A hardy perennial, among amateur tax avoidance schemes, is claiming that an employee’s wages are nontaxable reimbursements of business expenses. In its most transparently bogus form, workers submit receipts for their expenses, the employer reimburses them through accounts payable, and their payroll wages reported on Form W-2 are reduced by an equal amount. As a result, the employer saves money on employment taxes, and the recipients can deduct employee business expenses in full, without being subject to the 2% floor on that deduction.

The IRS has issued many pronouncements with regards to variations on this theme, asserting that they violate the rules for “accountable plans” (IRC, §62(c)), which are the proper vehicle for expense reimbursements. Revenue Ruling 2012-25 (9/10/12) discusses three questionable arrangements:

  1. A cable TV company requires installers to furnish their own tools and pays them “tool allowances”. To receive the tool allowance, the worker must substantiate his expenses. If the substantiated expenses are less than the tool allowance, the employer pays additional taxable wages to make up the difference.
  2. A hospital staffing contractor sends nurses on assignment to a wide variety of locations. If the work location is beyond commuting distance of the nurse’s home, she receives a per diem allowance to cover deductible lodging, meals and incidental expenses. If the location is closer to home, there is no per diem, but the employer pays a higher wage rate. In either case, the total pay (wages plus per diem) is approximately the same.
  3. Construction workers use their personal vehicles to travel between construction sites. The employer pays them a flat “mileage allowance” that does not vary with automobile usage. (Though the ruling does not mention it, the employer presumably adds the allowance to W-2 wages to the extent that it is not supported by actual work mileage.)

In each case, the employee’s gross pay does not vary with his deductible business expenses. Hence, in the IRS’s view, the arrangements fail one of the conditions for an accountable plan: reimbursements must have a “business connection” with the expenses that are purportedly reimbursed. If pay remains the same regardless of the expenses incurred, there is a mere attempt to escape taxation by recharacterizing wages after the fact. The ruling summarizes the general principle thus:

The presence of wage recharacterization is based on the totality of 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 has incurred deductible business expenses related to the employer’s business. Wage recharacterization may occur in different situations. For example, an employer recharacterizes wages if it temporarily reduces taxable wages, substituting the reduction in wages with a payment that is treated as a nontaxable reimbursement and then, after total expenses have been reimbursed, increases taxable wages to the prior wage level. Similarly, an employer recharacterizes wages if it pays a higher amount as wages to an employee only when the employee does not receive an amount treated as nontaxable reimbursement and pays a lower amount as wages to an employee only when the employee also receives an amount treated as nontaxable reimbursement. An employer also recharacterizes wages if it routinely pays an amount treated as a nontaxable reimbursement to an employee who has not incurred bona fide business expenses.

There is nothing new or striking in this ruling. Its issuance reflects the fact that a bevy of fast buck artists persistently reinvent these ideas and sell them to unsuspecting employers.