The tax treatment of tool reimbursement plans has long been a point of contention for businesses that require employees to provide their own tools. In many instances, motor service technicians who work for dealerships or auto repair or body shops must supply their own tools and keep them on site at their employer’s business location. As a result, many employers split the employee’s compensation into two parts—wages and tool reimbursements. Without much success, automobile repair shops and other businesses have long sought to have such plans classified as accountable plans. Now, in Letter Ruling 200930029, the IRS has shown a pathway for obtaining that tax-favored status. Those hoping for a little relief from the burdensome substantiation requirements, however, will be disappointed.
Typical Tool Reimbursement Plans
Tool reimbursement plans are not a new phenomenon. They are commonly used in car and truck repair and body shops, but they are also found in other types of businesses that combine skilled labor and tools. The employer can administer these plans, but they are often run by a third party.
In many tool reimbursement plans, an employee’s compensation is divided into two parts: one part treated and taxable as wage compensation, and the second part treated as a nontaxable reimbursement for the cost of tools used. The employee may (or may not) receive two checks for the two parts of the compensation. When a tool reimbursement plan is adopted, there is often no change in the employee’s total compensation—just a recharacterization of part of the payment.
Employers (or third-party administrators) use a variety of methods to determine the amounts to be paid to employees under tool reimbursement plans. Sometimes they will try to determine the actual cost of employees’ existing tools when they begin the plan; sometimes they will estimate the replacement cost of employees’ tools; and sometimes they will rely on surveys to determine the expected cost and replacement interval for tools used by employees in the industry. Other costs such as insurance and tool maintenance costs may be considered.
When employees start the plan, their regular pay is reduced by the amount paid as a tool allowance. If the total annual tool allowance is paid before the end of the year, the employees’ regular pay is then increased until the end of the year, so their total gross compensation remains the same. The only difference is that amounts identified as tool reimbursement allowances are purported to be nontaxable and not subject to payroll taxes, while the regular pay is fully taxable. Treating tool reimbursements in this way attempts to save taxes for both employers and employees.
Overview of the Relevant Provisions
Sec. 62(a)(2)(A) provides that in arriving at adjusted gross income, a taxpayer may deduct certain employee business expenses incurred “under a reimbursement or other expense allowance arrangement with his employer.” Sec. 62(c) further provides that the arrangement will not be considered a reimbursement or other expense arrangement if it does not require the employee to substantiate the expenses to whoever makes the reimbursement or if it allows the employee to retain reimbursements in excess of the amount of expenses substantiated. Regs. Sec. 1.62-2(c)(1) states that for the arrangement to be considered an accountable plan, it must meet the requirements of (1) business connection, (2) substantiation, and (3) return of payments in excess of expenses. The business connection requirement is partly described in Regs. Sec. 1.62-2(d)(1), which provides that advances, allowances, or reimbursements have a business connection if they are for deductible business expenses “paid or incurred by the employee in connection with performance of services as an employee of the employer.”
The practical difference between an accountable plan and a nonaccountable plan is also described in Regs. Sec. 1.62-2(c)(4). Payments received under an accountable plan are excluded from the employee’s gross income. They are not included on an employee’s Form W-2 and are not subject to payroll taxes. Amounts received under a nonaccountable plan, however, are included in gross income, are reported on the employee’s W-2, and are subject to payroll taxes.
Problems with Typical Tool Reimbursement Plans
For a number of years the IRS has considered tool reimbursement plans to be nonaccountable. It explained its position in a 2000 industry specialization program coordinated issue paper on the motor vehicle industry (Service Technician Tool Reimbursements (7/21/00)). The IRS revised the paper in 2008 (Motor Vehicle Industry Employee Tool and Equipment Plans, LMSB-04-0608-037 (7/2/08)). Both versions concluded that tool reimbursement plans typically administered by dealerships and repair shops fail all three requirements for accountable plans. As a result, payments under such plans are fully taxable and are subject to payroll taxes.
In part, the 2000 and 2008 coordinated issue papers followed the logic in Shotgun Delivery, Inc., 85 F. Supp. 2d 962 (N.D. Cal. 2000), aff’d in part and rev’d in part, 269 F.3d 969 (9th Cir. 2001). The taxpayer, a courier service, paid expense reimbursements to its employee drivers on the basis of revenues generated (customers were charged a tag rate) without regard to the number of miles driven or the amount of expenses incurred. As a result, the court ruled that Shotgun’s reimbursement plan failed the business connection requirement. The reimbursement plan did not correlate with expenses employees incurred or reasonably expected to incur.
The 2008 paper also referred to Rev. Rul. 2005-52, in which an employer provided a tool allowance to employees based on a combination of annual employee questionnaires and national survey data on employee tool usage. However, the employees were not required to substantiate their actual expenses, and they were never required to return any part of their tool allowance. Consequently, the plan failed the substantiation and return of excess requirements.
