Picture this: You just settled in at your desk with your morning coffee. You see an email from Angela in Accounting about outstanding expense reports. Then, Sally in Sales asks you to approve a client dinner. And finally, your top performer is waiting on reimbursement for that industry conference they attended.
Meanwhile, you're asking yourself: “Wait. Which of these expenses am I legally required to pay back, and which ones will trigger tax headaches for everyone?”
If you’re nodding along to this scenario, you’re not alone. For small business owners, employee expense reimbursement can feel like one more administrative burden in an already packed day. But understanding how to handle these reimbursements correctly matters for your bottom line. And it matters for your team’s financial well-being.
In this article, we’ll break down what you need to know about expense reimbursements. We’ll examine your legal obligations and how to keep them tax-free. And we’ll outline practical systems to make the whole process less painful for everyone involved.
Employee Expense Reimbursement: What It Is and How It Works
Simply put, an employee expense reimbursement happens when your team members spend their own money on business-related costs, and you pay them back.
Common examples of reimbursable employee expenses include:
- Travel expenses (flights, hotels, meals)
- Mileage for business-related driving
- Professional development and education costs
- Office supplies purchased by remote workers
- Client entertainment expenses
You need a clear system for handling these reimbursements. Without one, you could face frustrated employees, unexpected tax liabilities, or even legal issues. That’s why it’s crucial to understand your options and obligations. So, let’s start with your legal obligations.
Are You Legally Required to Reimburse Employee Expenses?
This is where things get a bit complicated. Under the Fair Labor Standards Act (FLSA), an employer must reimburse work-related expenses if those expenses would bring an employee’s earnings below minimum wage.
For example, let’s say you have minimum wage employees who must purchase their own uniforms or tools. You’re typically required to reimburse those costs to maintain compliance with federal wage laws.
Beyond these minimum requirements, reimbursement obligations vary by state:
- California, Illinois, Massachusetts, and several other states have specific employee reimbursement laws.
- Other states follow the federal standard, which only requires reimbursement when it affects minimum wage compliance.
The best practice? Check your specific state laws and consult with an employment attorney if you’re unsure about your obligations.
Are Employee Reimbursements Taxable?
Here’s where you need to pay close attention. How you structure your reimbursement plan determines whether your employees will owe taxes on the money you pay them back.
The IRS recognizes two types of reimbursement plans: accountable plans and non-accountable plans.
Accountable Plans: The Tax-Friendly Option
An accountable plan meets three specific IRS requirements:
- Business Connection. Reimbursements must be for legitimate business expenses incurred while performing services for your company. For mixed-use items (like cell phones used for both personal and business purposes), you should only reimburse the business portion.
- Adequate Substantiation. Employees must submit receipts, invoices, or other records within 60 days to verify expenses. IRS Publication 463 outlines what qualifies as proper documentation. Some expenses don’t require receipts, such as non-lodging expenses under $75 or reimbursements based on IRS Per Diem rates.
- Refund of Excess Payments. If an employee receives more than they spent—such as a travel advance exceeding actual costs—they must return the extra funds within 120 days.
If your reimbursement plan follows these rules, payments are not considered taxable income and won’t be subject to payroll taxes.
Non-Accountable Plans: The Tax Headache
A reimbursement plan that doesn't meet the accountable plan requirements is considered non-accountable.
The disadvantages of a non-accountable plan?
- Reimbursements are considered taxable wages to employees.
- Payments are subject to income tax withholding and payroll taxes.
- Reimbursements must be included on employees’ W-2 forms.
- Both you and your employees pay more in payroll taxes.
In most cases, non-accountable plans create unnecessary tax burdens for everyone involved. Unless you have a specific reason for using this approach, an accountable plan typically makes more financial sense.
Implementing an Effective Employee Reimbursement System
Now that you understand the basics, here are practical steps to create a reimbursement process that works:
1. Create a Clear Expense Policy
Document expenses that are eligible for reimbursement. Include required documentation, submission deadlines, and the approval processes. Make this policy easily accessible to all employees.
2. Consider Per Diem Options
For travel expenses, using the IRS per diem reimbursement rates can eliminate the need for detailed meal and lodging receipts. While this can significantly reduce paperwork, keep in mind that standardized rates vary by location.
3. Leverage Technology
Expense management and mileage tracking apps simplify the submission, approval, and payment process. Consider apps like those from Ramp, Dext and MileIQ.
- Mileage tracking apps automatically record business travel.
- Receipt scanning features eliminate paper storage issues.
- Approval workflows keep everything moving efficiently.
4. Issue Company Cards for Regular Spenders
Sometimes businesses have employees who regularly incur business expenses. Offering company credit cards through a provider like Ramp can simplify the process even further. Just ensure you have proper controls and review processes in place.
Common Expense Reimbursement Pitfalls to Avoid
When managing expense reimbursements, watch out for these common mistakes:
- Inconsistent enforcement. Inconsistent reimbursement policies can hurt morale and lead to potential legal issues.
- Delayed reimbursements. Employees are essentially giving your business interest-free loans when they pay for expenses. Prompt reimbursement shows respect for their financial situation.
- Inadequate documentation requirements. Without proper receipts and business purpose details, you risk tax complications if you’re ever audited.
- Missing state-specific requirements. Some states have specific timelines and rules for reimbursing employee expenses. So, make sure to check your local regulations.
Making Employee Expense Reimbursements Work for Your Business
Managing employee expense reimbursements doesn’t have to be complicated. Start by understanding the distinction between accountable and non-accountable plans. Then, implement clear policies and leverage technology. This will allow you to create a system that protects both your business and your employees from unnecessary tax burdens.
Start by reviewing your current approach: Are you meeting the three accountable plan requirements? Could you simplify your process with per diem rates or expense management software? Making these improvements now can save significant headaches during tax season and beyond.
Now you understand how to structure an expense reimbursement plan, but maybe you'd rather have a payroll partner handle compliance for you. Check out our article “Should I Outsource My Payroll?” to see if it might be the right move for your business.
For more tips on building a better business, check out our One Step Better business podcast wherever you listen to podcasts.
Topics:
