Reimbursing Business Expenses Through Salary “Restructuring”

The IRS reconsiders its position – Letter Ruling 99916011

Article summary. The tax code prohibits employers from paying for the reimbursement of their employees’ business expenses under an “accountable” arrangement through salary reductions. In a 1993 ruling, the IRS extended this prohibition to salary “restructuring” arrangements. Since such arrangements were a common church practice, this ruling had a significant impact on churches. The IRS recently issued a new ruling addressing salary restructuring arrangements. The new ruling repudiates the 1993 ruling, and suggests that salary restructuring arrangements may be used in the context of accountable plans.

In a surprise development, the IRS has issued a private letter ruling suggesting that some salary “restructuring” arrangements may be used in connection with accountable business expense reimbursement arrangements. This is a very significant development for churches, since nearly 90 percent of churches now use accountable arrangements to reimburse staff members’ business expenses, and many use some form of salary “restructuring” to pay for the reimbursements. The recent IRS ruling repudiates a 1993 ruling in which the IRS concluded that employers could not use salary “restructuring” arrangements to fund reimbursements under an accountable plan. This feature article will review the prohibition on the use of salary reductions to fund business expense reimbursements under an accountable arrangement. It also will address the 1993 and 1999 IRS rulings, and evaluate the relevance of the most recent IRS ruling to church compensation practices.

The requirements of an accountable reimbursement arrangement

The income tax regulations list three requirements that must be met in order for a business expense reimbursement arrangement to be accountable:

(1) Business Connection

A reimbursement arrangement meets the business connection requirement if it reimburses employee expenses that could be claimed by the employee as a business expense deduction, and that are paid or incurred by the employee in connection with the performance of services as an employee. The business connection requirement will not be satisfied if the employer “arranges to pay an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur business expenses.”

(2) Substantiation

A reimbursement arrangement meets the substantiation requirement if it requires each business expense to be substantiated to the employer within a reasonable period of time. An arrangement that reimburses business expenses governed by section 274(d) of the tax code (travel, transportation, entertainment, business gifts, cell phones, and personal computers) meets this requirement if the information submitted to the employer substantiates the elements of each expenditure. For example when substantiating expenses for travel away from home, the employee is required to substantiate the amount, time, place, and business purpose of the expenses.

(3) Returning Excess Reimbursements

A reimbursement arrangement, to be accountable, must require the employee to return to the employer within a reasonable period of time any amount paid under the arrangement in excess of the expenses substantiated. If a reimbursement arrangement meets the three requirements, but the employee fails to return, within a reasonable period of time, any amount in excess of the amount of the expenses substantiated, only the amounts paid under the arrangement that are not in excess of the substantiated expenses are treated as paid under an accountable plan. The excess amounts are treated as paid under a nonaccountable plan.

Using salary reductions to fund employee business expenses

The “reimbursement requirement”

The regulations caution that in order for an employer’s reimbursement arrangement to be accountable, it must meet a reimbursement requirement in addition to the three requirements summarized above. The reimbursement requirement is defined by the regulations as follows:

Application of the reimbursement requirement

The IRS interprets this regulation to prohibit accountable reimbursement plans from reimbursing employee business expenses through salary reductions. Employers who agree to pay an employee a specified annual income, and also agree to reimburse the employee’s business expenses out of salary reductions, have “arranged to pay an amount to an employee regardless of whether the employee incurs business expenses.”

In explaining this regulation, the IRS observed:

Let’s illustrate this rule with an example. Assume that a church pays its senior pastor, Rev. G, an annual salary of $52,000 ($1,000 each week). The church also agreed that it would reimburse Rev. G’s substantiated business expenses through salary reductions. At the beginning of each month, Rev. G substantiates his business expenses for the previous month, and he is issued a paycheck for the first week of the next month consisting of both salary and expense reimbursement. To illustrate, assume that Rev. G substantiated $400 of business expenses for January of 1999 during the first week of February. The church issued Rev. G his customary check of $1,000 for the first week of February, but only $600 of this check represents taxable salary while the remaining $400 represents reimbursement of Rev. G’s business expenses. The church only accumulates the $600 to Rev. G’s W-2 or 1099 that it will issue at the end of the year.

