Most employees will incur business expenses at some point or another. This might be related to travel expenses, medical expenses, taking clients out to dinner, or paying for tools and equipment, amongst other costs. As a result, it’s important to have a defined procedure in place for processing out-of-pocket reimbursements.
Implementing a program for expense reimbursements can offer you a number of benefits as an employer. For one thing, repaying out-of-pocket reimbursements in a timely manner can help you build a happy and engaged workforce. Employee reimbursements can also offer you a number of tax incentives from a payroll perspective. In contrast, failing to reimburse your employees or taking too long to process payments can damage your company culture and have a negative impact on your employer brand.
Here’s everything you need to know about out-of-pocket reimbursements.
Table of Contents
Table of Contents
What are out-of-pocket reimbursements?
Unless you provide your employees with a company credit card or an expense card, then they may occasionally need to pay for expenses out of their own pocket. This might include travel expenses, costs relating to the purchase of tools, equipment or business supplies, general business expenses, and employee stipends. Your employees may also need to pay upfront for certain medical expenses, although this will depend on the terms of your employee reimbursement plan.
Out-of-pocket reimbursement, also known as expense reimbursement, is the process of repaying employees for any of your approved out-of-pocket expenses. If your HR policies cover it, you may also choose to reimburse employees for costs associated with wellness initiatives, training and development, and remote work expenses. These expenses are usually reimbursed in line with a company-approved process. Employees also need to supply detailed receipts outlining their business expenses.
Types of out-of-pocket reimbursements
According to IRS Publication 535: “To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”
Here are a few examples of out-of-pocket reimbursements that you might include in the list of approved expenses included in your employee reimbursement plan.
Work-related expenses are usually classified as any out-of-pocket expense that an employee has incurred whilst performing the duties of their job.
According to the IRS, reimbursable work-related expenses usually include the following:
- Education or training, provided training is directly related to an employee’s role.
- Business supplies. Any supplies that an employee purchases for business purposes, such as paper or stationery.
- Work-related tools and supplies, such as manual tools, uniforms, computer equipment, or software and applications required for work.
- Miscellaneous business-related expenses, such as petty cash, union dues and expenses, and professional membership fees.
As an employer, you can reimburse any of these expenses at cost, provided your organization has an accountable plan for expense reimbursements.
Some employers also include medical expenses in their employee reimbursement plans. This can be a great way to boost your employee health benefits package.
Medical expense reimbursement plans (MERPs) are sometimes used as an alternative to a traditional employee health plan (such as an FSA or an HSA). Even if an employee does have an existing health plan, these forms of reimbursement plans, also known as Section 105 plans, can help employees cover out-of-pocket healthcare expenses including deductibles, copays, and coinsurance costs that aren’t usually covered by insurance companies.
Remote work expenses
An increasing number of companies have started offering hybrid and remote work policies to their employees, especially since the start of the Covid-19 pandemic. As a result, many employees are incurring additional expenses associated with working from home. This often includes utilities, WiFi, computer hardware and software, furniture such as desks and chairs, mobile phones, and tools for communicating with colleagues.
To address these increasing costs, many employers are now including remote work expenses in their out-of-pocket reimbursement plans. In this instance, you can either get your employees to send their invoices and receipts whenever they incur expenses, or you can offer them a defined remote work allowance.
In terms of the law, there are currently no federal laws requiring employers to reimburse remote employee expenses. However, some states have implemented remote work policies relating to the reimbursement of work equipment expenses.
For example, the California Labor Code states that employers must reimburse remote employees for all their work-related expenses. Moreover, section 2802 of the code requires that the employer should pay a “reasonable percentage” of an employee’s cell phone plan when the cell phone is required for work.
Mileage and travel expenses
Another common type of out-of-pocket expense included in many reimbursement plans is mileage and travel expenses. These are costs that your employees incur during the course of work-related travel. This might be a national or international business trip, travelling to a conference or meeting, or expenses incurred whilst visiting clients. Unless you offer per diems for business travel, then it is a good idea to reimburse your employees for all the costs they incurred during their trip.
It is up to you as an employer to define which travel expenses you will accept from your employees. Many employers offer to reimburse expenses related to transportation (flights, trains, buses, cabs, etc.) and accommodation (hotels, motels, etc.). Meals and entertainment costs are only classified as business reimbursable expenses if they meet the criteria outlined in IRS Publication 463.
Some employers also include personal car mileage reimbursement in their travel expenses policy. This is the mileage corresponding to an employee’s business use of a personal vehicle whilst commuting to and from work or travelling to meet clients, for example. Most organizations use standard IRS mileage rates to calculate mileage expense reimbursement. As of 2022, the standard mileage rate for business travel is 62.5 cents per mile.
Out-of-pocket maximums and deductibles
Out-of-pocket maximums are limits on the out-of-pocket medical expenses that an employee with health insurance pays for covered healthcare services in a given plan year (12 months from the plan’s effective date). Some insurers refer to this as an out-of-pocket limit.
An out-of-pocket maximum includes any deductibles, copays, and coinsurance premiums that exceed the established deductible limit. However, it does not include an employee’s standard monthly insurance premiums.
According to federal law, any healthcare plan that meets Affordable Care Act (ACA) standards must include out-of-pocket maximums. As of 2022, out-of-pocket maximum limits are $8,700 for individual coverage and $17,400 for family coverage. As of 2023, out-of-pocket limits will increase to $9,100 for individual coverage and $18,000 for family coverage. Plans can’t have out-of-pocket maximums that exceed these limits, but many offer lower maximums.
