What is Per Diem?
Per diem (Latin for ‘per day’) refers to payments that reimburse employees for expenses, such as lodging and meals, they incur when traveling to perform their jobs away from home. But the government imposes strict guidelines on when and how these payments can be implemented.
Per diem is paid in lieu of paying actual travel expenses directly, according to the Internal Revenue Service (IRS), when the allowance meets three criteria:
- Paid for ordinary and necessary business expenses incurred, or that the payer reasonably anticipates will be incurred, by an employee for lodging, meal, and incidental expenses; or for meal and incidental expenses for travel away from home performing services as an employee of the employer in pursuit of a business or trade
- Reasonably calculated not to exceed the amount of expenses or the anticipated expenses
- Paid at or below the applicable federal per diem rate, a flat rate or stated schedule, or in accordance with any other service-specified rate or schedule.
Per diem payments come into play when an employee is employed at a location that requires travel to a location outside a 50-mile radius from his or her primary residence. Since an employee would in essence be paying duplicate living expenses (a mortgage or rent plus a hotel charge, for instance), per diem payments are a way to ensure the employee is not financially penalized for work travel. In addition to lodging and meals, other covered expenses could include mileage, ground transportation fees, dry cleaning, laundry, phone use, WiFi and restaurant or room attendant tips. Only expenses that an employee incurs while performing services for the employer while away from home are covered.
Because per diem payments are not considered wages, per diem payments are non-taxable and are not reflected on the taxable income section of an employee’s W-2 and the employer does not pay statutory employer costs (FICA, FUTA, SUTA) and other standard statutory payroll costs. Employers also can deduct a portion of the per diem payment as a business expense from annual tax returns. Lodging is completely deductible, but meals and incidentals are deductible only as they qualify as business expenses.
For companies that cannot find the labor supply at the work site without incurring significant additional cost, reimbursement of living expenses offers a practical alternative. Although expenses could be submitted individually, that volume could present a significant administrative burden to the employer. Per diem payments alleviate the reporting burden by estimating expenses and utilizing a flat fee to cover them.
To aid in tax planning and reporting, the U.S. State Department provides per diem rates for the contiguous 48 states (plus the District of Columbia) for meals, lodging and other travel expenses. These CONUS rates (CONUS refers to “Continental United States”) acknowledge area wage differentiation and are seen as the standard because they are the maximum allowances that federal employees are reimbursed for expenses incurred while on official travel.
Compliant per diem practices
In order for employers to reimburse employee business expenses on a non-taxable basis, the expenses must by paid under an accountable plan meeting these requirements for business connection, substantiation and return of excess. Other accountable plan rules are outlined in Publication 15 (Circular E), Employer’s Tax Guide.
Business connection requirement
An arrangement meets the business connection requirement if the employer pays advances, allowances or reimbursements only for deductible business expenses that the employee pays or incurs while performing services for the employer while away from home. The deduction is not permitted for amounts that are lavish or extravagant under the circumstances. An employer risks falling outside the parameters of the business connection requirement if the employer:
- Pays an employee the same per diem payment whether or not the employee incurs the expense
- Supplements the base rate of the wages paid to an employee in lieu of an applicable non-taxable per diem payment.
- Reduces the base rate wage payment of an employee when per diem payments are being made only to then resume the wage payment again after the expenses are no longer being incurred.
This last point speaks to the issue of wage recharacterization, which essentially applies when an employer starts with a base wage and splits out part as reimbursable per diem payments.
This split rate practice is barred by DOL and IRS regulations. To minimize risk, employers should identify and pay wages at or exceeding the minimum fair market wage, and then separately identify and make per diem payments that do not vary by the hour. Often vendors pay at the minimum wage, which is often much lower than the minimum fair market wage.
To meet the substantiation requirement, an arrangement requires the employee to substantiate each business expense to the payer within a reasonable period of time. The IRS also accepts an optional, simplified method, known as “deemed substantiation,” for an employee to substantiate the amount of his or her expenses incurred while traveling away from home when performing services for the employer. This method provides a deemed substantiated amount of expenses but still requires the employee to substantiate the time, place and business purpose.
Risks of not fulfilling the return of excess per diem requirement
An accountable plan also requires the employee to return to the employer any amount the employer paid in excess of the employee’s expenses within a reasonable period of time. In order to satisfy this requirement, an employer needs a mechanism or process to determine when an allowance exceeds the substantiated amount.
Note that companies are not prohibited from altering their compensation structure to include reimbursement of substantiated expenses under an accountable plan, as long as the amount is only paid if bona fide expenses are incurred for the employer, and the employer does not use an alternate method to get the same amount of gross pay to employees who do not incur those expenses.
Want to learn more about the correct use of per diem payments? Access Aerotek’s new guide, Ensuring Compliant Per Diem Practices in Aviation.