When an employer requires an employee to move his or her primary residence to work, or continue working, for the employer, oftentimes the employer, as an inducement for the employee to accept the offer employment or continue employment, will agree to pay for some or all of the employee’s “relocation costs.” Employers must be aware of the critical tax implications that can flow from such an arrangement.
Agreements to reimburse the employee for the costs of relocating vary. For example, an employer and employee may agree that the employer will reimburse the employee for moving his or her personal belongings to the new location and perhaps one round-trip airfare for the employee and his or her family; or, the employer may agree to reimburse the employee for all associated relocation costs and related expenses up to a maximum amount. Regardless, if the reimbursement constitutes taxable income for the employee and is subject to Section 409A of the Internal Revenue Code (the “Code”), but the terms of the arrangement do not comply with the Code’s requirements , the employee may have to pay a whopping 20% excise tax on the reimbursement.
Not all moving or relocation expenses are treated alike for federal income and payroll tax purposes. Generally speaking, for moves within the United States an employee may deduct from his or her gross income the reasonable expenses associated with (1) moving his or her household goods and personal effects, and (2) travelling to his or her new home. However, these categories of expenses are deductible only if all of the following requirements are met: (1) the move is closely related to the start of employment, (2) the new job location is at least 50 miles farther from the prior home than the employee’s prior job location is from the former home, and (3) the employee works full time for at least 39 weeks during the first 12 months of employment at the new location.
If the expenses are of a type that may be deducted and meet the foregoing requirements, then an employer’s reimbursement of those expenses will also not be subject to withholding for income taxes, social security and Medicare taxes, provided that the reimbursement arrangement meets the following additional requirements: (1) the expenses have a business connection, i.e., the expenses were incurred in connection with performing services for that employer, (2) the employer requires that the employee adequately account for the expenses within a reasonable period of time, and (3) any excess reimbursements are returned to the employer within a reasonable period of time.
If the relocation cost reimbursement arrangement does not meet the foregoing requirements, or if the employer reimburses the employee for expenses that do not qualify as deductible moving expenses of the type outlined above, the amount of the reimbursement is subject to income taxes, social security and Medicare taxes. For example, employers may agree to pay for return trips to the former residence, pre-move house hunting expenses, temporary housing, storage costs for personal belongings (excluding those incurred in transit), or costs associated with entering into a new rental lease or canceling a prior lease. Reimbursement for any of these costs will be includable in income and subject to social security and Medicare taxes because they do not qualify as the type of expense that may be deductible, even though they may otherwise meet the requirements to be excluded from compensation. Since the reimbursements are taxable, careful consideration must be given in the event that the reimbursement constitutes non-qualified deferred compensation subject to Section 409A.
By way of background, subject to certain exceptions, and generally speaking, Section 409A requires that any compensation promised in one year that could by its terms be paid in a later tax year must be paid only upon certain permissible payment “events,” such as, for example, a fixed date or schedule, or upon termination of employment.
An agreement to reimburse an employee for relocation expenses may or may not cross tax years, but if under the terms of the agreement the reimbursement could be made in a later tax year, then it constitutes deferred compensation subject to Section 409A, and there are important documentary and operational requirements that must be met under Section 409A. If the agreement does not comply with these documentary and operational requirements, the reimbursement amount that the employee receives could be subject to the 20% excise tax.
First, the relocation reimbursement agreement should be written and the written document must provide (1) an objectively determinable non-discretionary definition of the expenses eligible for reimbursement, (2) the reimbursement will be for expenses incurred during an objectively and specifically prescribed period, and (3) that the amount of expenses eligible for reimbursement in one year will not affect the expenses eligible for reimbursement in any other year. (The reason for the rule outlined in number (3) is because the IRS does not want the employee to be able to, indirectly or directly, pick a more favorable tax year by, for example, holding on to the reimbursement request or delaying the incursion of the cost.)
Second, the reimbursement must be made on or before the last day of the employee’s tax year following the year in which the expense was incurred, and the right to the reimbursement cannot be exchanged for another benefit.
For the most part, an employer’s expense reimbursement policy will satisfy the rules regarding the timing of the reimbursement. Unfortunately, employers all too often either provide for a very vague definition of the “relocation costs” that may be reimbursed, or agree to a cap without taking into consideration that the expenses incurred in one year could impact the expenses eligible for reimbursement in the following year. Employers should draft their relocation agreements carefully to provide the desired benefit to the employee while staying within the confines of the limitations of Section 409A. Accordingly, we recommend that whenever an employer or employee agree to a relocation cost reimbursement arrangement, that counsel review the arrangements to ensure that it is either exempt from or otherwise in compliance with Section 409A.