FAVR driving in the sunset

The Ultimate Guide to Understanding FAVR

How a customizable, tax-free vehicle reimbursement helps companies stay on mission after the tax reform

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As America’s workforce increasingly turns mobile, companies rely more than ever on employees who spend hours each week driving their cars as part of the job. And with a mobile workforce comes the challenge of properly reimbursing those employees for the use of their vehicle.

Most organizations pay either a set monthly car allowance or a mileage reimbursement rate (typically the standard mileage rate set by the IRS). But another strategy has gained traction with employers across the country: the fixed and variable rate reimbursement often referred to as a FAVR reimbursement (pronounced "favor," or /ˈfāvər/).

Chapter 1:

What is fixed and variable rate reimbursement (FAVR)?

Fixed and variable rate refers to an IRS revenue procedure designed for businesses to reimburse employees tax-free for the business use of a personal vehicle.

A FAVR car allowance reimburses employee vehicle costs by identifying both the fixed, localized costs (insurance, depreciation, registration) and variable costs (gas, oil, maintenance) when setting the employee’s reimbursement.

Neither a traditional car allowance nor a mileage reimbursement makes distinctions between the types of expenses or sets rates based on localized costs. These fatal flaws lead to inaccuracies, inequitable reimbursements, and costly consequences.

A FAVR program also bases reimbursement rates on the expenses associated with a standard vehicle most appropriate to the employee’s job. This promotes both accurate and equitable payments.

Each employee receives a fixed regular payment (like a car allowance) along with a variable cents-per-mile rate that rises and falls with variable expenses, with all rates based on employee zip code and a standard vehicle.

Why consider a fixed and variable rate car allowance?

First of all, different employees face different costs. Gas prices vary from locality to locality, as do insurance rates, tax rates, and fees such as registration. Different employees drive different amounts as well. Neither a standard car allowance nor a mileage reimbursement can address these variations equitably or cost-effectively.

Second, the costs of driving for work change over time, but traditional plans respond inadequately to these changes. Most employers choose a standard car allowance or mileage rate for its simplicity. They set a certain monthly amount that seems reasonable or is borrowed from a competitor, and then leave it there for years. Or they go with the IRS mileage rate, which may change annually, but cannot respond adequately to cost spikes or wide discrepancies between costs of driving in different parts of the country. (The IRS rate also has other, more serious problems we’ll cover later.) The fact is, companies choose simple vehicle programs so that they don’t have to think about it, and this guarantees that the policies will not result in accurate or equitable reimbursements.

Third, the tax reform has made changes that will render traditional vehicle reimbursement programs less and less effective. The reasons for this are complicated, so let’s unpack them.

Chapter 2:

The new tax law and vehicle reimbursement

How the new tax law affects car allowances and mileage reimbursements

Changes in the tax code will force many businesses to address their car reimbursement policies either this year or next year. Three reasons why:

Diagram 1

In light of these changes, companies must at least re-evaluate their policies. There is a lot at stake if you don’t get it right:

  • Labor code violations
  • Increased attrition rates
  • Uncontrollable costs

Let’s explore the most popular solutions to the tax reform challenges. We’ll see why each one will prove ineffective.

The standard car allowance vs. the new tax law

Under the old tax code, a car allowance was treated as taxable income. Under the new law, it’s still taxable income but worth less to the employee. Employees can no longer deduct business mileage to offset the taxation of their vehicle allowance.

What if you just increase your current car allowance? Bad idea. You just increased your costs as well as the amount of money going to taxes (30 – 40% for most employees, plus FICA/Medicare for the employer). Oh, and you still did not solve the problem of inaccurate and inequitable business expense reimbursement.

The fuel card or fuel reimbursement vs. the new tax law

Say instead of increasing the taxable car allowance, you add a gas card or fuel reimbursement. Now you have increased your costs significantly while adding the challenges of program administration.

Unless employees log business mileage, that fuel card is treated as taxable income. So unless you want the headache of taxing the fuel card, you’ll need to create a mileage tracking program – and chargeback employees for the personal use of gas (or tax the personal use).

The IRS mileage rate vs. the new tax law

You could also try the IRS mileage rate, which is non-taxable. This solves the taxation problem, and for many employees, it could help with the loss of the unreimbursed expense deduction. But it creates a new set of problems.

  • A mileage rate makes it hard to control costs because it depends on employee-generated mileage. The more they drive or report, the more you pay.

