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IRS ruling may require new reimbursement procedures

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in Small Business Tax,Small Business Tax Deduction Strategies

Do your employees need special tools for their jobs? Typically, you provide the tools that workers need or you reimburse employees for tools they must buy on their own. If you handle everything correctly, those reimbursements are tax-free to employees and tax-deductible for you.

Alert: Be sure to make those tool reimbursements under an "accountable plan." A new IRS ruling says that if your employees don't properly substantiate their expenses, your company's reimbursements to them won't be tax-free. Employees can't simply estimate the amounts, even if the estimates are reasonable. (IRS Revenue Ruling 2005-52)

Don't estimate reimbursements

The IRS case surrounded an auto-repair business that required service technicians, as a condition of employment, to provide and maintain certain tools. Technicians received an hourly "tool allowance" in addition to their regular wages.

The tool allowance was based on data from a national survey of average auto mechanic tool expenses and specific information from the technicians.

The technicians weren't required to keep track of tools they purchased. Nor were they required to return any of the tool allowance that they didn't spend on tools. Whatever they were paid, they kept.

The IRS examined the plan to see if it met the three rules for an "accountable reimbursement plan" (see box at right). Although the repair shop met the first requirement, the IRS determined that it failed the second and third. The plan didn't require exact substantiation of costs nor did it require employees to return excess reimbursements.

As a result, the reimbursements were taxable as wages. That means the employer had to cough up federal employment taxes on the reimbursement payments.


Bottom line: If you reimburse employees for tool or equipment costs, make sure to keep track of those individual expenses, and don't let employees keep the extra reimbursement amounts.

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