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Letter to the Editor

Tool Reimbursement

Is this a cost-cutting tool or a red flag for auditors?

The pitch is clearly appealing: Reimburse your employees for their tools with money on which you don't pay employer-related taxes, and which is not subject to income or FICA tax to the employee.

Sound too good to be true? It may be. While there's no shortage of companies offering to set up such a "tool reimbursement program" for your shop, not all of these programs may comply with IRS guidelines that, as any accountant or tax lawyer will tell you, can be a bit muddy and ever-changing.

The latest ruling from the IRS on tool reimbursement for the automotive aftermarket came just this past August, and while it is not likely the final word on how tool reimbursement programs must be structured, it appears to have put some of the existing programs out of bounds.

So if you have a tool reimbursement plan in place - or are thinking about adding one - it's best to understand the risks and requirements.

"They are a minefield," said Cory King, an attorney with the firm of Fine, Boggs, Cope & Perkins LLP, in Carlsbad, Calif., and a frequent trainer at automotive industry events. "If you step in the right place, you're fine. But if you do not step in the right place, you're going to lose a leg, if not more."

Three simple requirements

California CPA Dennis Frankeberger said tool reimbursement programs began in the 1940s in the logging industry, where employees were expected to bring their own saws and tools to the job site.

"The concept is that your employees bring three items to your workplace," Frankeberger said. "They bring their talent, their time and their tools. Right now you pay them for their time and talent. There is a mechanism through IRS code to be able to pay them for their tools."

Frankeberger has no business connection with any of the firms offering tool reimbursement programs, although he is working with a coalition established to work with Congress and the IRS to make the rules governing the programs more clear and favorable to the automotive aftermarket. He said that the new IRS revenue ruling in August may have clarified but did not change the law.

"What a revenue ruling does is interpret the law that's currently in existence," Frankeberger said. "The law [regarding tool reimbursement programs] has been around for a while. The law has not changed. There have been several interpretations. This is the latest one."

Steven Mopsick, the former chief counsel for the IRS in Northern California who now has his own law firm in Sacramento, agreed with Frankeberger's definition of a revenue ruling.

"It lets the public know what the IRS is thinking about an interpretation of the law," Mopsick said. "They're not binding on the tax courts. If you go to litigation and a revenue ruling is in question, a court may say the revenue ruling is not well-reasoned and choose not to follow it."

But, Mopsick added, not complying with a revenue ruling does put a business at some risk.

"There are [tool reimbursement] plans out there that are really just tax-avoidance schemes in the sense that they try to give the employee a little bit of extra compensation but it's not really for the expense of their tools," he said. "Don't try to give a worker money that is really disguised wages. That's one of the biggest issues that the IRS folks have. They call that the recharacterization issue."

He said that the August revenue ruling said that in order for an automotive technician’s tool reimbursement plan to be acceptable to the IRS, it must meet three requirements.

First, it must be reimbursing employees for expenses that have a true business connection, that is, for tools they are using on the job.

Second, those expenses must be substantiated to the employer so the employer knows for what exactly he is reimbursing the employee. A reasonable estimate of expenses, the IRS ruled, is no substitute for substantiation of actual expenses.

Third, the plan must provide that any excess reimbursement paid to an employee be paid back to the employer.

(To review the August 2005 IRS revenue ruling (2005-52) related to tool reimbursement for automotive technicians, visit: www.ustreas.gov/press/ releases/reports/ruling.pdf.)

What to look for in a plan

Frankeberger and Mopsick said the ruling indicates some key elements shops should look for in a tool reimbursement plan. First, they say, it must be receipt-based.

"We are very clear that the interpretation of the current law is you can only reimburse technicians or mechanics for tools they purchased that are supported by a receipt," Frankeberger said. "A written log or inventory of tools will not stand up with the IRS. I feel that if you don't have a receipt, it's not substantiated. I could not defend you in an audit if you didn't have a receipt. I wouldn't even try."

If a technician buys tools second-hand, Frankeberger said, they should get some kind of receipt from the seller, even if it is just a list of what was purchased for how much on the back of the seller's business card. Some tool companies can provide a history of all tools a technician has purchased from that company, and that, too, may provide adequate documentation.

But the receipt requirement doesn't necessarily mean that reimbursement can't be paid out over time using an established rate, Mopsick said. Such plans have been approved in other industries, though not specifically in the automotive repair industry.

"The ruling does not say that rate-based plans are no longer okay," he said. "There's no mention of rate-based plans in that ruling."

But, he said, the receipts are necessary to help establish the rate and to ensure that reimbursements are justified and that it is clear when reimbursement exceeds actual expenses so excess reimbursement can be returned to the company.

The second recommendation Frankeberger and Mopsick had for shop owners is to only reimburse for tools an employee acquires while in your employment, not those purchased prior to joining your company.

"In years past, I always said, well, if I'm working at this collision center and I brought my tools, that's good enough, it all qualifies," Frankeberger said. "The new interpretation that's come out has strengthened or tightened that down quite a bit. The tools that qualify are only the tools acquired at that job with that employer."

"The very safest position in this area is to insist that the only reimbursement is going to be for tools that were acquired during the course of employment with this particular employer," Mopsick agreed. "We think that's wrong and unfair. But nevertheless that interpretation is one that revenue agents are going to take."

It is that very issue that a coalition of tool reimbursement program providers (the American Craftsman and Tradesman Association) are working to change. After all, they said, the IRS allows workers in some other industries to be reimbursed for tools acquired prior to joining a particular company.

Frankeberger and Mopsick admitted the change may be a long-term process. But Mopsick said some influential members of Congress are very sympathetic to the argument that "if you're going out to look for a skilled craftsman to work in your shop, and you're requiring that person to come to the job with the tools to do the job, and you're not going to provide those tools, you would think that the law should provide for the ability to reimburse that person to bring those tools to the job."

A third recommendation for those considering a tool reimbursement program is to ask the program administrator if any of their clients have been audited, or if the company has a "private ruling letter."

"The answer is probably going to be no," Frankeberger said. "You're going to hear from some of these companies that they have a substantial authority letter from a CPA or an attorney. I have seen five such opinion letters, and I think all five of them are worthless."

Still, Frankeberger and Mopsick said, even under the current IRS guidelines, properly structured tool reimbursement plans can offer substantial tax savings for employers and employees.

INSIGHT would like to hear from shop owners and managers about any experiences they may have at tax time with tool reimbursement issues. INSIGHT will continue to track new developments on this front.   o

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