically identified in tax law, taxable fringe benefits come in many forms depending on how your business compensates its employees. Here are some common examples:

  • Company Vehicles - If an employee is provided with a company vehicle for personal use, the value associated with the personal use is considered a taxable fringe benefit.
  • Fuel Stipends - If an employee receives a monthly fuel stipend, without regard for the actual amount of miles driven, that stipend would be a taxable fringe benefit.
  • Gym Memberships - Unless your company provides a gym for its employees on-premises, providing employees with a stipend for gym memberships would be a taxable fringe benefit. On-premise gyms, however, can be excluded from taxable compensation.
  • Health Insurance Premiums of the Business Owner - Unlike premiums paid for other employees, health insurance premiums that a business pays for its owners must be reported as a taxable fringe benefit. The business owner can generally deduct the premiums on their personal tax return.

The general rule when determining whether a benefit is taxable or non-taxable is to first determine whether the benefit is specifically excluded from compensation by tax law. If it’s not, then it’s probably taxable to the employee

Non-Taxable Fringe Benefit Examples

Here are some fringe benefits that tax law specifically excludes from an employee’s taxable compensation. 

  • Commuter Benefits - Employers can provide non-taxable assistance for transit fares and parking up to an annual maximum limit.
  • Educational Assistance - Tuition, books, supplies and other education expenses paid by an employer can be excluded from an employee’s taxable income.
  • Adoption Assistance - Financial support provided by an employer for adopting a child can be non-taxable to the employee.
  • Dependent Care Assistance - Assistance that an employer provides for dependent care can be non-taxable if it enables the employees to work.

This isn’t an exhaustive list, so review IRS Pub. 15-B if you have questions about a specific type of fringe benefit. If a benefit isn’t specifically noted in this publication as being non-taxable, then that benefit is probably taxable compensation. 

Drafting an Employee Reimbursement Policy: Step-by-Step Guide

A comprehensive reimbursement policy provides a straightforward process for employees to get reimbursed and helps your business comply with IRS rules. This step-by-step guide will walk you through the elements that should be incorporated into your policy.

Alignment with Accountable Plan Rules

First and foremost, the policy should align with the IRS’ accountable plan rules to avoid triggering taxable reimbursements for your business and its employees. To do so, the policy should address these areas at a minimum:

  1. Submission Time Period - Require employees to submit their expenses within 60 days of incurring the cost. Advances to employees should be accounted for within 30 days of the advance date.
  2. Handling Excess Reimbursements - Clearly state that reimbursements or advances in excess of the actual cost are taxable and should be returned within 120 days of the expense date.
  3. Types of Reimbursable Expenses - Define the kinds of expenses that can be reimbursed, specifying that all reimbursements must have an underlying business purpose. Make it clear that non-deductible expenses such as fines or entertainment (See Pub. 535) aren't reimbursable.
  4. Receipt Substantiation - Require receipts for all reimbursements, with a note that expenses below $75, except for lodging and small cash payments, do not require a receipt as per IRS rules. Of course you can choose to impose stricter requirements if deemed necessary.

Additional Inclusions in the Policy

To round out the policy, consider including the following elements:

  1. Reimbursement Request Process - Detail the process of requesting reimbursements, including the necessary forms, the frequency of submissions, any software to be used, and the responsible approvers. A clear process reduces confusion and streamlines operations.
  2. Setting Maximum Allowable Amounts - Establish maximum limits for certain expenses. This step helps with budgeting and sets clear expectations regarding what is considered reasonable.
  3. Preferred Suppliers - Identify and list preferred suppliers for certain goods or services to help control expenses by locking in favorable rates.
  4. Usage of Purchase Cards vs. Expense Reports - Clearly state when employees should use company purchase cards versus when to file expense reports to maintain proper control over spending.
  5. Reimbursements for Fringe Benefits - Describe the process for fringe benefit reimbursements, emphasizing that such compensations should be reported through payroll to ensure compliance with tax rules.
  6. Per Diems vs. Actuals for Business Travel - In lieu of substantiating specific travel costs, your business can reimburse employees using the federal per diem rates to lighten the administrative burden on employees. The policy should still require employees to track dates, nights, and the travel’s business purpose.

By crafting a detailed reimbursement policy that adheres to accountable plan rules, you create a predictable process through which employees can seek reimbursement for on-the-job expenses while avoiding compliance issues with the IRS.

Sample Employee Reimbursement Policy

Here’s a sample reimbursement policy. Use this template as a starting point for your company’s policy. Be sure to customize it so that it’s relevant to your employees and business operations.

Formally Adopting the Employee Reimbursement Policy

Once the reimbursement policy is drafted, your company should formally adopt the policy through a corporate resolution. Although not mandated by the IRS, this step is important for a number of reasons.

