Accounting for and Documenting Ministry Expenses

To be tax-deductible, a ministry expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in the specific ministry type. A necessary expense is one that is helpful and appropriate for the ministry type. An expense does not have to be indispensable to be considered necessary.

Business or ministry expenses of nonprofits may be paid either directly by the ministry, or indirectly by an employee who is then reimbursed by the ministry. A ministry reimburses expenses through a reimbursement plan. When applied properly, expenses reimbursed through an accountable expense reimbursement plan do not result in taxable income. Conversely, expenses reimbursed through a nonaccountable expense reimbursement plan, or excessive reimbursements through an accountable plan result in taxable income to the employee.

Accountable Expense Reimbursement Plan

An accountable expense plan is a reimbursement or expense allowance arrangement set up by a ministry, which requires: (1) a business purpose for the expenses, (2) substantiation of expenses to the employer, and (3) the return of any excess reimbursements.

The substantiation of expenses and the return of excess reimbursements must be handled within a reasonable time. The following methods meet the "reasonable time" definition:

The fixed date method applies if
- an advance is made within 30 days of the time an expense is paid or incurred;
- an expense is substantiated to the employer within 60 days of the time the expense is paid or incurred; and
- any excess amount is returned to the employer within 120 days of the date the expense is paid or incurred.
The periodic statement method applies if
- the employer provides employees with a periodic statement setting forth the amount paid under the arrangement that is more than substantiated expenses;
- the statements are provided at least quarterly; and
- the employer asks the employee to provide substantiation for any additional expenses that have not yet been substantiated and/or return any amounts remaining unsubstantiated within 120 days of the statement.

If business expenses are substantiated and any unused payments are returned, expense reimbursements have no impact on taxes. The expenses reimbursed are not included on Form W-2 or deducted on the tax return.

Example 1: A nonprofit adopts an accountable reimbursement plan using the "fixed date method," authorizing a salary of $26,000 and agreeing to pay business expenses up to $10,000.

During the year, $9,000 of expenses are substantiated under the accountable guidelines. The nonprofit provides a Form W-2 reflecting compensation of $26,000. The substantiated expenses of $9,000 are not reported to the IRS by the nonprofit or on its tax return.

The employer retains the $1,000 difference between the amount budgeted and the amount reimbursed to the employee.

Example 2: An employer authorizes a salary of $23,000 with an auto allowance of $5,000 and $3,000 for other business expenses. The employer does not require or receive any substantiation for the auto or other business expenses. This is a nonaccountable reimbursement plan.

The employer should provide a Form W-2 reflecting compensation of $31,000. The auto and other business expenses incurred could be claimed on Form 2106 (2106-EZ) and Schedule A as "miscellaneous deductions," if reported by an employee for income tax purposes.

Nonaccountable Expense Reimbursement Plans

Nonaccountable reimbursements and excess reimbursements over IRS mileage or per diem limits must be included in gross income and reported as wages on Form W-2. If the ministry pays an "allowance" for certain business expenses, it represents taxable compensation. An allowance not based on actual expenses does not meet the adequate accounting requirements for an accountable reimbursement plan and, thus, must be included in income.

If a ministry allows employees to retain excess reimbursements by calling them a "bonus," the expense reimbursement plan becomes nonaccountable. This is also referred to as a "recharacterization of income." All payments under a nonaccountable plan are reportable as compensation on Form W-2.

Unreimbursed expenses or expenses reimbursed under a nonaccountable plan can be deducted only as itemized miscellaneous deductions and only to the extent that they, with other miscellaneous deductions, exceed 2% of adjusted gross income. Unreimbursed expenses are not deductible if the taxpayer does not itemize.

Documenting Business Expenses

For expenses to be allowed as deductions, evidence must show that the money was spent for a legitimate business reason. Documentary evidence that can be confirmed by a third party generally meets that provision. Canceled checks or credit card slips are excellent forms of evidence. To the IRS, third-party verification is important; if business expenses are paid in cash, a receipt will substantiate the transaction.

Documenting a business expense can be time-consuming. The IRS is satisfied if the following five "Ws" are noted on the back of the credit card slip or other receipt:

Why (business purpose)
What (description, including itemized accounting of cost)
When (date)
Where (location)
Who (names of those for whom the expense was incurred; e.g., meals and entertainment)

The only exception to the documentation rules is if individual outlays for business expenses, other than for lodging, come to less than $75. The IRS does not require receipts for such expenses, although the five Ws are still required. A receipt is always needed for lodging expenses, regardless of the amount.

Use of a nonprofit's credit card can be helpful to charge organization-related business expenses. However, the use of a credit card does not automatically provide substantiation without additional documentation; e.g., business purpose and business relationship.