Letter Ruling 99916011
Background. A securities firm employs investment consultants who incur travel and other employee business expenses in connection with the performance of services for their employer. The company adopted a plan to provide for the reimbursement of employee business expenses incurred by the investment consultants. It contains the following features:
- The plan is mandatory for all investment consultants within the company.
- Investment consultants are reimbursed for employee business expenses that would be deductible as business expenses on their personal tax returns.
- Prior to the start of a calendar year, each investment consultant's manager determines the amount, if any, to be excluded from the consultant's commissions in the next year. If the manager reduces a consultant's commissions, such amount is not less than $600 and not more than the reimbursement "cap." The reimbursement cap equals the greater of $10,000 or 2.5% of the consultant's commissions in the prior year. The amount of reimbursement that a consultant may receive under the plan in a calendar year may not exceed the lesser of the actual expenses or the reimbursement cap.
- If a consultant's expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the consultant and will not be carried over from one calendar year to the next.
- If a consultant does not request reimbursement under the plan, he or she receives no additional compensation and remains subject to the base compensation reduction.
- All consultants requesting reimbursement are required to prepare an expense report within 45 days after the expense is incurred. In preparing an expense report, a consultant must enter, in detail, the elements of each expense. For business travel expenses, a consultant must show the business purpose, the amount of each separate expense, when the expense was incurred, and the travel locations. For other employee business expenses, the consultant must show the business purpose, amount, and date of each expense item. Consultants must submit a receipt for any expense item exceeding $25 (this amount may be increased from time to time up to the applicable legal limit of $75). Business mileage is substantiated by a record or log indicating when the expense was incurred and the business purpose for the transportation expense.
- The employer examines all expense reports prior to payment to determine if the business purpose and amounts are reasonable. The employer approves, denies, or asks for additional information within 15 days of receiving the request for reimbursement. If additional information is requested, the consultant must provide it within 15 days, or the request will be denied.
The employer asked the IRS for a ruling that (1) the amounts reimbursed under the plan will be fully excludible from gross income of the consultants, and (2) that the amounts reimbursed are not wages subject to employment taxes and withholding, and need not be reported on Form W-2.
The IRS ruling. The IRS began its ruling by noting that if an employer's reimbursements of an employee's business expenses are "accountable," they are not included in the employee's income, they are not reported on the employee's W-2, and they are not subject to tax withholding. To be accountable, three requirements must be met: (1) the reimbursed expenses are "business connected"; (2) the employee adequately substantiates the expenses within a reasonable time; and (3) the employee is required to return to the employer any portion of a reimbursement in excess of substantiated expenses.
The IRS cautioned that "if an arrangement does not satisfy one or more of the three requirements, all amounts paid under the arrangement are treated as paid under a nonaccountable plan." The result is that such reimbursements "are included in the employee's gross income for the taxable year, must be reported to the employee on Form W-2, and are subject to the withholding and payment of employment taxes."
The IRS then briefly explained the three requirements of an accountable expense reimbursement arrangement:
The IRS explained this requirement as follows:
An arrangement meets the business connection requirement … if it provides advances, allowances (including per diem allowances, allowances for meals and incidental expenses, and mileage allowances), or reimbursements for business expenses that are allowable as deductions under … the Code, and that are paid or incurred by the employee in connection with the performance of services as an employee. [The regulations] impose a reimbursement requirement, which will not be satisfied if the payor arranges to pay an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur allowable business expenses.
The IRS explained this requirement as follows:
[The] regulations provide that the substantiation requirement is met if the arrangement requires each business expense to be substantiated to the payor (the employer, its agent or a third party) within a reasonable period of time. An arrangement that reimburses business expenses governed by section 274(d) of the Code [pertaining to travel, transportation, entertainment, business gifts, cell phones, and personal computers] meets the substantiation requirement if the information submitted to the payor sufficiently substantiates the requisite elements of each expenditure or use. For example, when substantiating expenses for travel away from home [the regulations] require that information sufficiently substantiating the amount, time, place and business purpose of the expense must be submitted.
If an arrangement covers expenses not governed by section 274(d) of the Code [the regulations specify] that the substantiation requirement will be satisfied if information sufficient to enable the payor to identify the specific nature of each expense and to conclude that the expense is attributable to the payor's business activities. Each element of an expenditure or use must be substantiated to the payor. It is not sufficient if an employee merely aggregates expenses into broad categories or reports individual expenses using vague, nondescriptive terms, such as miscellaneous business expenses.
