IRS Illustrates Employee Reimbursement Plans

By Deborah Spyker, CPA, M.Tax., Denver, and Mary Gorman, CPA, J.D., Washington, D.C.

Editor: Michael Dell, CPA

Gross Income

The IRS and the Tax Court have historically resisted the characterization of concurrent salary reduction and expense allowance or reimbursement arrangements as accountable expense reimbursement arrangements for purposes of Sec. 62, on the basis that such transactions improperly reduce wages subject to income and payroll taxes and allow employees to escape the deduction limitation on nonreimbursed employee business expenses (see, e.g., Lickiss , T.C. Memo. 1994-103).

Now, in Rev. Rul. 2012-25, the IRS has described four situations where employers have recharacterized taxable wages as nontaxable business expense reimbursements and has ruled on whether these arrangements satisfy the business connection requirement of the accountable plan rules.


Sec. 62(a)(2)(A) allows a deduction for certain business expenses paid by an employee in connection with the performance of services for an employer under a reimbursement or other expense allowance arrangement. However, under Sec. 62(c), an arrangement is not treated as a reimbursement if (1) the arrangement does not require the employee to substantiate the expenses, or (2) the arrangement provides the employee the right to retain any amount in excess of the substantiated expenses.

Regs. Sec. 1.62-2(c) states that if a reimbursement arrangement meets the requirements of business connection (described below), substantiation, and returning amounts in excess of substantiated expenses, all amounts paid under the arrangement are treated as paid under an accountable plan. As such, the amounts are excluded from the employee’s gross income, are exempt from withholding and payment of employment taxes, and are not reported as wages on the employee’s Form W-2, Wage and Tax Statement . However, if the arrangement fails any of the three requirements, the arrangement is treated as a nonaccountable plan. Accordingly, the amounts are included in gross income, are subject to employment tax, and must be reported on the employee’s Form W-2.

Under the business connection requirement, the employee must pay or incur a deductible expense, and the expense must arise in connection with the employee’s performance of services for the employer (Regs. Sec. 1.62-2(d)(1)). In addition, the business connection requirement is not satisfied if an employer pays an amount to an employee regardless of whether the employee actually incurs or is reasonably expected to incur deductible business expenses (Regs. Sec. 1.62-2(d)(3)(i)). This type of arrangement is known as “wage recharacterization” because the payment is not a business expense reimbursement but rather a substitute for an amount that would otherwise be paid as wages.

Analyzing previous rulings and legislative history, the IRS explained that the presence of wage recharacterization is based on the totality of the facts and circumstances. Generally, wage recharacterization is present when the employer structures compensation so that the employee receives the same or a substantially similar amount whether or not the employee incurs deductible business expenses related to the employer’s business.

Four Situations

The IRS illustrated these rules through four examples and ruled in all but one case (Situation 4) that, under the facts presented, the recharacterization of wages as a business expense reimbursement did not satisfy the business connection requirement.

Situation 1: Employer A employs cable television technicians. Because Employer A requires the technicians to supply their own tools, it has historically taken that into account in determining the technicians’ hourly compensation rates. However, Employer A decides to begin a tool reimbursement arrangement. Under the plan, employees provide Employer A with an amount equivalent to their tool expenses for the year. Employer A divides the amount of the expenses by the number of hours the employee is expected to work in the year and then recharacterizes a portion of the employee’s hourly rate as a business expense reimbursement. Although employees substantiate their actual tool expenses, and those expenses are tracked against the annual amount, once employees reach that amount, Employer A reverses the recharacterization to restore their hourly compensation to the rate before the reduction for tool expenses.

The IRS ruled that Employer A ’s plan does not satisfy the business connection requirement because it pays the same amount to a technician regardless of whether the technician incurs (or is reasonably expected to incur) expenses related to Employer A ’s business. The plan ensures that each technician receives approximately the same gross hourly amount by substituting a portion of what was paid as taxable wages with a tool rate amount that is treated as a nontaxable reimbursement. Accordingly, the arrangement is merely a recharacterization of wages.

Situation 2: Employer B employs nurses to work at various hospitals on short-term assignments. It compensates the nurses on an hourly basis the same amount regardless of whether the nurses have to travel away from home to work at a hospital. However, when the nurses are required to work away from home, Employer B treats a portion of the nurses’ hourly compensation as a nontaxable per diem.

The IRS ruled that Employer B’s plan does not satisfy the business connection requirement because it pays the same amount to nurses regardless of whether they incur (or are reasonably expected to incur) travel expenses related to Employer B’s business.

Situation 3: Employer C employs construction workers, some of whom are required to travel between construction sites using their personal vehicles for business purposes. On top of their taxable hourly wages, Employer C pays all of its workers, including those who are not required to travel, a flat amount per pay period that Employer C treats as a nontaxable business mileage reimbursement.

The IRS ruled that Employer C’s mileage reimbursement plan does not satisfy the business connection requirement because it pays mileage reimbursement even to workers who have not incurred (and are not reasonably expected to incur) deductible business expenses in connection with Employer C’s business. Accordingly, the purported business mileage reimbursement is merely recharacterized wages.

Situation 4: Employer D employs housecleaning professionals who are required to provide their own cleaning products and equipment. It compensates its employees on an hourly basis, taking into account the fact that they have to supply their own equipment. Employer D decides to start using a reimbursement arrangement. Accordingly, Employer D alters its compensation structure by reducing the hourly compensation paid to all employees. Under the new reimbursement arrangement, employees can substantiate to Employer D the actual amount of deductible expenses incurred in purchasing their equipment in connection with performing services for Employer D . Any reimbursement under the arrangement is paid in addition to the hourly compensation. Employees who do not incur expenses for equipment in connection with their jobs, or who do not properly substantiate such expenses, continue to receive the lower hourly compensation and do not receive any reimbursement or other compensation to substitute for the reduced wages.

The IRS ruled that Employer D’s reimbursement arrangement satisfies the business connection requirement because it reimburses employees only when a deductible business expense has been incurred in connection with performing services for Employer D, and the reimbursement is not in lieu of wages that employees would otherwise receive. Although Employer D has reduced the amount of compensation it pays all of its employees, the reduction is a substantive change in the compensation structure. Under the arrangement, reimbursement amounts are not guaranteed, and employees who do not incur deductible business expenses or who do not properly substantiate such expenses continue to receive the reduced hourly compensation.


Given that the IRS has long maintained its current position concerning wage recharacterization business expense reimbursement schemes, it is likely the recent revenue ruling reflects concern about continuing noncompliance. For this reason, employers that maintain compensation arrangements that are variable, based on reimbursed business expenses, need to carefully review these plans to ensure that they will not be viewed as a recharacterization of wages.


Michael Dell is a partner with Ernst & Young LLP in Washington, D.C.

For additional information about these items, contact Mr. Dell at 202-327-8788 or

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.