Office Administration Payroll

IRS nixes reimbursement plans as wage recharacterizations

Alice Gilman
Alice Gilman
Published: November 30, 2012
Updated: June 11, 2019

It would be great if you could wave a magic wand and convert some of employees’ taxable wages into nontaxable business reimbursements. But you can’t. A new revenue ruling reiterates that employees’ expenses must have a business connection before you can reimburse them tax-free. (Rev. Rul. 2012-25, IRB 2012-37)

Creativity doesn’t pay

The IRS concluded that these three scenarios improperly recharacterized employees’ taxable wages as nontaxable business expense reimbursements.

  • Technicians’ wages were reduced, but they re­­ceived the difference in nontaxable tool allowances. When they maxed out on their tool allowances, their taxable pay was restored. IRS: The business connection isn’t met because employees always received the same gross amount, regardless of whether they used their tools.
  • All nurses received the same pay. However, nurses who traveled away from home overnight had their pay reduced and received an equivalent amount as a per diem, which compensated them for their lodging, hotel and meal costs. IRS: Again, employees receive the same gross amount, regardless of whether they incurred travel expenses.
  • In addition to their regular pay, construction workers received mileage reimbursements for the business use of their cars, regardless of whether they incurred those expenses. IRS: There’s no business connection because employees who didn’t incur expenses routinely received mileage reimbursements.

The only arrangement that passed muster was one where employees who substantiated their business expenses were reimbursed, even though their pay was reduced beforehand for other reasons. IRS: The reimbursements were limited to employees who incurred business expenses, and were paid in addition to—not in lieu of—wages.

•  THE TAKEAWAY: The IRS has struggled for years with tool plans that recharacterize a portion of employees’ wages as nontaxable business reimbursements. This ruling indicates that it’s looking beyond tool plans for suspect reimbursement arrangements.

WHAT TO READ NEXT