In a similar fashion, typical tool reimbursement plans fail the business connection requirement. In most tool plans the reimbursement is based on the value of the employee’s tool inventory. As a result, there is no logical relationship between the amount paid as a tool allowance and the amount of actual tool-related expenses an employee incurs. The reimbursement does not consider the tools’ actual cost, history of purchases, depreciation, etc. Amounts paid to reimburse a new employee for an existing tool inventory do not qualify because the cost of that inventory was not incurred while the employee worked for the employer. In addition, amounts paid to employees as tool rental charges do not qualify because tool rental charges are not employee expenses.
Furthermore, Regs. Sec. 1.62-2(d)(3)(I) provides that a business connection is not established “if a payor arranges to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) business expenses.” Tool reimbursement plans do just that when they reclassify wages as tool reimbursements (and then sometimes reclassify them again back to wages) with no change in total compensation. As a result, they fail the business connection requirement.
Typical tool reimbursement plans also fail the substantiation requirement. Tool reimbursement plans do not generally involve listed property, so the more rigorous substantiation requirements of Sec. 274(d) do not normally apply. Nonetheless, Regs. Sec. 1.62-2(e)(3) provides that substantiation requires that information “submitted to payor [is] 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. Therefore, each of the elements of an expenditure or use must be substantiated to the payor.” In addition, Regs. Sec. 1.162-17(b)(4) requires the submission of “an expense account or other required written statement to the employer showing the business nature and the amount of all the employee’s expenses.” These rules require identification of cost, date of acquisition, business use, etc. Typical tool plans do not satisfy this requirement. Reimbursements based on tool value or cost estimates do not substantiate the actual cost incurred. Such methods provide no evidence that the employee had any expense at all. Items in an employee’s inventory may have been previously reimbursed or expensed. Even if substantiation is required for new tool purchases, reimbursements to cover the cost of an existing tool inventory are not considered substantiated.
Typical tool plans also fail the requirement to return the excess reimbursement. Because such plans do not generally require substantiation, there is no return of unsubstantiated reimbursements.
The Approved Plan
In Letter Ruling 200930029, the employer designed the tool plan in question for technicians who work on tools and equipment the employer sells. Technicians provide and exclusively use their own tools. The tool plan provides reimbursements to technicians for deductible tools, equipment, and training (certifications) related to their work for the taxpayer. The tool reimbursements are completely unrelated to compensation.
Each year the employer creates a budget amount for the tool reimbursement plan. The employer may stop the plan or reduce the tool reimbursement budget at any time. Each technician is eligible for and is notified of a specific maximum potential reimbursement amount based on his or her expected needs.
Only qualified employees can participate in the plan. They must work for the employer for at least 30 days, and they must complete a certification form, which explains the terms of the plan, such as the types of expenses reimbursed and the requirements of the plan. Employees must certify that they understand and agree to the terms.
The plan reimburses only costs incurred by a technician after becoming a qualified employee. Covered costs include such items as tools, equipment, uniforms, supplies, and training directly related to the taxpayer’s business. The plan will not reimburse for tools obtained prior to becoming a qualified employee or for depreciation on such tools. Furthermore, the plan will not reimburse the employee for tools not exclusively used for the employer’s business, not maintained at the employer’s business, not needed for job assignments, not purchased from an approved vendor, or not considered necessary in the industry.
To receive a reimbursement, technicians must submit a claim form on which they certify that:
- The expense is required to fulfill their job assignments;
- The item will be used only on job assignments for the employer;
- The item was acquired from the approved vendor list;
- They will not seek reimbursement from any other source;
- They will not claim the expense as a tax deduction;
- They understand the plan; and
- The information provided is correct and complete.
The technicians must also identify the job assignments for which the item will be required. The technicians’ manager must also certify the correctness of those job assignments and that the item will be used only for the benefit of the employer’s business. Proof of purchase—invoice, receipt, etc.—must be attached.
Employees must submit claims within 30 days of purchase. The claims may be partly or fully denied because of incomplete documentation or ineligibility of expenses. Only reimbursements are made; there are no advances or allowances. The employee must return reimbursements made in error within 30 days and must repay any reimbursements paid during the last six months of employment at the time of separation.
The IRS has now stipulated a set of requirements that, if incorporated into a tool reimbursement plan, will likely result in accountable plan status. For those seeking to minimize the administrative burden of such a tax-favored plan, however, this ruling is not much help. The provisions incorporated into the approved plan appear to go beyond the minimal requirements identified in the Code and regulations. Nonetheless, the IRS seems to have provided a safe-harbor path for achieving accountable plan status for a tool reimbursement plan.
Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or email@example.com.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.