Tax Considerations on Expense Reimbursements

This article originally appeared in the February 2018 issue of PIA Magazine and has been updated to reflect current events.

Whether you are an insurance agency shareholder, partner, employee, or independent agent, you need to be aware of the tax treatment of reimbursed and unreimbursed business expenses. Like most businesses, agencies typically reimburse employees for ordinary and necessary business expenses. Therefore, expense reimbursements may be treated as taxable income subject to federal income and employment taxes, depending on the circumstances.

Ordinary expenses are common business expenses incurred in most insurance agencies. However, necessary expenses are helpful to conducting business. Examples include travel, lodging, meals, gifts, automobile expenses, home office expenses, promotional expenses (e.g., advertising, brochures, and other materials), malpractice insurance premiums, continuing education, and certifications, as well as professional association membership dues.

For an agency to deduct expenses on its income tax return, the expenses must be both ordinary and necessary business expenses. In other words, the expense must be common and accepted in your business and must be helpful and appropriate for your business.  However, an expense does not have to be required to be considered necessary.

The tax treatment of reimbursed and unreimbursed business expenses depends on many factors, including:

Type of expense reimbursement plan. An agency can have an accountable or nonaccountable expense reimbursement plan. To qualify as an accountable plan, the IRS requires:

• The agency to pay for only deductible business-related expenses;
• Employees to substantiate business expenses in a timely manner (within 60-days) by submitting documentation such as an expense report, travel log, or receipts; and
• Employees to return reimbursements that exceed substantiated expenses to the employer (within 120 days after the expense was paid or incurred).

Generally, the agency can deduct reimbursement expenses (for the period of January 1, 2021, through December 31, 2022, the deduction for business meals provided by restaurants has been expanded to 100%) in an accountable plan. Reimbursements made under an accountable plan are excluded from a taxpayer’s gross income for federal and employment purposes.

A nonaccountable plan does not require employees to substantiate business expenses or return reimbursements that are more than the expenses incurred. Although the agency can still deduct nonaccountable business expenses, employee reimbursements are considered income for the employee and must be reported on the taxpayer’s Form W-2.

Under-reimbursed expenses. If an employee’s actual expenses are more than the amount reimbursed by the employer, the employee can no longer deduct the unreimbursed expenses as an itemized deduction.  The elimination of the deduction for unreimbursed employee business expenses was one of the most significant changes under the Tax Cuts and Jobs Act of 2017.

Payroll deductions. If an agency incorrectly reports all or part of expense reimbursements under an accountable plan as income to the employee, both the agency and employee will overpay payroll withholding taxes. The employee should ask for a corrected Form W-2 or take an above-the-line deduction in the amount of the reported income. The taxpayer also can file Form 843 (Claim for Refund and Request for Abatement) for employment tax overpayments.

Per-diems exception. An employer may reimburse employees using a per-diem rate for travel-related expenses. Per diems may be treated as expenses under an accountable plan, even if documentation is not required for the amount reimbursed. However, the employee must substantiate the time, place, and business purposes related to the expenses. If per diems are higher than the federal rate, the excess must be treated as employee compensation subject to federal income and employment taxes.

S corporation shareholders. The shareholders can no longer deduct unreimbursed business expenses paid by S corporation shareholders as miscellaneous itemized deductions.

Unreimbursed partner expenses. Deductible expenses paid by partners are reported on Schedule E and reduce taxable income and the self-employment tax. The deduction is not allowed unless the partner substantiates the:

• Amount of the expense;
• Time and place of the expense;
• Business purpose of the expense; and
• Business relationship to the partner of the persons involved.

If a partner was reimbursed or would have been reimbursed by the partnership for the expenses, a deduction cannot be taken.

Partnership agreements. Generally, the terms of a partnership agreement will determine if a partner can deduct unreimbursed expenses paid with personal funds on their individual return. However, if a partnership agreement does not provide direction on the treatment of partner expenses, the partnership’s standard reimbursement policy can be considered in determining the deductibility of expenses paid personally by partners.

Partnership non-reimbursement policies. If a partnership agreement includes a non-reimbursement policy for certain expenses incurred outside of the partnership or for expenses that partners are not required to pay, a deduction may be disallowed at the partner level.

Independent agents. The treatment of travel, meal, and entertainment expense allowances for independent agents depends on whether documentary evidence (e.g., receipts, canceled checks, and bills) is submitted to the agency. If so, the agency generally can deduct such expenses as business expenses (for the period of January 1, 2021, through December 31, 2022, the deduction for business meals provided by restaurants has been expanded to 100%; entertainment expenses are not deductible). The agency must keep separate records on the details of these expenses. It does not have to file an information return to report travel and entertainment expense reimbursements.

If the independent agent does not submit documentary evidence on travel and entertainment expenses, the agency is not required to keep separate records. Instead, it is up to the independent agent to do so. The agency would deduct the travel and entertainment expenses and other fees paid to the independent agent as nonemployee compensation. The agency is not subject to any disallowance rules for meals or entertainment expenses in this situation.  The limitations would, however, apply to the independent agent. The agency is required to file Form 1099-NEC (Nonemployee Compensation) to report nonemployee compensation of $600 or more during the calendar year.

There are many other things to consider when reporting reimbursed and non-reimbursed expenses. It is always advisable to consult a tax professional to ensure that you comply with federal and employee tax laws.

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©2021 Klatzkin & Company LLP. The above represents our best understanding and interpretation of the material covered as of this post’s date. The content is provided for informational purposes only and does not constitute accounting, tax, or financial advice. Please consult your advisor concerning your specific situation.