Such arrangements are used by many churches. However, they are nonaccountable according to the regulation quoted above, since Rev. G would receive his full salary of $52,000 if he chose not to incur any business expenses. As a result, the church would report the full salary of $52,000 as income on Rev. G’s W-2 or 1099.

The above-quoted regulation (imposing the reimbursement requirement) effectively put an end to a common church practice that allowed many clergy to enjoy the advantages of an accountable plan without any additional cost to the church. Unfortunately, regulation 1.62-2(d)(3), by imposing the reimbursement requirement, makes such arrangements nonaccountable. Such arrangements are not “illegal.” They simply cannot be “accountable.” Churches that continue to use such arrangements must recognize that all reimbursements paid through salary reduction are treated as paid under a nonaccountable plan. This means that all salary reduction “reimbursements” are treated as taxable income to the employee, and the church must withhold any applicable taxes from these reimbursements.

The IRS national office, in correspondence with your editor, confirmed that the regulation prohibits churches from using salary reductions to fund business expense reimbursements under accountable reimbursement arrangements. In explaining its interpretation, the IRS noted that the tax benefits available to accountable reimbursement arrangements (i.e., the employer’s reimbursements are not reportable as income to the employee, and are not subject to tax withholding) are based on the fact that the reimbursements are coming out of the employer’s resources and accordingly it “has an incentive to require sufficient substantiation to ensure that the allowance to the employee is limited to actual business expenditures incurred on the employer’s behalf and for the employer’s benefit.” This justification simply does not apply when an employee’s business expenses are reimbursed out of his or her own salary (through salary reductions). The IRS gave the following example:

The IRS concluded:

In summary, regulation 1.62-2(d)(3), by imposing the so-called reimbursement requirement, effectively prohibits employers (including churches) from allowing employees to pay for their own business expenses under an accountable arrangement through salary reductions. Even if such arrangements meet the three requirements for an accountable reimbursement arrangement (described above), they do not meet the regulations’ “reimbursement requirement.” This is so for the following two reasons:

(1) The employer is not “reimbursing” the employee’s expenses. A reimbursement assumes that the employer is paying for the employee’s business expenses out of its own funds. When an employer pays an employee for his or her business expenses through a salary reduction, it is the employee and not the employer that is paying for the expenses. Such an arrangement is not an employer “reimbursement.”

(2) The church has agreed “to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) business expenses,” in violation of the reimbursement requirement prescribed by the regulations.

Employers are free to pay for an employee’s business expenses through salary reductions, but they must recognize that such an arrangement is nonaccountable. The effect of this is that the salary reductions must be accumulated to the employee’s taxable income, and the employer is obligated to withhold applicable taxes on the salary reductions. In summary, there are no tax advantages associated with such arrangements.

The 1993 IRS ruling-salary “restructuring” is the same as a salary reduction

Can the regulation prohibiting the funding of business expenses under an accountable arrangement through salary reductions be avoided by proper drafting of an employee’s compensation package?

Let’s illustrate this important question with an example. Assume that Rev. K and his church are discussing compensation for the next year, and that the church board proposes to pay Rev. K $50,000. However, since it will require Rev. K to pay his own business expenses, the church board decides to pay Rev. K a salary of $46,000, and establish a separate church account for $4,000 out of which substantiated business expenses will be reimbursed. At the end of the year, any balance remaining in the reimbursement account would belong to the church, not Rev. K. It would not be distributed to Rev. K as a “bonus” or as additional compensation. Since Rev. K has no right to any of the reimbursement account funds ($4,000) unless he adequately substantiates his business expenses, this arrangement should be permissible under the regulation. The church has not “agreed to pay an amount to an employee regardless of whether the employee incurs deductible business expenses.” Unfortunately, the IRS disagreed with this conclusion in a 1993 private letter ruling. IRS Letter Ruling 9325023.

