Per Diem Allowance

A per diem allowance is a payment made under a reimbursement or expense allowance arrangement to cover an employee's costs of traveling away from home. The IRS defines the term precisely in Revenue Procedure 2019-48 section 3.01: it is a payment "(1) Paid for ordinary and necessary business expenses incurred, or that the payor 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, (2) Reasonably calculated not to exceed the amount of the expenses or the anticipated expenses, and (3) 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."

What the arrangement buys is relief from paperwork with legal force behind it. Internal Revenue Code section 274(d) requires a taxpayer to substantiate travel expenses, and a per diem paid within the federal rate is treated as substantiating the amount without receipts. Note that "per diem" also names an unrelated concept in long-term care insurance, where it refers to a statutory daily limit on tax-free benefits; that provision has nothing to do with travel reimbursement.

Who publishes which rate. Revenue Procedure 2019-48 section 3.02 names three separate rate-setters, and confusing them is the commonest practical error:

• Continental United States. "The General Services Administration (GSA) publishes the rates for localities in the continental United States (CONUS), as noted in Appendix A to 41 C.F.R. ch. 301. The GSA rates are available on the internet at www.gsa.gov." The rates are per-locality and change annually, so there is no single national number.
• Outside the continental United States. Rates "are established by the Secretary of Defense (rates for non-foreign localities, including Alaska, Hawaii, Puerto Rico, the Northern Mariana Islands, and the possessions of the United States) and by the Secretary of State (rates for foreign localities)."
• The high-low method and the transportation industry. The IRS "publishes an annual notice that provides the special per diem rates ... and the list of high-cost localities." The high-low method, in section 5 of the revenue procedure, replaces the per-locality table with a single high rate for designated high-cost localities and a single low rate for everywhere else in the continental United States.

A per diem rate has two components, and which one applies depends on what the employer is covering. The federal per diem rate is the lodging rate plus the meals and incidental expenses (M&IE) rate for the locality. Where the employer pays actual lodging separately, or provides it, the allowance can be an M&IE rate only.

The accountable plan is the frame around all of it. Section 62(c) provides that an arrangement is not a reimbursement arrangement if it does not require the employee to substantiate expenses or if it lets the employee keep amounts in excess of substantiated expenses. Where the requirements of business connection, substantiation and returning excess amounts are met, "all amounts paid under the arrangement are treated as paid under an accountable plan and are excluded from income and wages." Where they are not met, everything paid under the arrangement is nonaccountable and is "included in an employee's gross income, must be reported as wages or compensation on the employee's Form W-2, and ... subject to the withholding and payment of employment taxes." The per diem rules do not create the accountable plan; they satisfy one of its three conditions.

The excess is wages, and there is a useful asymmetry in how it is handled. Under 26 CFR 1.62-2(h)(2)(i)(B), "the portion of the allowance that relates to substantiated travel days, that exceeds the substantiated amount for those days, and that the employee is not required to return is subject to withholding and payment of employment taxes." But the arrangement does not have to claw that excess back to stay accountable: it satisfies the return-of-excess condition if the employee is required to return the portion relating to unsubstantiated travel days. So an employer can pay above the federal rate deliberately, treat the difference as wages, and keep the arrangement intact.

The meal limitation still applies to the payer. Section 6.05 of the revenue procedure provides that the amount deemed substantiated remains subject to the section 274(n) limitation on food and beverage expenses, generally 50 percent, and section 2.02 notes the higher 80 percent figure for individuals subject to the Department of Transportation's hours-of-service limits. A per diem simplifies substantiation; it does not make a meal fully deductible.

Two limits that catch owners of small businesses. First, the revenue procedure "does not provide rules for using a per diem rate to substantiate the amount of lodging expenses only." Section 4.03 lets a self-employed individual substantiate meal expenses at the federal M&IE rate, so the meals-and-incidentals per diem is available to the self-employed but the lodging per diem is not. Second, and more sharply, section 6.07 provides that the full per diem and high-low methods "do not apply if a payor and an employee are related within the meaning of § 267(b), but for this purpose the percentage of ownership interest referred to in § 267(b)(2) is 10 percent." An owner-employee holding more than 10 percent of their own company therefore cannot use the lodging-inclusive per diem for their own travel and must substantiate lodging with receipts.

Proration for partial days. Under section 6.04, a taxpayer computing a meals-and-incidentals deduction for a partial day must prorate. The Federal Travel Regulations method allocates three-fourths of the applicable rate to each partial day of travel; for a reimbursement covering lodging, meals and incidentals, a payer may use that method or "any method that is consistently applied and is consistent with reasonable business practice."

1. Set the arrangement up as an accountable plan. Business connection, substantiation, and a requirement that the employee return amounts relating to unsubstantiated days.
2. Find the applicable federal per diem rate for each locality where the employee stops for sleep or rest, from GSA for the continental United States, or use the high-low method from the IRS's annual notice.
3. Pay at or below that rate for each day of travel, prorating partial days.
4. Collect the rest of the substantiation. The per diem proves the amount; the employee still has to establish time, place and business purpose within a reasonable period.
5. Treat any unreturned excess as wages, reported on Form W-2 and subject to withholding and employment taxes.

A hypothetical shows the arithmetic without needing a rate table. Suppose the applicable federal meals and incidental expenses rate for the locality is $70 a day, and an employer pays a flat $85 a day. The employee travels four full days.

• The employer pays 4 × $85 = $340.
• The amount deemed substantiated is the lesser of the allowance and the federal rate: 4 × $70 = $280. That $280 is excluded from the employee's income and wages.
• The remaining $340 − $280 = $60 relates to substantiated travel days but exceeds the deemed-substantiated amount. If the employee is not required to return it, that $60 is wages, subject to income tax withholding and employment taxes.
• The arrangement is still an accountable plan, because the return-of-excess condition is satisfied by requiring the employee to return amounts relating to unsubstantiated days, not amounts above the rate.
• On the employer's side, the $280 is a meals and incidental expenses amount and remains subject to the section 274(n) limitation on food and beverages.

These are illustrative figures. The actual federal rates vary by locality and change every year, so the current figure has to come from GSA or the IRS's annual notice rather than from any page that quotes a number.

Pros

• Removes receipt collection for the amount of the expense, which is the largest administrative cost of business travel.
• Gives both sides certainty in advance: the employee knows what they will be paid and the employer knows what it will owe.
• Amounts within the rate are excluded from the employee's income and wages entirely, so there is no gross-up and no reporting on Form W-2.
• The high-low method reduces a per-locality table to two rates, which is simpler for an employer with travel across many cities.

Cons

• It substantiates the amount only. Time, place and business purpose still have to be established, so the paperwork does not disappear.
• Anything above the federal rate that the employee keeps is wages, with withholding and employment tax consequences on both sides.
• The rates are per-locality and change annually, so an employer using a flat company-wide figure will overpay in cheap markets and underpay in expensive ones.
• A self-employed person can use the meals and incidental expenses per diem but not a lodging per diem, so the receipt saving is partial.
• An owner related to the payer within the meaning of section 267(b), reading that section's ownership threshold as 10 percent, cannot use the lodging-inclusive method at all.