Tool Allowances vs. Reimbursements: Which Works Best?

Contractors often ask if they should pay for their employees’ tools or compensate employees for normal wear and tear on their own tools. One option is to pay technicians a little more and ask them to provide their own tools. This can be easier than debating who lost or broke a tool.

There are several ways to manage tool allowances and reimbursements. The right approach depends on your company’s policies, how you want employees to access the money, and the tax and labor requirements that apply.

Option 1: Offer a Tool Stipend

You can offer extra pay to help employees cover the cost of acquiring or replacing personal tools used for company purposes. One method is to pay employees 20 cents (or any amount) more per hour. This money is paid to them regardless of what they spend on tools. They will be responsible for providing the required tools.

A fixed stipend is straightforward to administer, but employers generally must treat it as taxable wages unless it meets the requirements for an accountable plan. According to the IRS, tool allowances must meet specific requirements before employers can exclude them from an employee’s wages. These include a business connection, adequate documentation of actual expenses, and returning any excess reimbursement.

Option 2: Offer a Tool Allowance Savings Program

You can offer extra pay to help employees cover the cost of acquiring or replacing personal tools used for company purposes. With this method, you pay employees an additional 20 cents (or any amount) per hour and place that money in a designated tool fund. You then use the funds exclusively to replace broken tools or purchase additional tools.

This program requires more administration because employees must check their tool fund balances and request reimbursement. That means more paperwork for your company.

To manage this type of program, establish clear rules for how funds accumulate, which purchases qualify, how employees request reimbursement, and what happens to unused balances. Keep records of contributions, purchases, reimbursements, and remaining balances.

Be careful about treating a fixed hourly allowance as a tax-free reimbursement simply because you set aside the money for tools. The IRS explains in its guidance on tool reimbursement arrangements that payments based on hours worked or other estimates generally do not meet the documentation and excess-return requirements for an accountable plan.

Option 3: Deduct Money from Their Paycheck

Under this program, you deduct money from an employee’s paycheck and keep that money for them until they need it. This could also work if you wish to loan your employee money to buy tools and let them pay you back.

However, these arrangements need to be structured carefully. Employers should distinguish between money voluntarily set aside for an employee and deductions used to recover the cost of tools or other business expenses.

Federal wage laws restrict deductions for tools required for an employee’s work when those deductions reduce the employee’s pay below the required minimum wage or overtime compensation. Review the U.S. Department of Labor’s guidance on deductions for tools and other workplace expenses, along with any applicable state laws, before implementing a payroll deduction program.

How to Manage Tool Allowances and Reimbursements

Regardless of which approach you choose, keep the accounting records clear and consistent. Tool allowances and reimbursements can affect payroll expenses, employee balances, and liabilities, depending on how the program is structured.

When managing these transactions:

1. Track the amounts paid or withheld. Record the money contributed to a tool fund, any employee reimbursements, and any amounts that remain outstanding.
2. Use appropriate accounts. Depending on the arrangement, you may need separate accounts for tool expenses and amounts owed to employees. Work with your accountant to determine the appropriate treatment.
3. Reconcile payroll and accounting records. Compare payroll records with the general ledger periodically to identify discrepancies and keep liability balances accurate.
4. Document the program. Put the tool allowance or reimbursement program in your company policy manual so employees understand the rules and responsibilities.

For contractors, accurate payroll records also support job costing. When employee-related expenses are classified consistently, you can better understand the costs associated with running your business and completing jobs.

Create a Required Tool List

Create a list of tools that your company requires its employees to own. Include specific model numbers or specifications if needed. Make it clear what employees must own and maintain and what your company will provide.

A written list helps prevent misunderstandings about who is responsible for purchasing, replacing, and maintaining tools. It also gives employees a clear reference when they join the company or when tool requirements change.

Tips for Tool Allowances and Reimbursements

• Make the terms clear. Explain how employees qualify for allowances or reimbursements, which purchases are eligible, and how they submit requests.
• Review the tax treatment. Determine whether payments are taxable wages or qualify for reimbursement under an accountable plan. Consult a qualified tax professional when necessary.
• Check labor-law requirements. Have a qualified employment attorney review your policy to ensure it complies with applicable federal and state laws.
• Define what happens when employment ends. Specify how outstanding advances, reimbursements, and any remaining tool fund balances will be handled, subject to applicable law and the terms of the arrangement.
• Account for differences between technicians. Consider whether technicians working in multiple trades need additional tools or more expensive equipment, and establish consistent criteria for handling those differences.

A well-defined tool allowance or reimbursement program can help contractors manage tool costs while setting clear expectations for employees. The key is to establish a policy that works for your business, document transactions properly, and review the arrangement periodically to ensure that your payroll and accounting records remain accurate.