In the 1993 ruling, the IRS addressed the question of whether the following arrangement could be considered to be accountable:

The IRS began its ruling by noting that “a gratuitous assignment of income does not shift the burden of taxation and the donor is taxable when the income is received by the donee.” The IRS continued:

The IRS then quoted the following example that appears in the income tax regulations:

The IRS noted that “the conclusion to be reached from this example is that an employer may not recharacterize a portion of an employee’s salary as being paid under a reimbursement arrangement or other expense allowance arrangement.” Further, the example illustrates that

The IRS concluded that the reimbursement arrangement proposed by Company X would

The IRS has issued audit guidelines for its agents to follow when auditing ministers. The guidelines inform agents that if a church has a salary reduction arrangement which “reimburses” a minister for employee business expenses by reducing his or her salary, the arrangement will be treated as a nonaccountable plan. This is the result

The guidelines instruct IRS agents to be alert to salary reduction arrangements that are used to fund reimbursements under an “accountable” arrangement. According to the IRS, accountable plans cannot reimburse employee business expenses out of salary reductions. The important point is this-the guidelines are educating IRS agents as to this issue, and so it is now far more likely that salary restructuring and salary reduction arrangements will be discovered and questioned in an audit.

Background

A securities firm employed investment consultants who incur travel and other employee business expenses in connection with the performance of services for their employer. The company adopted a plan to provide for the reimbursement of employee business expenses incurred by the investment consultants. It contains the following features:

The employer asked the IRS for a ruling that (1) the amounts reimbursed under the plan will be fully excludible from gross income of the consultants, and (2) that the amounts reimbursed are not wages subject to employment taxes and withholding, and need not be reported on Form W-2.

The IRS Ruling

The IRS began its ruling by noting that if an employer’s reimbursements of an employee’s business expenses are “accountable,” they are not included in the employee’s income, they are not reported on the employee’s W-2, and they are not subject to tax withholding. To be accountable, the “business connection,” substantiation, and “return of excess reimbursements” requirements explained above must be met. The IRS cautioned that “if an arrangement does not satisfy one or more of the three requirements, all amounts paid under the arrangement are treated as paid under a nonaccountable plan.” The result is that such reimbursements “are included in the employee’s gross income for the taxable year, must be reported to the employee on Form W-2, and are subject to the withholding and payment of employment taxes.”

The IRS concluded that the company’s plan satisfied all three requirements for an accountable plan. With respect to the third requirement, the IRS noted that “because the plan is a reimbursement arrangement, the amount reimbursed should not exceed the amount substantiated; thus, there should not be an excess to return.” As a result, assuming that expenses “are properly deductible and substantiated,” the IRS reached the following conclusions:

(1) Reimbursements made to a consultant under the plan may be excluded from the consultant’s income as payments made under an accountable plan.

(2) Reimbursements made to a consultant under the plan are not wages subject to employment taxes, and are not reportable on the consultant’s Form W-2.

What ministers and lay church leaders need to know

Ministers, lay staff members, church treasurers, and church board members should be aware of the following points:

1. Reimbursing employee business expenses out of church funds. Churches and clergy wanting to eliminate any of the questions concerning the use of salary restructuring arrangements should adopt accountable reimbursement policies that reimburse business expenses out of church funds. Churches that are concerned with unlimited reimbursement arrangements can set a maximum amount that will be reimbursed per employee.

2. Salary reduction agreements. Some churches prefer to “reimburse” employee business expenses out of their employee’s own compensation, through a salary reduction arrangement. The objective is to eliminate any additional cost to the church for an employee’s business expenses. The tax code prohibits employers from paying for accountable reimbursements out of salary reductions. Such arrangements are not “illegal.” They simply cannot be “accountable.” Churches that use such an arrangement must recognize that all reimbursements paid through salary reduction are “nonaccountable,” and must be reported on the minister’s W-2. The 1999 IRS ruling addressed above does not change this limitation.

