IRS issues guidance on per diem expense reimbursements

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The Internal Revenue Service is reminding employers that they need to track the amount of expense reimbursement allowances paid to employees on a per diem basis.

Generally, amounts employers pay employees to reimburse them for substantiated business expenses aren’t subject to income tax or employment tax. Per diem payments for meals and lodging that do not exceed the federal per diem rate for a particular city are deemed to be substantiated without accounting for actual expenses.

However, if an employer pays expense allowances that exceed the federal per diem rates, the excess amounts are subject to income tax and employment tax if they are not repaid to the employer, unless the employee actually substantiates all of the expenses covered by the per diem allowance.

In Revenue Ruling 2006-56, the IRS tells employers that if they routinely pay per diem allowances in excess of the federal per diem rates, but don’t track the allowances and don’t require the employees either to actually substantiate all the expenses or pay back the excess amounts, and don’t include the excess amounts in the employee’s income and wages, then the entire amount of the expense allowances is subject to income tax and employment tax.

The guidance illustrates when a per diem allowance arrangement that fails to track the excess amounts and does not include the unsubstantiated, unrepaid excess amounts in the employee’s income and wages constitutes a pattern of abuse of the rules for tax-free expense reimbursements. The finding that the arrangement is abusive causes all allowances paid under the arrangement to be subject to income tax and employment tax, not just the excess amounts.

IRS Revenue Ruling 2006-56 is effective immediately. However, the IRS says that it recognizes that employers may need some time to adjust their systems so they can track excess allowances and account for them correctly. The IRS is issuing instructions to its agents not to apply the results under the revenue ruling for taxable periods ending on or before Dec. 31, 2006, in the absence of intentional noncompliance.

To read the ruling, click here.