The IRS explains Per Diem as an allowance paid to employees for lodging, meals, and incidental expenses incurred when travelling. This allowance is in lieu of paying their actual travel expenses.

However, that is not the way per diem is treated by some in the IT Consulting/Staffing industry.

Under an arrangement with the employee, the Company chooses to re characterize a portion of the percentage offered as salary as per diem. For example if the employee was earning $50.00 per hour, the employer would characterize $15.00 as per diem. In effect, the employee’s W-2 wage would be approximately $63,700.00/year as reported on the W-2, Wage and Tax Statement. In effect, the employer and the employee have colluded to reduce the tax burden by re characterizing a portion of the employee’s salary. There may be other variations on this arrangement, but the basic components remain the same. It is otherwise called ‘per diem skimming’.

The IRS discusses a typical arrangement in a 1990 letter. See: LTR-RUL, UIL No. 125.04-00 Cafeteria plans, Nontaxable benefit; UIL No. 3121.01-06 Definitions, Wages, Payment for expenses; UIL No. 3306.02-00 Definitions, Wages; UIL No. 3401.01-00 Definitions, Wages subject to withholding, Letter Ruling 9052002, (Sep. 05, 1990)

On ***** the Taxpayer adopted a Travel Reimbursement Plan as part of its Flexible Benefit Program.

The Flexible Benefit Program offers employees a choice among group medical insurance, group disability income insurance, dependent/child care expenses, medical expenses and out of town travel expenses. To participate in the Flexible Benefit Program, employees complete a “Salary Reduction Agreement.” Section I of that Agreement states, “WHEREAS, Employee wishes to obtain the benefits of IRC Section 79, 105, 106, 125, 129, 162 and any other Sections, as amended, that provide benefits; and WHEREAS, Employer is willing to assist Employee in obtaining said benefits. NOW, THEREFORE, it is mutually agreed as follows: Employee’s cash compensation per pay period shall be reduced $***** plus (if selected) $44.00 per day for Out of Town Travel expense effective with a pay period beginning on or after January 1, *****.”

Under the Taxpayer’s Travel Reimbursement Plan, a participating employee receives a $44 per diem allowance for meals and lodging expenses for each day the employee certifies to the Taxpayer that the employee was away from home overnight on business. Article IV, section 4.02 of the Travel Reimbursement Plan states that, “A Participant shall submit a reimbursement request weekly setting forth the number of days away from home during the previous week while traveling on business for the Company.” In exchange for the $44 allowance, the participating employee’s salary is reduced by $44 pursuant to the Salary Reduction Agreement.

Article V of the Travel Reimbursement Plan states that,

The Company will fund this Plan by making employer contributions, in whole or in part, pursuant to salary reduction agreements under which a Participant elects to reduce his compensation and to have such amounts contributed to the Plan, as employer contributions, by the Company on his behalf.

A participating employee, who is paid on a weekly basis, benefits financially in that taxable wages, for purposes of federal income tax withholding and the Federal Insurance Contribution Act (FICA), are reduced by the $44 for each day the employee is away from home overnight on business. The reduced federal income tax withholding and reduced FICA result in an increase in the take-home pay of the employee (i.e., the salary reduction amount is taken out of gross weekly income on a pre-tax basis and the identical amount is immediately “reimbursed” to the employee in the same paycheck). Wages shown on the employee’s Form W-2 exclude the per diem amounts. Employees who do not participate in the Travel Reimbursement Plan have their entire gross income subject to withholding and FICA taxes and their Forms W-2s reflect the total gross income earned.

The Taxpayer also realizes financial benefits under the Travel Reimbursement Plan in that the salary reduction amounts reduce the Taxpayer’s liability for FICA taxes and Federal Unemployment Tax Act (FUTA) taxes.

The Taxpayer maintains that the $44 paid for each day a participating employee certifies absence from home overnight on business is excludable from the employee’s gross income under section 1.16217(b)(1) of the income Tax Regulations because it constitutes reimbursement for travel expenses for which the employee is required to account to his employer. Additionally, the Taxpayer maintains that because the salary reduction is for travel, it is excluded from “wages” as defined in sections 3121, 3301 and 3401 of the Internal Revenue Code.