Staying compliant (tax-free/taxable expenses)
According to the Fair Labor Standards Act (FLSA), you are not legally required to offer expense reimbursement to your employees unless the expense reduces an employee’s pay below the established minimum wage. However, most organizations choose to do so as it is generally considered to be fair and common practice. It can also help to create a better employee experience, provided you create a clear and consistent policy for effective expense management. This means defining what you accept as an employee expense, how employees submit expense reimbursement requests, and how you incorporate expenses into your payroll process.
You also need to understand what the IRS classifies as an expense from a tax point of view.
Before you can class a business expense as tax-deductible, you need to make sure it falls under the definition of an accountable plan. An accountable plan follows IRS regulations for the reimbursement of expenses that are not counted as income.
Essentially, to be classed as tax deductible, the expense must be classed as both ordinary and necessary. An ordinary expense is one that is commonly accepted in your industry. A necessary expense is anything that is helpful and appropriate for your business or trade. An expense does not have to be indispensable for you to consider it ordinary and necessary.
If expenses meet these requirements, then they are classed as legitimate business expenses and they are therefore not subject to income tax. Employers can then claim these expenses, in full or in part, as tax deductions. If an expense doesn’t meet these requirements, then you must treat it as an out-of-pocket reimbursement under a non-accountable plan. And this means you need to class it as income and tax it through payroll accordingly.
Creating a reimbursement plan
If you offer out-of-pocket reimbursements, then it’s vital that you create a detailed reimbursement plan that establishes clear guidelines on what you will and won’t accept as an employee expense. A clear policy also outlines the procedure that employees must follow when they submit a reimbursement request. Plus, it streamlines the approval and payment process so that it’s clear which expenses should be classed as tax deductible when it comes to payroll.
Here are a few things that you need to include in your out-of-pocket reimbursements plan:
- The types of expenses that qualify for reimbursement
- How reimbursements need to be submitted
- Time limits for submitting requests
- Supporting documents that employees must include with their requests (receipts or invoices)
- The person who is responsible for approving out-of-pocket reimbursement claims (departmental managers, HR, finance, etc.)
- Spending limits for each expense category
- Any specific suppliers and vendors that you want your employees to use
- How and when you will reimburse employees
- The consequences of expense fraud and overspending.
It’s also important to make sure that your employees understand that they must keep detailed records of all their expenses, including receipts and invoices where appropriate. This will ensure that the expense approval process runs smoothly and help you avoid any potential disputes relating to out-of-pocket reimbursements.
Common out-of-pocket reimbursement examples
Let’s take a look at a few common out-of-pocket reimbursement examples. This will help you understand what you could include in your employee reimbursement plan.
Sales rep out-of-pocket reimbursements
Let’s say you have a team of sales reps in your company. These sales reps spend most of their time on the road travelling to meet clients and suppliers. You don’t provide them with company cars, so they have to use their own vehicles and pay for their own gas.
In this case, the money your sales reps spend on gas can be classified as a reimbursable expense. To claim the expense back, sales reps should submit regular records of their mileage and gas costs for payment. Alternatively, they could decide to use the deduction when they file their taxes and claim it as a business expense. Depending on your policy, you might also decide to reimburse wear and tear on their personal vehicles.
Business manager out-of-pocket reimbursements
Some of your managers may need to go on the occasional national or international business trip. Unless they have use of a company credit card, they will need to cover their own travel expenses. This might include flights, accommodation, meals, and tips. It might also include additional expenses if they have to entertain clients, for example. They can then submit all receipts and invoices corresponding to the trip as expenses once they return.
Remote employee out-of-pocket reimbursements
If some of your employees work from home, then they are going to incur certain out-of-pocket expenses. For one thing, working from home is going to increase the cost of their utilities. Remote employees also need a reliable internet connection. They may also need to buy new equipment unless you provide them with a company computer and cell phone. Plus, they are likely to need software solutions to connect to your server and communicate with their colleagues. They will also probably need a steady supply of paper, printer cartridges, and stationery.
Because employees rely on all the above to perform their duties, most employers would class these costs as reimbursable expenses. This means that remote employees should submit records of all expenses that they incur each month. Alternatively, you should provide them with a remote work allowance that covers all of the above.
Factorial’s expense reimbursement through payroll
Once you have defined your reimbursement plan, you also need to make sure you have access to the right tools and software to manage the employee reimbursement process. This helps you centralize your data and automate your requests. That way, it is much easier for you to process large volumes of data from multiple departments.
So, what tools should you use?
Without a doubt, an expense management software tool is the most effective solution for managing the out-of-pocket reimbursements process. Aside from streamlining the process, the best solutions can also be easily integrated with your payroll software so that you can ensure accurate and timely payments each month. This makes the whole process much simpler for your team and helps to keep your employees happy.
For example, with Factorial Expenses, you get the benefit of efficient expense reimbursement management with all the added features of Factorial’s all-in-one solution. This is because we have integrated our expense management software with our HRIS and payroll features. That way, you can be sure that you correctly classify any expenses that might be tax deductible in line with established IRS rules. Plus, with our time and expense tracking feature, employees can automatically upload their expenses and receipts and classify expenses according to categories. Managers can then review out-of-pocket reimbursement requests in their own time and accept or reject them.
Aside from simplifying the payroll process, you can also generate detailed expense reports with our solution. This gives you valuable insight into how employees are spending money, and where. That way, you can keep on top of your out-of-pocket reimbursements whilst reducing the time you spend processing paperwork.