First off I'll include some background info, so sorry for the length...

So I've been working at a site for about a year and a half now as a contract employee, and have been getting per diem to cover living expenses as a separate line item on my paycheck. (This is my first contract gig; no prior experience with per diem.) This is paid by my employer, is under the GSA max per diem rate for the county I'm working in, and was/is not reported on my W-2 as income. I originally expected to only be here as needed until the company staffed up with regulars but worked here for a year on the first contract, then was renewed for the position with a different contract by a different company, and so I've continued to receive a per diem allowance as a separate line item with no taxes withheld. I submit timecards to prove my hours, days, and location of work but I don't submit any expense reports. I do own a house in another state that I consider my permanent residence and visit a few times a year, and I incur duplicate living expenses (utility/maintenance costs) at the house.

Just recently I've been looking deeper into some per diem stuff and I keep coming across vague language about per diem requirements. Being now more confused and concerned than I was before, I hope to get some questions answered:

1) If my employer is NOT withholding payroll taxes on my per diem, does the employer therefore have an accountable program? Or do I have to treat the allowance as unaccountable, taxable income even though it isn't reported on my W-2?

2) If it's an accountable program, can I keep going as I am now or do I have to start itemizing, submitting expense reports, etc. Do I have to itemize my living expenses on my taxes? If so, any idea why the employer wouldn't be requiring this up front as proof/verification of the per diem payments? Literature I've read on this is vague as to what exactly is required if the per diem is paid as a regular allowance and is below the GSA maximum.

3) If I don't leave the area after a year but start a new but different temporary contract with a different company, should my new employer have started withholding taxes from the per diem allowance? My new employer was aware that I'd been working here for a year already.

4) What is some helpful info I need to get from my employer to help get to the bottom of all this?

For me the bottom line is, if I'm supposed to pay (and should have been paying) income taxes on per diem that has not been reported or withheld then I could owe a whole lot of money in back taxes and I need to start dealing with that, and I also need to see how/why my employer is not withholding those taxes as they ought to be. If not, and the status quo for my per diem allowance is okay, then I need to put my mind at ease!

Thanks!

1) Your employer's plan is unaccountable, because you are not being required to submit expense reports, but rather are being paid a set amount per day.

2) Whether you are required to submit expense reports or not is NOT your decision; it is the decision of your employer.

3) The fact that you are there a second year mandates that you should be paying taxes on the per diem being paid to you. The IRS position on this matter is clear: a temporary job that allows non-taxable per diem can last no longer than one year, regardless of who the employer is.

4) Your employer probably feels that your situation will not last and, eventually, you will either move on to a different location or be offered a full-time job at your current location. I suspect they will NOT be open to the correct interpretation that they should have started withholding taxes on the first day of your second year in that location, because to do so would open them to some rather hefty fines by the IRS for failing to properly withhold those taxes.

As for you, to be legal, you need to claim the per diem amount as income on Line #21 on Form 1040 as "other income". You will pay state and federal income taxes, but should avoid the FICA (Social Security and Medicare) taxes. You may want to make a quarterly estimated tax payment by 15 Sep 09 using Form 1040-ES, less you have a VERY unpleasant surprise come 15 April 2010.

Helpful answer, thanks!

That sucks, and it'll cost me a large amount off my bottom line, but that was my gut feeling given some of the other stuff I've read. Better to figure it out now and at least have some time to prepare for the fleecing I guess.

What about the first year's pay though? My understanding is that the per diem I received over the first year is still tax-free, especially since it was under a different contract..

The assumption with us contractors IS that we'll be around short-term, which is why the contract was for a year and not longer. I was a bit surprised that the new employer would be able to keep paying per diem separately, and I even brought this up with them on more than one occasion. But different companies have different ways of "bending" the rules, and I figured since they'd been at this for plenty long enough to know what they were doing so I went along. Oops.

In my opinion, the first year's per diem IS tax-free, because you were still in temporary status at that time.

If you or your employer knew for sure that your job would exceed one year, then (and only then) would the first year's per diem lose its tax-free status.

BTW, thanks for the tip!