  • Low-mileage drivers are under-reimbursed, while high-mileage drivers are over-reimbursed. This creates an unfair disparity between drivers in different-sized territories.

  • If you’re switching from a car allowance, you now must keep track of employee mileage and monitor it for accuracy.

In summary, employees face both fixed and variable expenses. A car allowance works ok for fixed expenses, but it cannot address variable expenses or disparities between certain localities’ fixed costs.

A mileage reimbursement addresses variable expenses but leaves employees shortchanged if their mileage can’t cover all their fixed expenses, which often amount to 60 – 70% of total vehicle costs. On top of this, you have the questions of taxation, logging mileage, and controlling costs.

If your company’s goal is to treat all employees fairly while addressing vehicle expenses in a cost-effective manner, you will run into trouble in the wake of the tax reform – unless you try a new approach.

FAVR explained in 90 seconds

What is FAVR?

FAVR reimbursement vs. the new tax law

The best way to solve the tax code conundrum is a fixed and variable rate reimbursement.

FAVR has been receiving quite a bit of attention over the past 18 months as a result of the tax reform and labor code changes. The fixed and variable rate is considered best practice for reimbursing employees. Here’s why:

Diagram 2

All of these advantages stem from the strategy of separating fixed costs from variable costs and addressing these differently. Why does that work? Let’s take a look.

Compare your vehicle program to a FAVR Plan

Chapter 3:

How FAVR works

How does a FAVR reimbursement program work?

The fixed and variable rate methodology mirrors how each person incurs vehicle costs.

Diagram 3

A FAVR plan takes a precise approach to reimbursing these two types of costs.

A standard vehicle is selected to generate the reimbursements for each employee. (Employees are free to drive whatever vehicle they like within company parameters, though.)

Driver data is applied to the standard vehicle. This means each employee is reimbursed for the standard vehicle based on where they live and drive.

Each employee receives a fixed amount to cover the fixed ownership costs for their home zip code, regardless of the mileage they travel.

Each employee also receives a variable rate multiplied by their mileage. This variable cents-per-mile rate adjusts each month based on gas prices within that employee’s territory.

The allowance and the mileage reimbursement are combined to deliver a geographically cost-sensitive payment that remains non-taxed.

The fixed and variable reimbursement rates are governed by IRS Revenue Procedure 2007-70. These rates are updated each year primarily based on the capital cost of the standard vehicles chosen by companies to generate their reimbursements.

Why does FAVR use a standard vehicle and not the employee’s vehicle?

Using a standard vehicle for business reimbursements promotes fairness by removing employee vehicle choices from the equation.

Your employees probably drive a vehicle that suits their lifestyle. Their preferred personal vehicle could be a gas-guzzler such as a pickup truck or a large SUV. Many employees expect your business to reimburse them based on what they drive.

FAVR levels the vehicle reimbursement playing field by using standard vehicles to generate payments. You either reimburse all employees based on one standard vehicle or different groups of employees using different vehicles appropriate to their roles.

Image 4

Using a standard vehicle delivers three distinct advantages:

1. Equitable treatment of employees

Scenario: Two employees play the same role in the organization and drive the same number of miles per month, but one drives a Toyota Prius, while the other drives a GMC Yukon. If you pay a flat, taxable car allowance, the person driving the Yukon will always say the allowance is too small. Alternately, if you reimburse mileage or fuel, that same driver will get a much larger reimbursement than the Prius driver.

Using a standard vehicle to generate reimbursement rates will resolve both forms of unfairness.

2. Equitable treatment of the company

Scenario: A business employs sales reps to take small samples to prospects, necessitating only a midsize car to get the job done. Most of the employees instead drive Hummers, expecting to be reimbursed for the costs of this massive SUV.

A FAVR plan would treat each employee fairly without subsidizing the costs to own and operate these massive personal vehicles.

3. Ability to control company costs

If you have employees driving gas guzzlers, how do you control your costs? A company’s vehicle reimbursement costs should not be determined by the lifestyle choices of employees. Instead, it should be determined by the requirements of the job.

Basing reimbursements off of an appropriate vehicle keeps expenditures aligned with the goals of the company.

Why was FAVR established in the first place?

Developed as a non-taxable car allowance option, fixed and variable rate has a long history. FAVR plans have been administered for over 80 years with an approval letter by the IRS. In 1992 the IRS officially recognized FAVR reimbursement programs as an accountable plan or non-taxable reimbursement option.

