rr-05-52.pdf

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Part I

Section 62.—Adjusted Gross Income Defined

26 CFR 1.62-2: Reimbursement and other expense allowance arrangements

Rev. Rul. 2005-52

ISSUE
In the following situation, is the tool allowance paid by the employer to the
employees paid under an accountable plan such that the payments are excluded from
the employees’ gross income and exempt from the withholding and payment of
employment taxes?

FACTS
Employer operates an automobile repair and maintenance business. Employer
hires service technicians to work in the business as employees. Employer requires
these employees, as a condition of employment, to provide and maintain various tools
needed for use in performing repair and maintenance services. Employer pays each
employee an hourly wage. In addition, Employer pays each employee a set amount for
each hour worked as a “tool allowance” to cover costs the employee incurs for acquiring
and maintaining his tools.

Employer sets each employee’s tool allowance annually by using a combination
of data from a national survey of average tool expenses for automobile service
technicians and specific information concerning tool-related expenses provided by the
employee in response to an annual questionnaire completed by all service technicians
who work for Employer. Employer does not reimburse expenses paid or incurred for
listed property, as defined by § 280F(d) of the Internal Revenue Code (the Code), or
depreciation expenses; thus, these expenses are not taken into account in calculating

the amount of the annual tool allowance. Employer uses the data to project the
employee’s total annual tool expenses. Employer then uses a projection of the total
number of hours the employee is expected to work during the year that will require the
use of tools to convert the employee’s estimated annual tool expenses into an hourly
rate for the tool allowance. Thus, the hourly tool allowance is an estimate of the tool
expense projected to be incurred per hour by the employee over the course of the
coming year.

At the end of each pay period, each employee reports to Employer his hours
worked requiring the use of tools. Employer multiplies the number of hours reported as
worked requiring the use of tools by the employee’s hourly rate for the tool allowance
and pays the resulting amount to the employee in addition to compensation for services
performed during the pay period. On a quarterly statement furnished to each employee,
Employer reports: (1) the amount paid to the employee as a tool allowance during the
quarter, and (2) the tool expenses estimated to be incurred in the quarter (i.e., the
hours reported worked requiring the use of tools times the tool allowance). Employees
are not required to provide any substantiation of expenses actually incurred for tools
either before or after the quarterly reports are issued. Employer does not require
employees to return any portion of the tool allowances that exceeds the expenses they
actually incur either before or after the quarterly reports are issued.

LAW
Section 61 of the Code provides that gross income means all income from
whatever source derived, including compensation for services, fees, commissions,
fringe benefits, and similar items.

Section 62(a)(2)(A) of the Code and § 1.62-2(b) of the Income Tax Regulations
provide that, for purposes of determining adjusted gross income, an employee may
deduct certain business expenses paid by the employee in connection with the
performance of services as an employee under a reimbursement or other expense
allowance arrangement with his employer.

Section 62(c) provides that, for purposes of § 62(a)(2)(A), an arrangement will
not be treated as a reimbursement or other expense allowance arrangement if (1) the
arrangement does not require the employee to substantiate the expenses covered by
the arrangement to the payor, or (2) the arrangement provides the employee the right to
retain any amount in excess of the substantiated expenses covered under the
arrangement.

Section 1.62-2(c)(1) of the regulations provides that a reimbursement or other
expense allowance arrangement satisfies the requirements of § 62(c) if it meets the

requirements of business connection, substantiation, and returning amounts in excess
of substantiated expenses. If an arrangement meets these requirements, all amounts
paid under the arrangement are treated as paid under an accountable plan. § 1.62-
2(c)(2)(i). Amounts treated as paid under an accountable plan are excluded from the
employee's gross income, are not required to be reported on the employee's Form W-2,
and are exempt from the withholding and payment of income and employment taxes.
§ 1.62-2(c)(4).

If an arrangement does not satisfy one or more of these requirements, all
amounts paid under the arrangement are treated as paid under a "nonaccountable
plan." § 1.62-2(c)(3). Amounts treated as paid under a nonaccountable plan are
included in the employee's gross income, must be reported as wages or other
compensation of the employee’s on Form W-2, and are subject to withholding and
payment of income and employment taxes. § 1.62-2(c)(5).

Section 1.62-2(d)(1) provides that an arrangement meets the business
connection requirements if it provides advances, allowances, or reimbursements only
for business expenses that are allowable as deductions and are paid or incurred by the
employee in connection with the performance of services as an employee of the
employer. If, however, a payor arranges to pay an amount to an employee regardless
of whether the employee incurs (or is reasonably expected to incur) bona fide employee
business expenses, the arrangement does not satisfy the business connection
requirements and all amounts paid under the arrangement are treated as paid under a
nonaccountable plan. § 1.62-2(d)(3)(i).

Section 1.62-2(e)(1) provides that an arrangement meets the substantiation
requirements if the arrangement requires each business expense to be substantiated to
the payor in accordance with paragraph (e)(3), within a reasonable period of time. An
arrangement for those expenses meets the substantiation requirements of § 1.62-
2(e)(3) if information submitted to the payor is sufficient to enable the payor to identify
the specific nature of each expense and to conclude that the expense is attributable to
the payor’s business activity. Generally the employee must submit an expense account
or other written statement to the employer showing the business nature and amount of
the employee’s expenses. See
§ 1.162-17(b)(4).

