Prior to the Tax Cuts and Jobs Act (“TCJA”) of 2018, it was common for employers to simply pay employees more and leave it to the employees to deduct their employee business expenses on their personal income tax returns.
The TCJA limited the employee’s ability to deduct employee business expenses. Many employers responded by adopting accountable plans. These plans allow businesses to deduct the expenses that their employees can no longer deduct themselves.
An accountable plan is a simple solution. It is one that most employers can implement by simply using a form or language found on the internet.
But accountable plans can and should be tailored to the taxpayer’s circumstances and the applicable rules. The accountable plan rules are more complex than one might think.
The recent Davidson v. Commissioner, T.C. Memo. 2020-58, court case provides an example of this. It helps explain the nuances of employee tool and equipment plans, which are one use of accountable plans.
Facts & Procedural History
This case involves an experienced tax attorney who spent several years working with employee tool and equipment plans. He worked for an accounting firm that provided written guidance for a tool and equipment plan. He then started working for the company that promoted the plan.
The tool and equipment plan was modified over time and the tax attorney received written guidance from various other tax attorneys and accounting firms over time. The guidance was not favorable.
Eventually, the IRS audited a number of clients who used the tool plans. This eventually led to tax shelter promoter penalties being imposed on the tax attorney.
While the tax promoter penalties were at issue in the tax litigation, the court explained the substantive rules for accountable plans. That is the focus of this article.
The Accountable Plan Rules
An accountable plan is simply a document or company policy that explains what expenses a business will reimburse its employees for.
According to I.R.C. § 62, to qualify as an accountable plan, the written document must provide that:
- expenses that have a business connection,
- expenses to be substantiated by the employee within a reasonable time period, and
- the employee return to the employer of amounts exceeding the employee’s actual expenses.
If the document complies with these rules then:
- the amounts paid to the employee are not counted as income for the employee for income or employment taxes and
- the expenses are deductible by the employer.
We are going to focus on employee tool and equipment plans in this article, but know that accountable plans can cover just about any deductible expense reimbursed by employers.
The business connection requirement is just that the expense that is reimbursed have some connection with the performance of services as an employee of the employer.
The court addressed the business connection requirement in the context of tools purchased prior to the start of employment. The court notes that:
Client-employees were instructed to, and did in fact, include on their enrollment forms the acquisition costs of tools that were unrelated to their work or purchased in years before their current employment.
The court concludes that this practice is directly inconsistent with the business connection requirement of the accountable plan rules. It cites the regulations in support of this holding. The regulations say that the plan has to cover expenses “that are paid or incurred by the employee in connection with the performance of services as an employee of the employer.”
Given this court case, existing tool plans should be updated to reflect that only tools purchased while employed by the employer count. Moreover, to address situations where employees have more than one employer at the same time, the plans may need to specify that expenses reimbursed by other employers do not qualify.
It should be noted that the promoter in Davidson received tax advice cautioning that the employee tool and equipment plan would likely run afoul of the business connection requirement if a client-employer paid its employees the same weekly amount whether or not the employees incurred business expenses.
It is not clear why the tax advice reached this conclusion as it seems inconsistent with the language in Rev. Proc. 2005-52 (“reasonable expectations for expenses can be used to establish that a plan meets the business connection requirement”). The court did not say that weekly pay is a problem and it did not address the “reasonable expectation” language in Rev. Proc. 2005-52.
To qualify as an accountable plan, the plan document has to specify that employees submit information to allow the employer to verify the nature of the expense. This is set out in Treas. Reg. § 1.62-2(e)(3).
The regulation even says that: “[i]t is not sufficient if an employee merely aggregates expenses into broad categories (such as ‘travel’) or reports individual expenses through the use of vague, nondescriptive terms (such as ‘miscellaneous business expenses’).”
In Davidson, the promoter’s company provided instructions to employees for identifying the tool acquisition costs. According to the court, the instructions provided to employees provided the following guidance:
- To list as many tools as possible and
- To estimate the amount of the costs if the employee did not have records of the acquisition costs of his or her tools.
The instructions did not tell employees to provide receipts to the employer.
Based on this, the court concluded that the substantiation requirement was not met.
This is consistent with the tool plan in Rev. Proc. 2005-52. That tool plan provided for reimbursement based on national expense data and an annual employee survey. The amount was applied to the number of hours the employees worked. The IRS concluded that the plan failed the substantiation requirement.
Given the Davidson case and Rev. Proc. 2005-52, tool plans should be clear to specify that receipts have to be provided so that the employer can determine the nature of the expenses.