Lock up two-way tax break for tool plans

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in Small Business Tax,Small Business Tax Deduction Strategies

Employers often provide workers with the tools they need for their jobs or reimburse them for their out-of-pocket tool costs. As long as employers handle things correctly, tool-cost reimbursements are tax-free to employees and deductible by the employer.

Strategy: Ensure that tool-cost reimbursements from your business are made via an “accountable plan.”  Otherwise, payments will be treated as taxable compensation to the employees.  

In a new ruling from the IRS, a tool-cost reimbursement plan didn’t meet the “accountable plan” requirements. (IRS Chief Counsel of Advice 201120021)

Here’s what happened: An employer compensated its employees on an hourly wage basis without attributing any specific amount to the provision of employee tools. The employer then decided to participate in a tool-reimbursement plan administered by a third party. Under the plan, each employee’s hourly wages would be divided into a reduced hourly wage and the tool-plan payment would be calculated as a percentage of the employee’s hourly wage.

The tool plan would require the employer to issue two checks. One would cover the reduced hourly wage amount, and the second would go to the tool-plan payment. The theory was that the second check wouldn’t be subject to federal employment taxes or federal income tax. After an employee received an amount equal to the amount capped by the employer’s tool inventory, the employee would no longer receive reimbursements and would return to his or her regular pay structure.

The IRS noted that an accountable plan must meet the following requirements:

  • A business connection
  • Proper substantiation
  • Return of amounts in excess of substantiated expenses.

If the plan fails to meet any of the requirements, or otherwise shows a pattern of abuse, it’s treated as a nonaccountable plan. Thus, the payments must be included in the employee’s income as compensation and are subject to employment tax.

In this case, the temporary reduction in an hourly wage amount for only as long as the tool rate amount is paid violates the business connection requirement. The employer can’t structure its compensation arrangement to avoid payment of employment tax by substituting reimbursements and expense allowances for amounts that would otherwise be paid as wages. The IRS determined there was no connection to expenses that would be incurred, or reasonably expected to be incurred, during employment.

Tip: Conversely, the IRS recently approved a tool-reimbursement plan as an accountable plan where payments weren’t made in lieu of any other compensation such as hourly wages. (IRS PLR 200930029)

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