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Company Reimbursements—Employee Pay or Not?

“Are reimbursements that an employee receives from his or her employer for business expenses counted as income on Form W-2?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Texas is representative of a common inquiry related to what items constitute wages for plan purposes.

Highlights of the Discussion

Generally, reimbursements that an employee receives from his or her employer for business expenses count as pay or income on Form W-2 (box 1) only if the reimbursements are treated as paid under a “nonaccountable plan” as opposed to an “accountable plan” [See IRS Publication 15 (Circular E)] and Publication 463, Travel, Gift and Car Expenses]. Conversely, reimbursements paid from an accountable plan are not treated as employee pay or income, and are not reported on Form W-2. An employer makes the decision whether to reimburse employees under an accountable plan or a nonaccountable plan.

Accountable Plan

To be an accountable plan, an employer’s reimbursement or allowance arrangement must satisfy all of the following rules.

  1. Employee expenses must have a business connection; meaning, an employee must have paid or incurred deductible expenses while performing services as an employee of the employer;
  2. An employee must adequately account to his or her employer for these expenses within a reasonable period of time; and
  3. An employee must return any excess reimbursement or allowance within a reasonable period of time.

Nonaccountable Plan

A nonaccountable plan is a reimbursement or expense allowance arrangement that does not meet one or more of the three criteria listed above. Be aware, however, that even if an employer has an accountable plan (as described above), the IRS will treat the following payments as being paid under a nonaccountable plan:

  • Excess reimbursements an employee fails to return to the employer, or
  • Reimbursement of nondeductible expenses related to the employer’s business.

An employer will combine the amount of any reimbursement or other expense allowance paid under a nonaccountable plan with an employees wages, salary, or other income, and report the total in box 1 of Form W-2.

Conclusion

Whether reimbursements to an employee for business expenses count as pay or income for the recipient depends on whether the employer pays such amounts from an accountable or a nonaccountable plan.

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Oops … How to fix switched contributions

“My client initially elected to make designated Roth contributions to her 401(k) plan and a few years later switched her election to pre-tax elective deferrals. We just discovered the employer is still treating her deferrals as designated Roth contributions. Is there a way to retroactively treat these amounts as pre-tax salary deferrals?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Massachusetts is representative of a common inquiry related to designated Roth contributions in 401(k) plans.

Highlights of the Discussion

Yes, there is a way of correcting the situation where an employer has failed to make the correct type of salary deferral to a 401(k) plan (i.e., pre-tax/designated Roth, or vice versa) based on the participant’s deferral election. It will require some correcting of IRS tax forms and the employer’s participation in the IRS’s Employee Plans Compliance Resolution System (EPCRS) program. Please refer to Fixing Common Mistakes-Correcting a Roth Contribution Failure and Revenue Procedure 2019-19.  

Generally speaking, an employer in this situation can correct the error by executing three steps.

Step 1: Transfer deferrals

The employer transfers the erroneously deposited deferrals, adjusted for earnings, from the designated Roth account to the pre-tax salary deferral account. The employer must ensure the information on IRS Form W-2, Wage and Tax Statement, for the participant is correct (i.e., reflecting the correct contribution type). That may involve the employer filing a corrected Form W-2 with the IRS showing the previously misidentified designated Roth contributions as pre-tax salary deferrals.

Step 2: Follow EPCRS or Audit CAP

Since the error represents an operational failure on the plan sponsor’s part, the sponsor should follow plan correction procedures outlined in the IRS’s EPCRS program. Depending on the circumstances, it may be possible for the employer to self-correct the error, without penalty or a formal filing with the IRS. Otherwise, a sponsor can file with the IRS under the IRS’s Voluntary Correction Program (VCP). If the error was discovered during an IRS audit, the only corrective option is to follow the Audit Closing Agreement Program (Audit CAP).

Step 3: Establish avoidance procedures

Part of correcting a plan error is to ensure that the error will not happen again. Plan sponsors should create, document and follow new policies and procedures that will prevent future failures such as these.

Conclusion

The IRS has identified the misclassification of employee salary deferrals as designated Roth contributions and vice versa by plan sponsors as a common plan mistake. Fortunately, there is a relatively painless IRS process to remedy the situation.

© Copyright 2020 Retirement Learning Center, all rights reserved