Editor’s Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.

RESEARCH TRIANGLE PARK, N.C. – Normally, employees are not subject to income or employment taxes when their employers reimburse them for business expenses. The IRS, however, has found that in some circumstances, employers are reimbursing employees too much, without adequate proof that the employees incurred the expenses.

In many cases, this is unintentional, but sometimes it can be abusive, such as when a company knowingly or negligently pays employees too much, so that the employee gets tax-free compensation while the employer has a tax deduction. As a result, starting January 1 employees receiving per diem expense reimbursement allowances may end up paying taxes on those allowances unless their employers are careful about how they manage and track their reimbursement plans.

Employers can reimburse their employees for business-related travel expenses in many ways. Some employers require actual receipts for reimbursement—in other words, they expect employees to substantiate their expenses. Others reimburse employees on a per diem basis, paying their employees X dollars per day when out of town on business, without requiring specific substantiation of the expenses. Some employers use a mix of the two methods, paying a per diem without requiring substantiation, but insisting on receipts for any payments above the per diem amount.

Expenses Can Be Reimbursed Under Accountable Or Non-accountable Plans

Under federal tax law, employers are allowed to reimburse employees who are traveling on business up to the federal per diem rates without having to substantiate those expenses. Employers can choose one of two methods for doing this during the year—the High-Low Method or the Regular Method.

Under the Regular Method, employers can reimburse employees at the same rate the federal government reimburses its employees for travel to a particular destination; current rates are available from the . Under the High-Low Method, there is one rate for high-cost areas and another rate for low-cost areas. The IRS determines whether a specific destination is a high-cost area (such as Los Angeles or New York City) or a low-cost area (such as Napa, Calif., or Bar Harbor, Maine).

The low-cost per diem rate for lodging, meals and incidentals is $148, and the high-cost per diem rate is $248. Under either method, the employee only needs to provide information as to the time, place and business purpose of the trip in order to be reimbursed on a tax-free basis. This type of plan is called a non-accountable plan.

Alternately, employers can use what is called an accountable plan, in which an employee must substantiate all of their expenses by keeping detailed records, providing receipts, and returning any expense reimbursements that exceed actual, substantiated expenses. In this case, the employer can reimburse an employee for actual expenses and the reimbursement is not subject to tax.

All Plans Must Require Employees To Substantiate Certain Expenses

The IRS has realized that in a number of cases, employers with non-accountable plans are reimbursing employees in excess of the applicable per diem rate, without substantiation and without requiring the employees to return the excess payments. Accordingly, the IRS recently released guidance in which it highlights the fact that employers must track the amount of expense reimbursement allowances paid on a per diem rate.

The IRS has now stated, in Revenue Ruling 2006-56, that if employers routinely pay per diem allowances that exceed federal per diem rates without tracking the allowances and either requiring employees to substantiate all of their expenses or to return any expense allowances paid that are in excess of the allowable per diem, then the IRS is going to require the employers to include the expense reimbursement allowance in the employee’s W-2 income, thus making it subject to income tax and employment tax. It is worth noting that this ruling applies to the entire expense allowance, not just to amounts in excess of the federal per diem rates or amounts that are not substantiated.

In order to avoid an unhappy result at the end of the year—since hundreds of dollars a day in expense allowances can add up to a lot of money for a sales rep or other employee who is on the road a lot—employees who receive per diem allowances might want to check in with their managers to make sure that their company’s expense reimbursement plan is being managed to comply with the new revenue ruling.

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high-technology clients for more than 20 years. Amalie L. Tuffin concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, taxation and securities matters. Questions or comments can be sent to atuffin@d2vlaw.com