The IRS has issued a Chief Counsel Advice (CCA) on whether reimbursements that an employer provides to its employees under a tool plan may be excluded from the employees' wage income [Chief Counsel Advice 201120021].
The facts. An employer participated in a tool plan, administered by a third party, that was designed to reimburse the employer's employees for the use of their own tools and equipment. Under the plan, tool payments are made to employees as purported nontaxable reimbursement for the cost of the tools that they are required to provide as a condition of their employment. The amount “reimbursed” was determined by taking an inventory of each employee's tools and equipment. The tool plan administrator asked each employee for a list of his or her tools and equipment and for any available receipts. The inventory included tools or equipment the employee acquired before being employed with the current employer. Neither the employer nor the plan administrator verified that the tools being claimed by the employees were 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 cost of tools and equipment. After enrolling in the tool plan, the employees' hourly wages were split into two components: (1) a reduced hourly wage; and (2) a tool plan payment, which was calculated as a set percentage of the employee's hourly wage. The employer issued its employees one check for the reduced hourly wage amount and a second check for the tool plan payment. The second check was excluded from the employees' wage income.
Employees continued to receive essentially the same amount per hour as they did before the tool plan arrangement. Once an employee had received an amount equal to the total amount to be reimbursed under the tool plan, the employee stopped receiving tool plan payments and began receiving his or her regular pay again at the hourly wage rate earned prior to the implementation of the tool plan.
The law. 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 certain requirements. One such requirement states that the reimbursed expense must be allowable as an income tax deduction and must be paid or incurred in connection with performing services as an employee of the employer (business connection requirement) [Reg. §1.62-2(d)].
The ruling. The CCA concluded that the tool plan violated the business connection requirement.
The CCA reiterated the 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 so 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 IRS said that the recharacterization violated the business connection requirement because the employee received the same amount regardless of whether tool and equipment expenses were incurred or were reasonably expected to be incurred.
The CCA also reiterated the 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 allowed the employer to reimburse deductible tool expenses that the employee paid or incurred prior to employment with the employer, the reimbursement arrangement did not meet the business connection requirement.
Payments made under the plan must be treated as made under a nonaccountable plan. The payments are subject to withholding and employment taxes, and must be reported as wages or other compensation on Form W-2.