By Mark Battersby –
The Internal Revenue Service is once again targeting the increasing number of employee tool and equipment plans where tax deductions benefit not only employers but so many workers who provide their own tools. Every rural building contractor and business that requires employees to provide their own tools should be aware of the difference between taxable wages and nontaxable reimbursements for employee-provided tools and equipment.
Are reimbursements to employees for tools, equipment, and supplies they use during their work ‘income’? Are they ‘wages’? This may appear to be a small issue. It is not, because many companies employing workers in a variety of fields require workers to provide their own tools and equipment.
If workers are expected to use their own tools and equipment on the job and get reimbursed for the expense, both employees and employers should be very careful in understanding the definition of an “accountable plan.” The IRS has significant concerns with certain employee tool and equipment plans that purport to receive tax-favored treatment as accountable plans.
An employee tool and equipment reimbursement plan can be a good deal for building businesses: Employees save money on tools they need on the job and the company saves on some payroll tax payments. Tool and Equipment Plans generally require employees to provide their own tools with the employer reimbursing costs.
Unfortunately, not all plans meet the guidelines for what the IRS calls an “accountable plan.” Whether a building business creates its own plan, or buys one from a third-party service, it’s crucial to follow the IRS guidelines. Failing to do so can result in misunderstandings with employees and, even worse, tax penalties.
In general, amounts treated as paid under an accountable plan can be excluded from the employee’s gross income, need not be reported as wages on the employee’s Form W-2, and are exempt from withholding and payment of employment taxes. Conversely, if the arrangement fails any of the requirements or otherwise shows a pattern of abuse of the rules, the amounts paid for tool reimbursements are treated as paid under a “non-accountable plan” and are included in the employee’s gross income, must be reported as wages or other compensation on the employee’s Form W-2, and are subject to withholding and payment of employment taxes.
In order to be treated as having been made under an accountable plan, a reimbursement must meet all of the following requirements:
- The reimbursed expense must be allowed as a deduction, and must be paid or incurred in connection with performing services as an employee of the employer;
- Each reimbursed expense must be adequately accounted for to the employer within a reasonable period of time; and
- Any amount in excess of actual expenses must be returned by the employee within a reasonable period of time.
If any one of these requirements is not met, reimbursements will usually be treated as if made under a non-accountable plan. That makes them subject to income tax withholding and employment taxes.
The requirement that the expense must be paid or incurred in connection with the employee’s performance of services for the employer might seem to be satisfied in every case. However, the regulations cross-reference the business expense rules, and therefore have limits. An arrangement will satisfy the business connection requirement if it provides advances, allowances, or reimbursements only for business expenses that are allowable as deductions, and that are paid or incurred by the employee “in connection with the performance of services as an employee of the employer.” Thus, this requirement will not be satisfied if the builder reimburses the employee, regardless of whether the employee incurs deductible business expenses.
An employee who doesn’t file a reimbursement claim will still have the option of claiming a tax deduction for unreimbursed business expenses on his or her tax return. However, that only works if the worker itemizes deductions and then it is unlikely that the full amount of the tools and equipment purchased will be recovered.
If an employee files a reimbursement claim later than the plan’s rules allow, any reimbursement made to him will count as taxable income. That hurts both the building business and the employee—the employee because payroll and income taxes must be deducted from the reimbursement, and the business because it’s now responsible for the employer share of payroll taxes on the reimbursement.
If an IRS audit detects a pattern of improper reimbursements, it could determine the plan no longer qualifies as “accountable,” and the business could be held responsible for paying withholding taxes on all reimbursements, not to mention the penalties associated with any violations.
For general contractors that rely heavily on subcontractors, it is appropriate to reimburse them for tools they purchase to work on one of the company’s projects. However, contractors should include reimbursements to subcontractors as income on the Form 1099 provided each tax year, and make it the subcontractor’s responsibility to deduct the tool purchase as a business expense on Schedule C of its tax return.
Unfortunately, many of the tool and equipment plans currently being marketed do not meet the IRS’s requirements for tax-favored accountable plans despite their claims to the contrary. Often the lack of substantiation requirements fail to ensure that only expenses incurred for that employer are included in the plan.
In fact, the IRS is focusing on the many plans being marketed that are designed and operated around a structure that re-characterizes a portion of the employee’s existing pay as a “reimbursement” for the employee’s tools merely to generate tax savings for both the employer and the employee. In other words, the employee continues to receive the same gross pay but what was previously paid as taxable compensation is re-characterized as nontaxable reimbursement until the employee’s alleged tool costs have been recovered, then the employee returns to his original amount of taxable compensation. The accountable plan rules make clear that amounts paid, whether or not there are expenses incurred, are not reimbursements and are not eligible for tax-favored treatment.
Who pays for tools and equipment also tends to be a hot button item when deciding whether a worker should be treated as an employee or as an independent contractor. The fact that workers supply their own tools and equipment does not make them independent contractors.
If the worker is an employee, the question is whether the company’s reimbursement for necessary tools and supplies will be income or wages to the employee. Both the building business and the worker would prefer to have the payment treated as a straight reimbursement, not income to the employee. The reimbursement would not be included as part of the employee’s reportable pay.
Obviously, it can be very important who pays for the tools and equipment. However, when an employer pays for or reimburses an employee for tools and supplies, far too often neither the builder nor the worker consider how the reimbursement should be treated for tax purposes. Both should.
Every builder and contractor that requires employees to provide their own tools, even those employing third-party plans, may want to seek professional help in understanding the tax law’s requirements. After all, the IRS is watching.
Mark Battersby is an expert in tax and financial matters. With more than 30 years experience in small business issues, he lectures and writes extensively on business topics. Contact him at 610-789-2480 or MEBatt12@earthlink.net.