The IRS recently issued a Coordinated Issue Paper that sets out its view of what constitutes an acceptable Employee Tool and Equipment Plan.
What Is Employee Tool & Equipment Plan ?
An Employee Tool and Equipment Plan is an agreement between an employer and one or more of its employees to reimburse the employee for the use of the employee’s tools and equipment. The idea is that a portion of the compensation paid to the employee is for use of his tools and equipment and, therefore, that portion is not taxable wages to the employee.
In addition to saving the employee federal income taxes, the employer would not have to withhold employment taxes on that portion of the employee’s compensation. As the IRS’s Coordinated Issue Paper points out, taxpayers can achieve this tax result by structuring the Employee Tool and Equipment Plan as an “Accountable Plan” pursuant to Code Sec. 62(c).
To qualify as an Accountable Plan, the Plan must meet some very minimal requirements. Specifically, the Plan must be for expenses connected to the employer’s business, require the employee to substantiate the expense, and provide that the employee must return any amount in excess of the amount of the expense that is substantiated.
The IRS Coordinated Issue Paper is directed at the Motor Vehicle Industry. It addresses tools purchased by employees in this industry. Accountable Plans can be used by taxpayers in other industries and for expenses for items other than tools.
The IRS Coordinated Issue Paper is also directed at Employee Tool and Equipment Plans that are “marketed” to employers. The Paper explains how the IRS will view these marketed plans. Assuming that the plans meet these IRS requirements, it appears that more taxpayers should be taking advantage of this tax savings opportunity.
Revenue Ruling 2005–52
Employee Tool and Equipment Plans are described in Rev. Rul. 2005-52. The ruling addresses a plan for an auto repair business. The auto repair business pays its auto techs an hourly rate and an add on rate for use of their tools. The amount of the “tool allowance” was based on an estimate.
The IRS concludes that the plan in the ruling fails the substantiation and the return of excess requirements and thus does not qualify as an accountable plan. The IRS reasoned that the substantiation and return of excess requirements must be based on expenses actually incurred.
Given this ruling and the IRS’s focus on Tool and Equipment Plans, those who use these plans should ensure that the plan only reimburses actual amounts the employee spent and requires the employees to substantiate the amounts spent.
While not addressed in the ruling, the plan should also be limited to those expenses incurred for tools for the employer. A plan that allows reimbursement for tools purchased prior to working for the employer or that are not actually used in the employer’s business could fail the business connection requirement.
If the accountable plan rules are met, an Employee Tool and Equipment Plan can save income and employment taxes. Those employing these plans should consider the language of the plans. This is particularly true as the IRS intends to review these plans.