In Chief Counsel Advice 201120021, the Service concluded that an enterprise’s tool reimbursement plan failed the accountable plan business connection requirement because it impermissibly recharacterized wages and reimbursed employees for tool expenses incurred before the start of employment. The IRS reiterated its view that for an expense to satisfy the business connection requirement of the accountable plan rules, it is not sufficient for an employee to incur a deductible business expense but the expense must also arise in connection with the employment. Thus, since the accountable plan rules were not sufficiently met, the amounts paid under the plan were to be included in the employees’ gross income and reported on their Forms W-2 and subject to employment taxes.
Tools plans have been the subject of a long standing controversy. As a condition of employment, it is common in many industries to require workers to provide their own tools and equipment which often must be maintained on the employer’s premise. The IRS has challenged this practice for years taking the aggressive position that amounts paid with respect to these tool plans are wages and thus subject to employment taxes.
The Internal Revenue Service previously established a cross divisional team to address significant concerns with certain Employee Tool and Equipment Plans, sometimes called Service Technicians Tool Reimbursement Plans, that purport to receive tax-favored treatment as an accountable plans under Internal Revenue Code.
An expense reimbursement arrangement is a tax-favored accountable plan if it satisfies the three requirements of business connection, substantiation, and returning amounts in excess of substantiated expenses, and if it does not evidence a pattern of abuse of the rules applicable to such plans. Amounts treated as paid under an accountable plan are excluded from the employee’s gross income, are not reported as wages on the employee’s Form W-2, and are exempt from withholding and payment of employment taxes. Conversely, if the arrangement fails any of the requirements or otherwise evidences a pattern of abuse of the rules, the amounts paid under the arrangement are treated as paid under a nonaccountable plan and are included in the employee’s gross income, must be reported as wages or other compensation on the employee’s Form W-2, and are subject to withholding and payment of employment taxes.
Many of the tool plans currently being marketed may not meet the requirements to be tax-favored accountable plans despite their claims to the contrary. It appears that the Service is operating on the assumption that the majority of the plans being marketed are designed and operated around a structure that recharacterizes a portion of the employee’s existing pay as a reimbursement for the employee’s tools merely to generate tax savings for both the employer and the employee. The accountable plan rules are sufficiently clear that amounts paid whether or not there are expenses are not reimbursements and are not eligible for tax-favored treatment.
As mentioned, the Service’s attention to tool plans is not new and has recently become more aggressive. These plans are widely marketed in various industries, including the automotive, heavy equipment, construction, aircraft maintenance, agriculture, and other industries. Taxpayers that are considering implementing such a plan or are currently operating with tool plans are advised to seek the assistance of tax counsel to review such plans. Given the increased scrutiny in the employment tax arena, careful planning is required.