Revenue Procedure 2002-41, 2002-1 C.B. 1098, provides an optional expense
substantiation rule applicable only to certain employers in the pipeline construction
industry. If an eligible employer’s arrangement to pay employee business expenses
otherwise satisfies the business connection and return of excess requirements, and
amounts paid under the arrangement do not exceed $13.00 per hour, adjusted for
inflation, an employee is deemed to have substantiated the expenses, and amounts
paid under the arrangement are treated as paid under an accountable plan.

Section 1.62-2(f)(1) provides that an arrangement meets the return of excess
requirements if the arrangement requires the employee to return to the payor within a
reasonable period of time any amount paid under the arrangement in excess of
substantiated expenses. Section 1.62-2(f)(2) provides authority for the Commissioner
to issue rules, for per diem or mileage allowances only, under which an arrangement
will be treated as satisfying the return of excess requirement even though the
arrangement does not require the employee to return the portion of the allowance
related to days or miles of travel substantiated but that exceeds the amount of the
employee's expenses deemed substantiated pursuant to rules prescribed under
§ 274(d).

Section 1.62-2(g)(2)(ii) provides that if a payor provides employees with a
periodic statement, no less frequently than quarterly, stating the amount, if any, paid
under the arrangement that exceeds the expenses the employee has substantiated as
required by the arrangement, and requesting the employee to substantiate any
additional business expenses that have not yet been substantiated (whether or not such
expenses relate to the expenses to which the original advance was paid) and/or to
return any amounts remaining unsubstantiated within 120 days of the statement, an
expense substantiated or an amount returned within that period will be treated as being
substantiated or returned within a reasonable period of time.

Additionally, § 1.62-2(k) provides that if a payor's reimbursement or other
expense allowance arrangement evidences a pattern of abuse of the rules of § 62(c)
and the regulations thereunder, all payments made under the arrangement will be
treated as made under a nonaccountable plan.

ANALYSIS
An amount paid by an employer to an employee to cover expenses incurred by
the employee in the course of employment can be excluded from the employee’s
income and wages only if a particular Code section provides an exclusion for such
amount or if the amount is paid under an accountable plan. No specific section of the
Code excludes from wages amounts paid to employees for acquiring and maintaining
tools used in the performance of services as employees. Thus, to be excluded from
wages, amounts paid to employees to cover expenses incurred to acquire or maintain
such tools must be paid under a reimbursement or other expense allowance
arrangement that meets the requirements of § 62(c).

An arrangement qualifies as an accountable plan only if it satisfies all three
requirements set forth in the statute and regulations. An arrangement that fails to meet
one or more of the three requirements will be treated as a nonaccountable plan.

The arrangement described in this revenue ruling fails to meet both the
substantiation and the return of excess requirements and thus does not qualify as an
accountable plan.

Although reasonable expectations for expenses can be used to establish that a
plan meets the business connection requirement, satisfaction of the substantiation and
return of excess requirements must be based on expenses actually incurred. The
arrangement in the facts of this ruling does not require employees to substantiate the
actual expenses they are incurring; rather the employees report their time worked
requiring the use of tools, and Employer converts the hours into an amount treated as
expenses incurred based on statistical data. Reporting hours worked requiring the use
of tools is not the equivalent of substantiating actual expenses incurred. Employers
may not substitute a reasonable estimate of expenses to be incurred based on
statistical data and hours worked for the substantiation of actual expenses that is
required by § 1.62-2(e)(3) absent explicit guidance permitting the use of such deemed
substantiation. See
, e.g., Rev. Proc. 2002-41.

Employer does not cure the absence of substantiation or return of excess by
providing employees with the quarterly statement described in this revenue ruling.
Employer does not require employees to provide substantiation of expenses actually
incurred nor does Employer require employees to return any excess received within a
reasonable period of time after receiving the quarterly statement. Thus, Employer is not
providing a periodic statement within the meaning of § 1.62-2(g)(2)(ii).

Each of the accountable plan requirements must be independently satisfied.
Thus, even if Employer required the employees to substantiate the actual amount of the
expenses, and Employer treated any portion of the tool allowances they receive that
exceeded substantiated expenses as additional wages, the arrangement would still not
be an accountable plan. With the exception of circumstances where employee
expenses are covered through a mileage or per diem allowance pursuant to § 1.62-
2(f)(2), an arrangement is not an accountable plan if it includes amounts paid in excess
of substantiated expenses in wages rather than requiring that they be returned. See
§
1.62-2(f)(1); Rev. Proc. 2004-64, 2004-49 I.R.B. 898, (mileage allowances), or Rev.
Proc. 2005-10, 2005-3 I.R.B. 341, (per diem allowances), or any successors.

HOLDING
The arrangement described in this revenue ruling is not an accountable plan.
Therefore, the arrangement is a nonaccountable plan and all tool allowances paid under
the arrangement must be included in the employees’ gross income, reported as wages
on the employees’ Forms W-2, and are subject to withholding and payment of federal
employment taxes.

DRAFTING INFORMATION
The principal author of this revenue ruling is Joe Spires of the Office of Associate
Chief Counsel (Tax Exempt & Government Entities). For further information regarding
this revenue ruling, contact Jeanne Royal Singley at (202) 622-0047 (not a toll-free call).