Expense accounts, also called expense allowances, are plans under which companies reimburse employees for business-related expenses. These expenses include travel, entertainment, gifts, and other expenses related to the employer’s business activity. Of particular interest to businesses and their employees is the tax treatment of business-related expenses, the types of expenses for which employees will be reimbursed, and the manner in which those reimbursements are made.
For tax purposes a company’s expense account plan is either accountable or nonaccountable. An “accountable” plan must meet the certain requirements of the Internal Revenue Service: there must be a business connection; expenses must be substantiated (usually through a receipt); and any amount received by an employee in excess of actual expenses must be returned to the employer. Substantiation means that the employer must be able to identify the specific nature of each expense and determine that the expense was business-related.
Expenses may not be aggregated into broad categories, and they may not be reported using vague terminology. If the company’s plan is in fact an accountable plan, then all money received by an employee under the plan is excluded from the employee’s gross income. It is not reported as wages or other compensation, and it is exempt from withholding.
Companies that fail to require employees to substantiate their expenses or allow employees to retain amounts in excess of substantiated expenses are considered by the IRS to have “nonaccountable” plans. Funds employees receive under nonaccountable plans are treated as income, subject to withholding, and such expenses are deductible by the employee only as a miscellaneous itemized deduction. Even then, the expenses are deductible only if they exceed 2 percent of the employee’s adjusted gross income.
The tax laws affecting business-related expenses change at intervals as the IRS revises its regulations based on its own experience; changes are almost yearly. In 1994, for example, deductions for meal expenses were reduced from 80 percent to 50 percent. But then, in 2000, the IRS changed restaurant rules again, requiring receipts for meals only if the meals cost $75 or more; in 2002 the IRS changed per-diem deduction rules.
Changes are also triggered by the passage of new legislation. The corporate scandals (Enron, WorldCom) have resulted in important legislation, the Sarbanes-Oxley Act of 2002, which requires much closer tracking and recordkeeping by publicly traded corporations. Sarbanes-Oxley is unlikely to affect most small businesses, but fall-out in the form of tightened record-keeping requirements or revised per-diem rates permitted by the IRS have to be watched.
For this reason, it is in the best interests of both employer and employee that all affected parties have a complete understanding of expense accounts and reimbursable expenses. Employees who find that they are incurring business-related expenses need to determine from their employer exactly what types of expenses are reimbursable, and companies—especially small business owners—need to make sure that employees do not take advantage of expense account policies with excessive spending on lodging, food, and entertainment—never mind fraudulent reporting thereof. In an effort to control spiraling travel and other business-related expenses, some companies have developed reimbursement policies that spell out in detail the various travel expenses that qualify for reimbursement.
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Specific Expense Account Policies For The Small Business
Small business owners are encouraged to carefully document all business-related expenses, both for tax purposes and to minimize their exposure to expense account fraud by employees (this type of fraud cost American businesses an estimated $600 billion in 2002 according to the Association of Certified Fraud Examiners, up from $400 billion in 1996). Specific steps and policies that should be considered include: 1. Establish strong internal control systems for tracking expense accounts and activities. These systems include written policies for expense reporting and reimbursement, including what can and cannot be expensed, regular schedules for submitting expense account reports, and original documentation requirements (receipts) for confirmation of expenses.
2. Institute report procedures to verify legitimacy of submitted expenses. Steps that can be taken in this regard include uniform standards for review of expense reports, comparisons of year-to-year costs, comparisons of submitted mileage expenses with actual mileage information for areas traveled (which can be obtained easily via various Internet travel sites).
3. Establish and maintain careful hiring practices, including comprehensive background/reference checks, before hiring new employees. Companies that take the extra effort to find quality employees for their work force are less vulnerable to fraudulent activity.
4. Be careful not to institute unreasonably stingy policies. Expense accounts, if left unmonitored, can develop into a significant source of income loss for small businesses. But owners and managers should also realize that today’s competitive business environment requires many companies to devote considerable financial resources to entertaining clients and business partners in order to ensure a stable and positive relationship.