Tool allowances must be based on actual cost.

Tool allowances based on hours worked and on statistical data were subject to withholding and included in employees' income. The IRS determined that such estimates could not be used as substitutes for actual substantiation of the tool expenses. The arrangement also failed return-of-excess criteria, because employees were not required to return amounts exceeding their actual expenses.

Facts

E operates an automobile repair and maintenance business. As a condition of employment, E requires service technician employees to provide and maintain various tools needed to perform repair and maintenance services. E pays each employee an hourly wage and a set amount for each hour worked as a "tool allowance," to cover the employee's costs of acquiring and maintaining his or her tools.

E 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 on tool-related expenses provided by the employee in response to an annual questionnaire. E uses the data to project the employee's total annual tool expenses.

To convert the employee's estimated annual tool expenses into an hourly rate for the tool allowance, E projects the total number of work hours that will require the use of tools. Thus, the hourly allowance is an estimate of the tool expense projected to be incurred per hour by the employee during the coming year.

Each employee reports his or her hours worked requiring the use of tools, to E at the end of each pay period. On a quarterly statement furnished to each employee, E reports the (1) amount paid to the employee as a tool allowance during the quarter and (2) tool expenses estimated to be incurred in the quarter (i.e., the hours reported worked requiring the use of tools multiplied by the tool allowance).

Employees are not required to (1) provide substantiation of expenses actually incurred for tools or (2) return any portion of the tool allowances that exceeds the expenses they actually incur, either before or after the quarterly reports are issued.

Law and Analysis

For purposes of determining adjusted gross income, Sec. 62(a)(2)(A) and Regs. Sec. 1.62-2(b) provide that an employee may deduct employee business expenses paid under a reimbursement or other expense allowance arrangement with his or her employer.

Under Sec. 62(c), an arrangement will not be treated as a reimbursement or other expense allowance arrangement if it (1) does not require the employee to substantiate the expenses covered by the arrangement to the payer or (2) allows the employee to retain any amount in excess of the substantiated expenses covered under the arrangement.

Under Kegs. Sec. 1.62-2(c)(1), an arrangement satisfies Sec. 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 it are excluded from the employee's gross income, are not required to be reported on his or her Form W-2 and are exempt from the withholding and payment of income and employment taxes; see Regs. Sec. 1.62-2(c) (4).

Conclusion

According to the IRS, the arrangement as described, fails to meet both the substantiation and the return-of-excess requirements. 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.

Here, the arrangement does not require employees to substantiate the actual expenses they are incurring; rather, they report their time worked requiring the use of tools; E converts the hours into an amount treated as expenses incurred based on statistical data. According to the Service, reporting hours worked requiring the use of tools is not the equivalent of substantiating actual expenses incurred. E may not substitute a reasonable estimate of expenses to be incurred based on statistical data and hours worked for the substantiation of actual expenses required by Regs. Sec. 1.62-2(e)(3), absent explicit guidance permitting the use of such deemed substantiation; see, e.g., Rev. Proc. 2002-41, 2002-1 CB 1098.

E did not cure the absence of substantiation or the return of excess by providing employees with the quarterly statement. E does not require employees to provide substantiation of expenses actually incurred, nor does it require employees to return any excess received within a reasonable period after receiving the quarterly statement. Thus, E is not providing a periodic statement within the meaning of Regs. Sec. 1.62-2(g) (2)(ii).

Thus, 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. REV. RUL. 2005-52, IRB 2005-35, 423

David O'Driscoll, J.D., LL.M.