Chief Counsel Advice 201120021
In Chief Counsel Advice, IRS has concluded that an enterprise's tool reimbursement plan failed the accountable-plan business connection requirement because it impermissibly recharacterized wages and reimbursed employees for tool expenses incurred before the start of employment. As a result, amounts paid under the plan must be included in the employee-participants' gross income and reported as wages or other compensation on their Forms W-2, and were subject to withholding and payment of employment taxes.
Background. Reimbursements are tax-free to the employee and aren't subject to withholding or payroll taxes if made under an accountable plan. To be treated as made under an accountable plan, a reimbursement must meet all of the following requirements:
(1) The 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; (Reg. §1.62-2(d)(1))
(2) Each reimbursed expense must be adequately accounted for to the employer within a reasonable period of time; (Reg. §1.62-2(e)) and
(3) Any amounts in excess of expenses must be returned within a reasonable period of time. (Reg. §1.62-2(f))
If the above requirements aren't met, reimbursements are treated as made under a nonaccountable plan and are subject to withholding and employment taxes, and must be treated as wages paid to the employee.
Under Reg. §1.62-2(c)(1), an arrangement satisfies the business connection requirement if it provides advances, allowances, or reimbursements only for business expenses that are allowable as deductions by part VI, subchapter B, chapter 1 of the Code, and that are paid or incurred by the employee “in connection with the performance of services as an employee of the employer.” Under Reg. §1.62-2(d)(3), the business connection requirement isn't satisfied where a payor pays an amount to an employee regardless of whether he incurs or is reasonably expected to incur deductible business expenses or other bona fide expenses related to the employer's business.
Long-running controversy. As a condition of employment, many businesses (such as auto repair shops and dealerships) that hire service technicians require them to provide their own tools and equipment, which must be kept on the employer's premises. For more than a decade, IRS has combatted efforts to recharacterize wages as accountable plan reimbursements, particularly those using plans marketed by promoters to achieve this result.
Tool and equipment reimbursement plans were the subject of: an Industry Specialization Paper (ISP Coordinated Issue—Motor Vehicle Industry; Service Technician Tool Reimbursements, UIL 62.15-00 (7/21/00)) that laid the foundation of IRS's arguments; Rev Rul 2005-52, 2005-2 CB 423, which dealt with a tool allowance based on a combination of data from a national survey of average industry tool and expenses and specific information from technicians based on a written survey; and Chief Counsel Advice 200745018, dealing with wages recharacterized as tool reimbursements tied to an hours-worked formula. Employee tool and equipment plans that purported to be valid accountable plans also were the target of an IRS cross-divisional team set up to target faulty plans.
In Shotgun Delivery Inc. v. U.S (1/20/2000, DC CA) 85 AFTR 2d 2000-875, a district court held that a delivery company's expense reimbursements to its drivers were not paid under an accountable plan and had to be treated as wages subject to payroll taxes and income tax withholding. The reimbursements did not meet the accountable-plan business connection requirement because they were paid whether or not drivers incurred business expenses. The court's holding was affirmed by the Ninth Circuit (Shotgun Delivery Inc. v. U.S, (10/16/2001, CA9) 88 AFTR 2d 2001-6391).
Facts. An employer participates in a tool plan, administered by a third party, that is designed to reimburse the employer's employees for the use of their tools and equipment. Tool payments are made to employees as purported nontaxable reimbursements for the cost of the tools they are required to provide as a condition of employment. However, neither the employer nor the plan administrator verifies that the tools being claimed by the employees are actually required in the performance of services for the employer.
Before enrolling in the tool plan, the employer compensated its employees on an hourly wage basis, with no specific amount attributed to the provision of tools or equipment. After enrolling in the tool plan, employees' hourly wages are split into two components: a reduced hourly wage and a tool plan payment, which is calculated as a set percentage of the employee's hourly wage. The employer issues its employees one check for the reduced hourly wage amount and a second check for the tool plan payment which is treated as not subject to employment taxes. Employees continue to receive essentially the same amount per hour as they did before the tool plan, but under the plan the amount is split into two portions, one treated as wages and the other treated as nontaxable reimbursement for tool expenses and the tool plan's administrative fee. Once an employee has received an amount equal to the total amount to be “reimbursed” under the tool plan (i.e., the value or estimated cost of the employee's tool and equipment inventory), he stops receiving tool plan payments and returns to his regular pay at the hourly wage rate earned prior to implementation of the tool plan.
The amount “reimbursed” is determined by taking an inventory of each employee's tools and equipment. The tool plan administrator asks each employee for a list of his tools and equipment and for any available receipts. The inventory includes tools or equipment the employee acquired before being employed with the current employer. If an employee does not have receipts to establish cost, the initial inventory of tools is valued using estimates, valuation publications, or current price lists. The tool plan doesn't obtain information about any previous depreciation taken by employees for the tools in inventory or prior reimbursements, which is necessary to determine the expenses actually incurred by employees in performing services for the employer. Purchases made after implementation of the tool plan are generally determined at actual cost and require receipts.
Arrangement fails business connection requirement. The CCA concludes, unsurprisingly, that the tool plan violates the accountable-plan business connection requirement. As a result, payments made under the plan are treated as made under a nonaccountable plan, are subject to withholding and payment of employment taxes, and must be reported as wages or other compensation on the employee's Form W-2.
The CCA reiterates IRS's long-standing position that where a plan recharacterizes amounts as a reimbursement allowance that would otherwise be paid if there were no expenses reasonably expected to be incurred, amounts paid won't be treated as made under an accountable plan. Although an employer may prospectively alter its compensation structure to include reimbursement of substantiated expenses under an accountable plan, it cannot structure its compensation arrangement so as to avoid the payment of employment taxes by substituting reimbursements and expense allowances for amounts that would otherwise be paid as wages. The CCA says such a recharacterization violates the business connection requirement of Reg. §1.62-2(c) because the employee receives the same amount regardless of whether expenses were incurred or reasonably expected to be incurred.
The CCA also reiterates IRS's long-standing view that for an expense to satisfy the business connection requirement, it's not enough for an employee to pay or incur a deductible business expense, but the expense must also “arise in connection with the employment.” Since the tool plan allows the employer to reimburse deductible tool expense that the employee paid or incurred prior to employment, the reimbursement arrangement does not meet the business connection requirement.
Observation: In other words, IRS is saying that if the employee bought his tools before he began employment, a reimbursement for his employment-connected use of them can't meet the business connection requirement. However, this appears to contradict IRS's own long-established guidance in the auto-expense reimbursement area. An employee required to supply his own auto may be reimbursed tax-free under the accountable-plan rules for the employment-related use of his auto via the standard mileage reimbursement rate or the FAVR (fixed and variable-rate reimbursement) method regardless of when he acquired it. The mileage allowance is in lieu of lease payments (or depreciation if the car is purchased) and out-of-pocket expenses, and the FAVR auto-reimbursement rules recognize depreciation as an expense that can be reimbursed tax-free under an accountable plan. The same should hold true for tool reimbursements.
References: For accountable plan requirements, see FTC 2d/FIN ¶L-4700; United States Tax Reporter ¶624.02; TaxDesk ¶296,000; TG ¶17800.
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