An employee who has a choice between a nontaxable benefit and a taxable benefit (such as wages) generally must, under the doctrine of constructive receipt, include in gross income the taxable benefit he or she could have chosen, even if the employee actually chooses the nontaxable benefit. Section 1.451-2 of the Income Tax Regulations provides that income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, section 125 of the Code provides an exception to the constructive receipt rule and states that, “Except as provided in subsection (b) [relating to discriminatory plans], no amount shall be included in the gross income of a participant in a cafeteria plan solely because, under the plan, the participant may choose among the benefits of the plan.” In addition, section 3121(a)(5)(G) for purposes of FICA and section 3306(b)(5)(G) for purposes of FUTA provide that the term “wages” does not include any payment made to, or on behalf of, an employee or his beneficiary under a cafeteria plan (within the meaning of section 125 ) if such payment would not be treated as wages without regard to such plan and it is reasonable to believe that (if section 125 applied) section 125 would not treat any wages as constructively received. Accordingly, if the cafeteria plan rules under section 125 are not satisfied, the protection against constructive receipt afforded by that provision is lost and the employee must include the taxable amounts in gross income (i.e., salary reduction amounts equal to the cost of the benefits selected).

Therefore, the taxation of particular benefits and the inclusion of those benefits in gross income ultimately depends on whether there is a valid cafeteria plan.

One may also want to look at an IRS publication from February 10, 1984 (News Release IR-84-22) which states:

So-called ‘reimbursement,’ ‘flexible spending’ and similar arrangements which purport to allow employees to pay their out-of-pocket … personal expenses with ‘pre-tax dollars’ are without substance and do not reduce employees’ taxable income.

Under these arrangements, employees submit proof of expenses to their employer, who re characterizes a portion of the employees’ otherwise agreed-upon salary as ‘reimbursement’ for such expenses. On that basis the employer treats, and advises employees to treat, the re characterized amount as a tax-free payment and removes it from ‘wages’ for employment tax purposes. There may be variations of this type of arrangement which are equally invalid.

The IRS has held that any ‘reimbursement’ under such arrangements is part of the employee’s income under Internal Revenue Code section 61 and is subject to federal income tax withholding and federal employment taxes.

The prevailing wisdom among CPAs and Tax Attorneys that we have discussed this issue with is that any attempt to “re characterize wages” may result in a Companywide invalidation of the reimbursement program leading it to be classified as a “non-accountable” plan which would then treat all such payments made to employees as taxable wages. A risk that is just not worth taking.

Typically the following scenarios may be seen as an attempt to engage in per diem skimming:

• HR/Technical recruiters that strike arrangements where the consultant’s rate is manipulated to offer a tax break by offering per diem amounts in the computation of total wage.
• Arrangements that explicitly offer the employee a choice between wages and per diem allowances.
• Contracts that offer the option to have a travel reimbursement item taxed when it is offered to all that qualify.
• Wages differing between professionals in the same facility with proportional differences in reimbursements.

Gagnon v United Technisource May 2010, is a decision from the UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT, where the Court of Appeals held that payment of a raise disguised as per diem was clearly flawed.

Further, in a Memo from the Office of Chief Counsel Internal Revenue Service Number: 201120021 Release Date: 5/20/2011, the IRS dealt with this issue by providing an example:

Treas. Reg. § 1.62-2(j) Example 1 illustrates a violation of the § 1.62-2(d)(3)(i) requirement that a reimbursement be paid only when expenses are incurred or reasonably expected to be incurred. The example provides that Employer S pays its engineers $200 a day. On those days that an engineer travels away from home on business for Employer S, Employer S designates $50 of the $200 as nontaxable reimbursement for the engineer’s travel expenses. On all other days, the engineer receives the full 200 as taxable wages. Because Employer S would pay an engineer $200 a day regardless of whether the engineer was traveling away from home, the arrangement does not satisfy the reimbursement requirement of paragraph § 1.62-2(d)(3)(i). Thus, no part of the $50 Employer S designated as a reimbursement is treated as paid under an accountable plan. Rather, all payments under the arrangement are treated as paid under a non-accountable plan. Employer S must report the entire $200 as wages or other compensation on the employees’ Form W-2 and must withhold and pay employment taxes on the entire $200 when paid. Where a plan serves to re characterize amounts as a reimbursement allowance that would otherwise be paid if there were no expenses reasonably expected to be incurred for the employer, amounts paid under the plan will not be treated as paid under an accountable plan. Further, although an employer may prospectively alter its compensation structure to include reimbursement of substantiated expenses under an accountable plan, an employer may not structure its compensation arrangement so as to avoid the payment of employment taxes by substituting reimbursements and expense allowances for amounts that would otherwise be paid as wages, as illustrated by a temporary reduction in an hourly wage amount only for as long as the tool rate amount is paid. Such re characterization violates the business connection requirement of Treas. Reg. § 1.62-2(c) because the employee receives the same amount regardless of whether expenses were incurred or reasonably expected to be incurred.

Under the circumstances, it is best not to use per diem payments to re characterize what would otherwise be taxable wages.