I have received many inquiries lately from clients regarding how Per Diem works and whether the Per Diem is taxable income to employees. This seems to be a question that causes a lot of confusion for many employers, as well as for employees. How does Per Diem work? Must it be substantiated (accounted for)?
Let me start first by explaining what Per Diem is. The IRS allows companies to reimburse employee business expenses using Per Diem rates (set annually by the IRS). There are different types of expense reimbursements that the IRS allows. Some of these reimbursements must be substantiated in order to receive the reimbursement. Other types of reimbursements do not have to be substantiated. Per Diem is a set amount the IRS allows for reimbursements that is TAX FREE income to the employee.
Per Diem rates are set by the IRS once per year, and are good for one year following the date the rates are set. Per Diem rates are good from October 1 through September 30. The Per Diem rates vary depending on location. Per Diem rates are made up of two parts: Lodging and Meals & Incidental Expenses (M&IE). The combined Lodging and M&IE rates are the maximum allowed Per Diem PER DAY for any given location. Locations are the continental United States (CONUS). Each state has its own specific Per Diem rate, with many states having additional rates assigned to specific cities and/or counties within the specific state. See IRS Publication 1542 for specific Per Diem rates.
There are maximum rates set for each of the two components that make up the total allowable Per Diem. Maximum rates for Lodging are separate from the maximum rates for M&IE. The two rates combined make up the total allowable Per Diem rate that can be used by an employer to reimburse expenses incurred by employees.
Using the IRS Per Diem rates to reimburse expenses is probably the easiest way for employers to reimburse employees for business-related travel expenses, since these expenses do NOT have to be substantiated. However, an employer should not use the Per Diem method to reimburse employees if there is reason to believe that an employee did not truly incur Lodging and/or M&IE expenses. In this case, the employer should implement an ACCOUNTABLE PLAN that is used company-wide for ALL employees.
Under an ACCOUNTABLE PLAN, an employee MUST provide written evidence of ALL expenses incurred (i.e., receipts for ALL expenses, along with an explanation of what the expense is for, including such information as the business purpose for the expense, who was present (employee, client, etc.), date and location of the expense). The employer may provide an employee with advance payment for anticipated expenses, however, the employee MUST substantiate all expenses within a reasonable time, and the employee MUST return any excess reimbursement to the employer. If the employee does not return excess reimbursements to the employer, the employer is required to consider this as taxable income to the employee (subject to all employment taxes).
There is another reimbursement plan available to employers, called an UNACCOUNTABLE PLAN. Under an UNACCOUNTABLE PLAN, different rules apply. This article does not cover the rules and requirements which apply to UNACCOUNTABLE PLANS.
To wrap up, employers who reimburse employees using IRS Per Diem rates may do so without having to substantiate the expenses (as outlined above). Per Diem reimbursements are TAX FREE to the employee, provided the employer does not reimburse employees more than the allowable Per Diem rates published in IRS Publication 1542. If an employer reimburses an employee more than the allowable Per Diem, the excess amount MUST be included as taxable income to the employee, subject to all employment taxes.