3. Salary restructuring arrangements. What about salary restructuring arrangements? Does the ban on using salary reduction arrangements to fund accountable expense reimbursements apply to these arrangements as well? The IRS answered “yes” to this question in a 1993 private letter ruling. However, in 1999 the IRS issued a private letter ruling that signals a retreat from the 1993 position.

Many churches use salary restructuring arrangements. The 1999 IRS ruling suggests that such arrangements can be accountable, if the following three conditions are met:

(1) Meet the three requirements of an accountable arrangement

These requirements (“business connection,” substantiation, and “return of excess reimbursements”) are summarized above. Each of these requirements must be met in order for a church’s reimbursement arrangement to be accountable.

(2) Meet the reimbursement requirement

Even if a reimbursement arrangement meets the three requirements of an accountable plan (business connection, substantiation, and return of excess reimbursements), it will not be accountable unless it meets the so-called reimbursement requirement. As noted above, the regulations define this requirement as follows:

To meet this requirement, it is essential that a church or other employer not agree to pay an employee a specified amount of compensation out of which business expenses may or may not be reimbursed. Salary reduction arrangements are not accountable because of this requirement. Why? Because with such an arrangement the employer agrees to pay the employee a specified amount of compensation for the year whether or not the employee submits any business expenses for reimbursement. And, when expenses are reimbursed, the reimbursements come out of the employee’s own compensation rather than out of church funds. This kind of arrangement is not really a “reimbursement” plan, since the church is not reimbursing anything. Rather, it is reducing the pastor’s reportable compensation to pay for the expenses.

Can a salary restructuring arrangement meet the reimbursement requirement? Possibly. In fact, this is the conclusion the IRS reached in its 1999 ruling. But this conclusion will not apply to any salary restructuring arrangement. There were several conditions present in the 1999 ruling that must be met for a salary restructuring arrangement to meet the reimbursement requirement.

(3) Meet the following essential conditions of the 1999 IRS ruling

The IRS concluded that a salary restructuring arrangement was “accountable” in its 1999 ruling. There were some factors present in that ruling that were essential to the conclusion reached by the IRS. These include the following:

4. Examples. The following examples illustrate the most important principles addressed in this article.

Example 1. A church pays its senior pastor compensation of $50,000 in 1999. In addition, the church agreed to reimburse business expenses incurred by the pastor during the year up to $5,000, if the pastor provided adequate substantiation of each expense within 30 days. This is an accountable reimbursement arrangement. Amounts reimbursed by the church are not reported on the pastor’s W-2, or by the pastor on Form 1040 (line 7).

Example 2. Same facts as the example 1, except that the church also reimburses some personal expenses of the pastor, such as the personal use of a car. The regulations specify that if an employer reimburses both business and personal expenses of an employee, the employer “is treated as maintaining two arrangements. The portion of the arrangement that provides payments for the deductible employee business expenses is treated as one arrangement that satisfies [reimbursement requirement]. The portion of the arrangement that provides payments for the nondeductible employee expenses is treated as a second arrangement that does not satisfy [the reimbursement requirement] and all amounts paid under this second arrangement will be treated as paid under a nonaccountable plan.” As a result, the church does not accumulate “business expense” reimbursements on the pastor’s W-2, and the pastor does not report these reimbursements as taxable income on Form 1040 (line 7). However, the reimbursements of personal expenses are deemed to be nonaccountable. The church must report these reimbursements on the pastor’s W-2, and the pastor must include them as taxable income on Form 1040 (line 7).

Example 3. Same facts as example 1, except that the church accepts the pastor’s signed statement as to the amount of business expenses he incurs each month without any additional substantiation. This arrangement does not meet the “substantiation” requirement, and so is not accountable. Amounts reimbursed by the church are reported on the pastor’s W-2, and the pastor must include them as taxable income on Form 1040 (line 7). He may be able to claim a business expense deduction on his tax return for business expenses that he is able to substantiate.

