By John Butler
How important to a church is having an Accountable Reimbursement Plan (ARP)? With an ARP, expense reimbursements and advances are not reported as wages and are exempt from withholding and employment taxes. Without an ARP, reimbursed expenses, even when legitimate, must be reported as wages and are subject to withholding and employment taxes. Even if an employee or minister takes the deduction on their personal return, some additional tax will be paid.
An ARP has three essential elements:
1.) Expenses are only reimbursed for deductible expenses submitted under the requirements of the church’s plan.
2.) Expenses must be substantiated to the church by IRS required documentation, within a “reasonable” time of being incurred.
3.) Excess advances must be returned to the church within a reasonable period.
The expense reimbursement element has three subparts:
- The employer must establish and operate the ARP. An employee cannot be reimbursed tax-free simply because they submit expense records. While a plan does not have to be in writing, having a written plan facilitates proving its existence to the IRS if challenged, and provides a structure for describing employer specific requirements.
- The ARP must only reimburse expenses meeting the requirements of the ARP, and the ARP reimbursements must be in addition to the regular compensation. An employee who does not meet all the requirements of the plan cannot receive a taxable reimbursement in lieu of meeting requirements. An employer cannot substitute tax-free reimbursements for compensation the employee otherwise would have received.
- The ARP must only reimburse for deductible business expenses and specifically identify the reimbursement or expense payment, keeping these amounts separate from other amounts (such as wages).
- The expense substantiation element has two subparts:
- Travel, entertainment, gift, and car expenses describes the information and documentation requirements in more detail.
- Required documentation must be submitted within a “reasonable time.” The IRS regulations provide that documentation submitted within 60 days of the expense being incurred is always reasonable. Longer periods would be subject to IRS challenge. Even if the church cannot afford to pay the expense immediately, it must be submitted to be non-taxable when finally paid.
- Excess advances must be refunded and not converted to taxable income. Advances and refunds must be done within a reasonable time. IRS regulations provide that advances made not more than 30 days before the anticipated expenses are paid or incurred, and refunds made within 120 days after expenses are paid or incurred are always reasonable. Again, longer periods would be subject to IRS challenge.
The IRS has identified two significant issues for attempted ARPs that fail to comply with the requirements:
1.) Under the regulations, a rare or occasional failure may only result in that expense reimbursement being taxable, but inconsistent compliance or chronic failure may result in all reimbursements under the program being taxable, even those that complied.
2.) For senior pastors and other executive level employees, unreported taxable income due to a flawed reimbursement ARP would be an “automatic excess benefit.” Top level employees are treated more harshly than other employees for these mistakes. If the church secretary’s flawed reimbursement is discovered in an IRS audit, the reimbursement simply becomes taxable and subject to interest and penalties. If the senior pastor’s reimbursement is discovered, the amount, plus interest, must be refunded to the church and a 25 percent penalty paid to the IRS.
Implementing an ARP is a two step process:
1.) The church board adopts a resolution that church ministry expenses will only be reimbursed when IRS required documentation is submitted within a reasonable time of the expense being incurred.
2.) The church administrator begins enforcing the resolution, by only reimbursing when required documentation is provided within a reasonable time.
More details and forms are in IRS Publication 463, and Dan Busby’s book, 2009 Church and Nonprofit Tax & Financial Guide, available in bookstores and at www.ecfa.org.
A qualified ARP saves the employee taxes and personal record keeping. For the lay employee, the savings may amount to 10 percent or more of each expense they reimburse under the ARP. Minister employees also benefit, though the savings are less easy to quantify. Consider your church’s reimbursement process, and assure your employees the maximum tax savings.
John Butler is tax counsel at Capin Crouse, Greenwood, IN. [www.capincrouse.com]