  • Provides Clarity for the Policy Owners - Having a signed resolution that articulates the accountable plan requirements and general principles helps shape a policy that aligns with management’s goals.
  • Sets the “Tone at the Top” - Management’s involvement in establishing the policy promotes a culture of compliance and sets an expectation that employees should seek reimbursement through the proper channels.
  • Memorializes Corporate Procedures - This practice aligns well with corporate formalities, helping to record and acknowledge significant actions undertaken by the company. By adopting resolutions for actions like implementing an accountable plan, you not only formalize corporate procedures but also maintain a transparent record of corporate actions.

Steps to Formally Adopt an Reimbursement Policy

The business can formally adopt the policy through a corporate resolution by following these procedures.

  • Draft the Resolution - Begin by writing up a resolution, highlighting all the accountable plan requirements. The resolution should be clear but broad to provide flexibility for implementation.
  • Engage the Decision-Makers - Consult your Board of Directors, LLC Members, or Partners to discuss and refine the policy. Their insights can be valuable in sculpting a policy that works well for the business.
  • Signing the Resolution - Once the resolution is fine-tuned, have it signed by the appropriate individuals within the organization. This signature formalizes the adoption of the policy, giving it legitimacy and setting the tone at the top.

Sample Resolution for Adopting an Expense Reimbursement Policy

Here’s a sample expense reimbursement policy adoption resolution. Change the template as needed to make it suitable for your business.

Building the Infrastructure for Employee Reimbursements

Once the policy is drafted and formally adopted, you’ll need to build the reimbursement infrastructure before implementing the policy. 

Building the infrastructure includes identifying the tools, processes, and communication channels through which employees will submit expense reports and receive reimbursements. The infrastructure should be clearly outlined in the company’s expense policy to avoid confusion.

Rolling out the policy without an adequate infrastructure will result in an ineffective policy, wasting the time and resources that went into building and adopting the policy.

Creating an Employee Reimbursement Form

The employee reimbursement form, often called an “expense report,” is the tool through which employees convey key information about their reimbursable expenses. The exact contents of the form will depend on the specifics of your business, but here are a few essential requirements:

  • Employee Details - Fields capturing identifying information like name, department, and contact information of the employee.
  • Expense Details - A summary of the expense incurred, including date, description, and the amount spent.
  • Signature of Employee - A section where the employee signs, certifying the legitimacy of the claim.
  • Approver's Signature - A dedicated space for the approver's signature, indicating the approval of the expense. 

A comprehensive reimbursement form helps contain important information about the reimbursement in a single document. This document can be referred to as a “source of truth” in the event of an audit or to answer questions that arise down the road.

Sample Expense Reimbursement Request Form

Here’s a sample expense reimbursement request form to get you started. Be sure to change it as needed for your business.

Collecting and Archiving Receipts

In addition to information included in the expense report, employees should provide documentation for the expenses in accordance with your company’s policy and accountable plan rules. 

IRS-compliant documentation includes receipts, bills, invoices, mileage logs, and other documents that substantiate the business purpose of the reimbursable expense.

Documentation should be attached to the expense report, whether digitally or physically, to ensure that all information related to the reimbursement is in one place. Employee expense reports and attached supporting documentation should be stored in a central file folder for future reference.

Reimbursing Employees

After approving the reimbursement form, the next step is setting up the payment method through which employees will reimburse the reimbursing employees. This can be accomplished in a number of ways.

  • Manual Checks & Direct Deposit - Reimburse employees by paying them directly with a check or ACH into their bank account. 
  • Payroll - The employee can be reimbursed through an off-cycle or regular pay run. Be sure to set up the reimbursement as a non-taxable, one-time pay type.
  • Expense Management Software - Dedicated expense reporting software combines the entire process, from collecting expense information and receipts to reimbursing employees, into a single system.

The best reimbursement method is often the one that employees are already familiar with or the one that the company is already paying for. Whatever method you choose, it should be referenced in the company’s expense reimbursement policy and consistently followed.

Using Software for Streamlined Expense Reporting

For small companies, or companies that infrequently reimburse employees, a manual process of submitting and approving expense reports, attaching receipts, and paying employees can work well. Larger companies might benefit from an all-in-one expense management software in the following ways:

  • Reimbursement Process Automation - Software can automate various steps in the reimbursement process, such as notifying and reminding an approver, making the entire process more efficient and less prone to errors.
  • Enhanced Reporting & Analysis - Software digitizes expense information to provide structured data and standardized reporting for analysis, such as comparing budgeted expenses to actuals.
  • Policy Enforcement - Software requires employees to input certain fields and attach receipts and disallows reimbursements when an expense falls out-of-policy.
  • Integrations with Other Software - Software often integrates with other tools in your business’ technology stack, such as accounting or payroll software, which reduces time spent on data entry.

In general, the benefits of an expense management are the time-savings and minimization of errors. If your business frequently reimburses employees, or if it wants to minimize errors in a manual process, then investing in expense management software could yield a positive return on investment.