Example 4. A church provides a pastor with a monthly $400 “car allowance.” The church board is certain that the pastor incurs business expenses of at least this much each month, and so does not require any additional substantiation. This arrangement does not meet the “substantiation” requirement, and so is not accountable. Amounts reimbursed by the church are reported on the pastor’s W-2, and the pastor must include them as taxable income on Form 1040 (line 7). He may be able to claim a business expense deduction on his tax return for expenses incurred in the use of his car for business that he is able to substantiate.

Example 5. A church issues its senior pastor a cash advance of $1,500 to cover all expenses incurred by the pastor in attending a church convention. The pastor is not required to substantiate any of her expenses. The entire amount represents a nonaccountable reimbursement, since the pastor is not required to substantiate expenses or return any “excess” reimbursement (in excess of substantiated expenses). The full amount of the cash advance must be reported by the church on the pastor’s W-2, and the pastor must report it as taxable income on Form 1040 (line 7). She may be able to claim a business expense deduction on her tax return for business expenses incurred during the trip that she is able to substantiate.

Example 6. Same facts as example 5, except that the pastor substantiates $1,200 of business expenses, but is allowed to keep the “excess” reimbursement ($300). The regulations specify that this arrangement is accountable up to the amount the pastor actually substantiates ($1,200), and it is nonaccountable with regard to the excess. As a result, the church must report the $300 excess on the pastor’s W-2, and the pastor must include this amount as taxable income on Form 1040 (line 7).

Example 7. In December of 1998, a church board agreed to pay its senior pastor a salary of $60,000 for 1999 ($1,154 per week). In addition, the church agreed to “reimburse” the pastor’s business expenses by reducing his salary. Each month, the pastor provided the church treasurer with the total amount of business expenses that he incurred for the previous month. The pastor provided no substantiation other than his own statement. Some months the pastor orally informed the treasurer of the amount of expenses for the previous month, while in other months he provided the treasurer with a note showing the total expense amount. The treasurer allocated the next weekly paycheck between salary and business expense “reimbursement”. To illustrate, in the first week of September the pastor informed the treasurer that he had incurred business expenses of $400 in August. The church treasurer issued the pastor his customary check in the amount of $1,154 for the next week-but it was allocated between business expense reimbursement ($400) and salary (the balance of $754). Assume that the pastor incurs $5,000 of business expenses during 1999. The church treasurer issues the pastor a W-2 showing compensation of $55,000 (salary of $60,000 less the “salary reductions” that were allocated to substantiated business expenses). This is incorrect. This arrangement does not meet the “reimbursement requirement” since: (1) The employer is not “reimbursing” the pastor’s expenses. A reimbursement assumes that the employer is paying for the employee’s business expenses out of its own funds. When an employer pays an employee for his or her business expenses through a salary reduction, it is the employee and not the employer that is paying for the expenses. Such an arrangement is not an employer “reimbursement.” (2) The arrangement fails the regulations’ “reimbursement requirement” since the church has agreed “to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) business expenses.” The church treasurer should have treated this arrangement as nonaccountable. The full amount of the salary reductions should have been reported on the pastor’s W-2, and the pastor should include this amount with taxable income on Form 1040 (line 7). He may be able to claim a business expense deduction on his tax return for expenses that he is able to substantiate.

Example 8. Same facts as example 7, except that the church requires the pastor to adequately substantiate (amount, date, location, and business connection) each expense in order to be reimbursed for it through salary reduction. Even though this arrangement meets the three requirements of an accountable plan (business connection, substantiation, return of excess reimbursements), it is not accountable since it does not meet the reimbursement requirement for the same reasons mentioned in example 7.

