April 2008

"Tool Plans": IRS Scrutinizing Employee Reimbursement

John K. Hanson • 480-425-2626 • Email

See also (below): LIFO Valuation of New Vehicles After Rev. Proc. 2008-23

In certain circumstances, the tax laws permit an employee to deduct amounts received from an employer in reimbursement of business-related expenses incurred by the employee. In addition to income tax savings for the employee, because the amount reimbursed is not reported as wages or other compensation, that amount is also exempt from employment taxes.

In recent years, plans designed to take advantage of these tax benefits, commonly known as “tool plans,” have been aggressively marketed in the automobile industry. In response to growing concerns that employers may be mischaracterizing wages as reimbursements solely for tax purposes, the Internal Revenue Service has organized a team to investigate and combat improper tool plans.

Given this heightened scrutiny, dealerships should review their tool plans to determine whether they comply with the tax laws. An employer’s use of an improper tool plan could expose the employer to liability for unpaid employment taxes as well as interest and penalties.

To pass muster, a tool plan must meet four requirements.

• The reimbursement must be for an expense incurred in connection with services performed for the employer.

• The expense must be substantiated by the employee in writing with sufficient detail to permit the employer to determine the business purpose for the expense.

• The employee must inform the employer of the expense within a reasonable period of time, typically within 60 days of the date the expense is incurred.

• If the amount of the reimbursement exceeds the expense incurred, the employee must return such excess amount to the employer within 120 days.

LIFO Valuation of New Vehicles After Rev. Proc. 2008-23

Prior to the issuance of Rev. Proc. 2008-23 on March 24, 2008, the IRS required auto dealers using the "last-in first-out" (LIFO) accounting method to maintain two separate pools for new automobiles and for new light-duty trucks. If the dealership also applied LIFO for used vehicle inventories, there was a similar two pool requirement. The IRS had issued guidelines for pooling used vehicles for LIFO but had not done so for new vehicles. Dealers were using the used vehicle guidelines for pooling new vehicles, but doing so created uncertainty in the classification of the pools as well as audit exposure.

In Rev. Proc. 2008-23, the IRS has allowed dealerships to:

• combine its two new vehicle pools into a single new vehicle LIFO pool, and

• combine its two used vehicle pools into a single used vehicle LIFO pool.

No LIFO pool may include vehicles with a GVW exceeding 14,000 pounds. This is known as the Vehicle Pool Method. It will eliminate the uncertainty of classifying vehicles between two different pools within used vehicles and new vehicles.

The Vehicle Pool Method is permitted beginning in calendar year 2007. Change to the Vehicle Pool Method can be made automatically with no advance IRS permission for 2007 federal income tax returns. If 2007 income tax returns have been filed, change to the Vehicle Pool Method can not be made until 2008. 

To ensure IRS compliance, any tax advice included in this memorandum may not be used by any recipient to avoid penalties imposed under the Internal Revenue Code, state or local tax law provisions. 

Please contact John K. Hanson at (480) 425-2626.

Sacks Tierney P.A. is a member of Meritas, one of the world’s largest and most respected legal resources, and an integrated, non-profit alliance of more than 170 independent commercial law firms located in over 60 countries.

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