#3—returning excess reimbursements
The IRS explained this requirement as follows:
With respect to the third requirement that amounts in excess of expenses must be returned to the payor, the … regulations provide that this requirement is met if the arrangement requires the employee to return to the payor within a reasonable period of time any amount paid under the arrangement in excess of the expenses substantiated.
The IRS concluded that the company's plan satisfied all three requirements for an accountable plan. With respect to the third requirement, the IRS noted that "because the plan is a reimbursement arrangement, the amount reimbursed should not exceed the amount substantiated; thus, there should not be an excess to return." As a result, assuming that expenses "are properly deductible and substantiated," the IRS reached the following conclusions:
(1) Reimbursements made to a consultant under the plan may be excluded from the consultant's income as payments made under an accountable plan.
(2) Reimbursements made to a consultant under the plan are not wages subject to employment taxes, and are not reportable on the consultant's Form W-2.
Significance of the case to church treasurers. Church treasurers should be aware of the following points:
1. Salary reduction agreements. The tax code prohibits employers from paying for accountable reimbursements out of salary reductions. Consider an example. A church pays Rev. J $1,000 each week, and also agrees to reimburse his substantiated business expenses for each month out of the first payroll check for the following month. Assume further that Rev. J substantiated $300 of business expenses for January. The church issued Rev. J his customary check of $1,000 for the first week of February, but only $700 of this check represents taxable salary while the remaining $300 represents a nontaxable reimbursement under an accountable plan. Only the $700 salary component of this check is included on Rev. J's W 2 form at the end of the year. The code prohibits this practice for accountable reimbursement plans. Such arrangements are not "illegal." They simply cannot be "accountable." Churches that use such an arrangement must recognize that all reimbursements paid through salary reduction are "nonaccountable," and must be reported on the minister's W-2.
2. Salary restructuring arrangements. What about salary restructuring arrangements? Does the ban on using salary reduction arrangements to fund accountable expense reimbursements apply to these arrangements as well? The IRS answered "yes" to this question in a 1993 private letter ruling. However, the private ruling addressed in this article signals a retreat from the 1993 position. The two rulings involve very similar facts, and in the 1999 ruling the IRS appears to be saying that employers may pay for reimbursements of employee business expenses under an accountable arrangement through salary "restructuring." There are two important points to note:
- The 1993 IRS ruling interpreting "salary reduction" arrangements to include salary "restructuring" arrangements was a private letter ruling that by law applied only to the taxpayers who requested it. The IRS has not reaffirmed the 1993 ruling in any official or binding precedent. The 1999 ruling discussed in this article is also a private letter ruling. What is the significance of this? To the extent that the 1993 ruling has been used in the past to prevent the use of salary restructuring arrangements to fund accountable expense reimbursements, the 1999 ruling can be interpreted as overruling the earlier ruling. While the 1999 ruling is of no more legal weight than the 1993 ruling, it is the same type of ruling and it entitled to the same weight.
- The 1999 ruling, while binding only on the taxpayer who requested it, suggests that an accountable expense reimbursement arrangement can be funded out of a salary restructuring arrangement having most if not all of the following characteristics: (1) the plan is mandatory for all employees; (2) employees are reimbursed only for those business expenses that would be deductible as a business expense on their personal tax returns; (3) prior to the start of each year, the employer determines the amount, if any, to be excluded from the employee's compensation in the next year; (4) reimbursements cannot exceed a "cap" specified by the employer; (5) if an employee's expenses are less than the reimbursement cap, the difference between the expenses and the reimbursement cap will not be received by the employee and will not be carried over from one calendar year to the next; (6) if an employee does not request reimbursement under the plan, he or she receives no additional compensation; (7) all employees requesting reimbursement are required to prepare an expense report within a reasonable time that substantiates the business purpose, amount, and date of each expense item (including a receipt for any expense item exceeding $75; (8) business mileage is substantiated by a record or log indicating when the expense was incurred and the business purpose for the transportation expense; and (9) the employer examines all expense reports prior to payment to determine if the business purpose set forth on the report is reasonable and if the amounts claimed are reasonable.