Example 9. In December of 1998, a church board agreed to set aside $60,000 for the pastor’s compensation package for 1999. It allocated this amount as follows: $45,000 salary, and $10,000 housing allowance, for total compensation of $55,000. In addition, the church agreed to reimburse substantiated business expenses of up to $5,000. The pastor was informed that if she incurred business expenses of less than $5,000 in 1999, she would not be paid or credited any portion of the unused balance. This arrangement would have been nonaccountable under the 1993 IRS ruling. However, the 1999 IRS ruling suggests that such an arrangement may be accountable, if the following factors are present: (1) The pastor is reimbursed only for those business expenses that would be deductible as a business expense on his personal tax returns; (2) prior to the start of each year, the church determines the amount to be excluded from the pastor’s compensation for the next year; (3) if the pastor’s expenses are less than the reimbursement cap ($5,000), the difference between the expenses and the reimbursement cap will not be paid to the pastor and will not be carried over from one calendar year to the next; and (4) if the pastor does not request any reimbursements under the plan, he receives no additional compensation. Remember that this conclusion is based on an IRS private letter ruling. Technically, such a ruling cannot be used as precedent for a particular tax position. However, the important point to note is that this ruling is of no less value than the 1993 IRS private letter ruling suggesting that such arrangements are not accountable. To increase the likelihood that this arrangement will be deemed to be accountable, the church board should adopt two resolutions-one establishing the “total compensation” amount (salary plus housing allowance), and the second establishing the reimbursement limit. Churches that use such arrangements should recognize that there is no guaranty that they will be deemed to be accountable by the IRS or the courts. It is still possible that the IRS will challenge the accountable nature of such arrangements. However, as a practical matter, ministers who can show an IRS agent during an audit that their situation is substantially similar to the 1999 IRS private letter ruling have a reasonable chance of prevailing.

Example 10. Same facts as example 9, except that the church distributes to the pastor any unused portion of the reimbursement cap at the end of the year. To illustrate, if the pastor only requests reimbursement of $3,500 of business expenses during 1999, the church treasurer issues her a “bonus” of $1,500 (the unused portion of the $5,000 cap) at the end of the year. The better view is that this entire arrangement is nonaccountable. The full $5,000 “reimbursement account” must be reported on the pastor’s W-2, and the pastor should include this amount with taxable income on her Form 1040 (line 7). She may be able to claim a business expense deduction on her tax return for expenses that she is able to substantiate. These conclusions are based on the following two considerations: (1) The income tax regulations contain the following example: “Employer Y provides expense allowances to certain of its employees to cover business expenses of a type described in paragraph (d)(1) of this section under an arrangement that requires the employees to substantiate their expenses within a reasonable period of time and to return any excess amounts within a reasonable period of time. Each time an employee returns an excess amount to Employer Y, however, Employer Y pays the employee a “bonus” equal to the amount returned by the employee. The arrangement fails to satisfy the requirements of paragraph (f) (returning amounts in excess of expenses) of this section. Thus, Employer Y must report the entire amount of the expense allowance payments as wages or other compensation and must withhold and pay employment taxes on the payments when paid.” (2) The regulations specify that the “return of excess reimbursements” requirement is met, and so a reimbursement arrangement is accountable, “only if the amount of money advanced is reasonably calculated not to exceed the amount of anticipated expenditures ….” A more aggressive view would be to treat only the “bonus” ($1,500) as nonaccountable, rather than the entire reimbursement account ($5,000). This outcome is based on examples in the income tax regulations illustrating that if employees are reimbursed more than their substantiated reimbursed business expenses, only the excess is deemed nonaccountable. This approach should not be adopted without the advice of a tax professional.

5. Private letter rulings. A private letter ruling cannot be used as legal precedent. It is a very limited decision that applies only to the taxpayer who requested it. This means that ministers and other taxpayers cannot rely on the 1999 private letter ruling addressed in this article as a basis for treating a salary “restructuring” arrangement as an accountable plan. On the other hand, the 1993 IRS ruling that treated a salary restructuring arrangement as a salary reduction plan was also a private letter ruling. As such, it is entitled to no more weight that the 1999 ruling. Neither can be used as a legal basis for a particular position. At best, they suggest what an official IRS ruling might be.

© Copyright 1999 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m24 m27 c0599