Should I use per diems for my business?

At Independent Contractor Tax Advisors, we frequently receive inquiries from our clients regarding how “per diems” work and whether or not they should use them. The short answer is: we don’t recommend it. Per diems do not mean tax-free money. Continue reading if you want to understand why.

In the context of income taxes (warning legal description coming), a per diem is a geographic-specific, daily rate at which an employer can reimburse employees for travel expenses (lodging & meals/entertainment) without triggering a tax liability to the employee IF (big IF) certain conditions are met. The rate is updated each year by the GSA (www.gsa.gov/perdiem) and the IRS borrows those rates for its purposes. Essentially, the IRS is saying that an employer (which is YOU in the case of our clients) can reimburse its employees (again, YOU in the case of our clients) up to the geographic-specific rate and not report the payment as W-2 income to the employee as long as certain conditions are met. If those conditions are not met, the entire per diem payment is considered W-2 income to the recipient. Bad news.

As you can see, this can be confusing for independent contractors and the self-employed because you are both the employer AND the employee. The key for the independent contractor/self-employed/freelancer is that if the per diem is treated as W-2 income, it’s a bad deal because you’re being taxed on something that should be deductible! (For more information about deductions, click here)

Now, there are two types of per diem plans: Accountable Plans and Nonaccountable Plans.

An “accountable plan” allows an employer to pay per diems without reporting it as W-2 income to the employee, a “nonaccountable plan” requires ALL per diem payments to be reported as W-2 income (bad news).

So, we assume that most of you are interested in the accountable plans because that’s the one that provides the actual tax advantage. Along with several requirements, here are the main drawbacks for using an accountable per diem plan:

1. The employee (you) must provide thorough written evidence of ALL expenses incurred (receipts, checks, invoices, travel mileage allowance rates, etc.) along with the location, date and a detailed explanation of what the business purpose/expense was for, AND
2. Employees must RETURN amounts in excess of the substantiated expenses within a reasonable time (usually within 30 days).

Hence the major problem with per diems. Many falsely believe that they can pay themselves a per diem, expense it through the business, not keep receipts, and just pocket the money. The IRS will win that argument all day long. If you keep any cash above and beyond the amount you actually spent (and can substantiate), you’ll be taxed on it.

So then, doesn’t it just make more sense to get reimbursed? Absolutely. You actually end up in the exact same place with the per diem plan or a reimbursement plan, but the record-keeping requirements of an accountable per diem plan is more onerous.

The adage, “If it sounds too good to be true, it probably is.”, certainly applies here. With that, let’s focus on the ways that we CAN reduce your taxes and put this bad idea to bed.

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Tags: business expenses as a freelancer, business income as an independent contractor, CPA firms for freelancers, freelancer tax savings, Independent Contractor S Corp