Question: Is a tool allowance excludable from an employee’s gross income?
Answer: It depends on how the tool allowance is set up. When cash allowances are provided to employees for tools, the allowance is excludable from an employee’s gross income if it qualifies as a “working condition fringe benefit.” To set up a working condition fringe benefit for a tool allowance, employees need to verify to the employer that the payment is actually used for the tools needed to perform the job. Employees must submit receipts or other supporting documentation, and they need to return any unused allowances to the employer.
In 2005, the IRS issued Revenue Ruling 2005-52, which stated that a tool allowance that was determined by estimates (instead of actual costs) was included in gross income (i.e., taxable). In Revenue Ruling 2005-52, employees were given an allowance based on an estimate of tool costs for the hours they worked. The employees were not required to submit receipts or other supporting documentation, nor were they required to return amounts in excess of substantiated expenses, which is why the IRS determined their tool allowance was taxable.