Implementing the Employee Reimbursement Policy

When the reimbursement infrastructure is ready, the next step is to finally roll the expense policy out to the wider organization. A well-executed implementation helps employees understand what they can be reimbursed for and how to go about it, ensuring that the work invested in building the policy to this point doesn’t get wasted.

Communicating the Policy and Procedures

The first step toward implementing the reimbursement policy is effectively communicating the transition plan to employees. Here are some points to address in the transition plan: 

  1. Transition Timeline - Specify when the new reimbursement policy will take effect, the first due date under the new policy, and–if applicable–the final due date for reimbursements under the old policy.
  2. Summary of Changes - Highlight the most important changes that employees will need to know, such as frequency of reimbursements, the process for submitting expense reports, and other changes.
  3. Where to Find the Policy - Let employees know where they can access a written copy of the reimbursement policy for their reference.
  4. Open Channel for Questions - Establish a point of contact to whom employees can reach out with any questions or clarifications regarding the policy.
  5. Roles & Responsibilities - Make it clear who is responsible for reviewing and approving reports including who is responsible for approving exceptions to the policy.

You’ll probably need to communicate this plan more than once, so anticipate follow up questions in your communications to reduce the amount of back and forth you’ll have.

Enforcing the Reimbursement Policy

After implementing the policy, consistency is key to maintain its effectiveness. Here are some ways to keep the policy relevant after implementation:

  1. Automated Reminders - Set up automated reminders through email or messaging platforms, reminding employees to submit their expense reports on time.
  2. Policy Owner - Appoint a designated person or team responsible for monitoring the reimbursement process to ensure consistency and fairness in the approval process.
  3. Timely Approvals - Make sure that approvals are done in a timely manner to avoid any delays in reimbursement, which can erode employee trust in the reimbursement process.
  4. Feedback Loop - Establish a feedback loop through which employees can be informed of any discrepancies in their reports and given the opportunity to rectify them.

Implementing an expense reimbursement policy is a collaborative process that requires active participation and understanding from all employees. A well-executed policy not only benefits the company, it also fosters a positive work environment where employees feel valued and taken care of.

Need help writing your employee reimbursement policy?

Implementing a well-designed employee expense reimbursement policy takes some time and expertise. Consider working with a professional if you want support throughout the implementation process. From IRS-compliant policy design, to infrastructure building, to final implementation, a knowledgeable professional can reduce your company’s time investment and prevent costly mistakes.

FAQs

Are expense reimbursements taxable?

Expense reimbursements are not taxable if they are made under an IRS-compliant “accountable plan.” However, if the reimbursements are made under a nonaccountable plan, they are considered taxable income.

How does an employee gas reimbursement work?

As with all reimbursements, the IRS requires an “adequate accounting” of reimbursable fuel costs, meaning that employees must provide their employer with details of each trip and receipts that correspond with the trip details.

When providing trip details, employees should include the times, dates, origin, destination, mileage, and the business purpose of each trip covered by the reimbursement.

In lieu of receipts, employers can reimburse employees based on the standard IRS mileage rate rather than the actual fuel cost. The mileage rate takes into consideration not only gas but also wear and tear on the vehicle, insurance, and other associated costs. Trip details are still required even if the standard mileage rate is used.

Fuel reimbursements that aren’t supported by adequate accounting should be treated as taxable compensation to the employee.

How does an employee internet reimbursement work?

Employers can reimburse employees for home office expenses, including home internet, if the reimbursements adhere to IRS accountable plan rules. 

Under these rules, the reimbursement must be supported by an adequate accounting of the reimbursable amount and any excess reimbursements must be returned to the employer. Reimbursements for home internet that aren’t supported by adequate accounting should be treated as taxable compensation to the employee.

An employee’s “adequate accounting” entails providing sufficient information to substantiate the amount, time, use, and business purpose of the reimbursable home office expense. This can be accomplished by providing a receipt and a reasonable estimate of the business use portion of the total expense amount.

Are employers required to have a written expense reimbursement policy?

No, the IRS doesn’t require employers to have a written expense reimbursement policy, but implementing a written policy that aligns with IRS accountable plan rules clarifies the process through which employees can receive tax-free reimbursements for on-the-job expenses.

How are 1099 contractors reimbursed?

Independent contractors, if they receive reimbursements or allowances for travel, gifts, or other expenses incurred on behalf of a client, should provide an adequate accounting of these expenses to the client. If contractors do not account to the client for these expenses, they must include the reimbursements or allowances in their income. Independent contractors are required to maintain adequate records of these expenses, irrespective of whether they account to the client for these expenses.

This content is for informational purposes only and does not constitute legal, business, or tax advice. You should consult your own attorney, business advisor, or tax advisor regarding matters mentioned in this post. We take no responsibility for actions taken based on the information provided.

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