When an employer pays an expense reimbursement or an advance to an employee (regardless of whether the employee incurs or is reasonably expected to incur the expense), the IRS considers the arrangement to be disguised taxable compensation to the employee. In other words, the purported expense reimbursement is treated as additional taxable compensation.

But when the employer makes these payments under a so-called “accountable plan,” they’re free from federal income and employment taxes for recipient employees. Additionally, the employer benefits because the reimbursements aren’t subject to the employer’s portion of federal employment taxes.

Accountable plans are required to meet four requirements in order for payments to recipient employees to qualify as tax-favored expense reimbursements, rather than taxable compensation:

In a 2009 private letter ruling, the IRS concluded that a company plan that reimbursed employees for the cost of providing their own job-related tools and equipment qualified as an accountable plan. The employer required that managers approve the expenditures and that the tools be kept on company premises and used exclusively for work performed for the company.

Unless your company’s plan qualifies as an accountable plan, the IRS will treat expense reimbursement or advance payments as additional taxable compensation. Examples of arrangements that won’t qualify include: 1) designating part of an employee’s salary as a travel allowance, and 2) reimbursing expenses out of the employee’s salary by reducing his or her paychecks by the reimbursed amounts.

To illustrate: Suppose ABC Co. operates expense reimbursement plans for its warranty repair technicians and salespersons. On any day a repair technician travels away from home on business, ABC designates $50 of that day’s pay as an allowance for travel expenses. The technician receives the $50, but his or her salary is reduced by that amount. The technicians aren’t required to substantiate actual travel expenses.

ABC also designates $500 of each salesperson’s monthly salary as an allowance for monthly business-related entertainment expenses. The salesperson receives the $500, but his or her monthly salary is reduced by that amount. Salespeople aren’t required to substantiate actual entertainment expenses.

These arrangements do not qualify as accountable plans because the allowances are paid regardless of whether the recipient employees actually incur business-related expenses and because the allowances are actually just part of the employees’ salaries. Therefore, ABC must report the allowances as taxable wages on the recipient employee’s W-2 forms.

The allowances are subject to federal income and employment taxes. ABC must withhold federal income tax and the employee’s portion of federal employment taxes on the allowances. ABC also must pay the employer portion of federal employment taxes on the allowances.

Setting up an accountable plan for employees’ business-related expenses can save taxes for both the employees and the employer. Consult your tax advisor for more details.

This post was originally published on May 31, 2016. It was updated on May 26, 2017 to provide you the most current information.