Even 27 years later, when people first hear about the fixed and variable rate reimbursement, they think it is some type of tax loophole, but it is an IRS accountable plan. FAVR is non-taxable just like the IRS mileage rate, but unlike the mileage rate, FAVR plans were designed for businesses rather than individuals and are more accurate, defensible, and equitable.

Chapter 4:

Why FAVR is non-taxable

What makes FAVR non-taxable, or an accountable plan?

Fundamentally, to be non-taxable, a payment must address a business expense. When it comes to payments to an employee for use of a personal vehicle, it gets tricky because the company must prove that the payment is a reimbursement of a business expense. It’s way too complicated to keep track of receipts and break down business use vs. personal use.

Fortunately, the IRS has detailed the rules a business can follow in order to keep its vehicle reimbursement plan accountable. For a FAVR vehicle program, the key is using projected expense data specific to the standard vehicle garaged in an employee’s zip code.

There are 28 rules that make FAVR non-taxable. Most of these rules involve data models to ensure you have a statistically defensible program. But there are four categories with flexible guidelines for company choices:

FAVR requirements
Image 5

These guidelines require employees to drive vehicles of certain age and value (MSRP when the vehicle was new). Similarly, there is a maximum FAVR cap for the standard vehicle used to generate the vehicle reimbursements. This means the vehicle used to generate the reimbursement can’t exceed the maximum price. For 2019 the FAVR cap has been increased to $55,000, an amount that provides quite a bit of flexibility in the number of business-class vehicles that can be used to generate the vehicle reimbursement rates.

The IRS FAVR guidelines also require employees to maintain insurance coverage at or above certain liability limits. This ensures that employees are paying the same amount as the projected insurance premiums for the standard vehicle garaged in their zip code. This practice also protects the company in the event of an employee car accident.

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Chapter 5:

Who is FAVR for?

Fixed and variable rate reimbursements were designed for mobile employees who drive 5,000 or more miles per month.

FAVR programs can also be designed for hybrid employees who are considered middle or upper management and also travel 5,000+ miles per year. This reimbursement approach is designed to be a business tool but can be customized to provide additional perks.

However, you can only offer a FAVR plan to employees based in the United States. Because the tax laws in Canada and Mexico are different, these plans can’t be provided for employees in these countries.

FAVR is designed for organizations that have at least five drivers on the plan within the year. These means both small and large organizations can take advantage of this tax-free reimbursement approach. However, in both cases, the complex IRS rules can make administration of the plan a challenge.

FAVR is for companies of all sizes

The key question is whether the company is equipped to develop and manage the program itself, or whether it's better to outsource FAVR administration.

Mobile employee entering mileage

Can FAVR be self-administered?

A fixed and variable rate program can be self-administered, but this is not recommended. The complexity of the 28 rules for IRS compliance keeps most organizations from doing so. Ensuring you have the proper methodology and statistically defensible data makes administering the program a huge challenge. Many organizations struggle just to manage a fuel card program, let alone a FAVR vehicle plan.

If an organization decides to go through the process of self-administration, they need to make sure they have accurate data, a GREAT training program, GREAT support, and a system to manage the compliance. Without these elements in place, the program will fail.

Most organizations instead contract with a FAVR plan administrator who is versed in compliance guidelines. This third-party administrator supplies the data, implementation, and management necessary to ensure the reimbursement remains IRS-compliant and tax-free to the organization and its employees.

employees administering a FAVR Plan

Chapter 6:

How should FAVR be administered?

What to look for in a FAVR administrator

To find the right partner to administer your non-taxable reimbursement plan, you need to know what to look for. You want to find a partner who offers:

Diagram 7

Learn more about mBurse FAVR programs and alternatives

How long does it take to implement a FAVR reimbursement plan?

There are three phases to building a professional vehicle reimbursement policy. On average, the process takes 30 days. The three phases are:

DESIGN

Your new policy is designed based on your company goals. Reimbursement rates are then generated based on the standard vehicle(s).

IMPLEMENTATION

Your new policy is implemented and communicated to your employees.

MANAGEMENT

Your new policy is managed with excellent support and a variety of training/support options.

Implementation can be challenging because changes often bring anxiety. However, an experienced plan administrator will coach both management and drivers through the process, helping them see the benefits of the new plan.

Typical plan benefits

  • Employees who receive a taxable car allowance often see a significant benefit boost because they are no longer losing 30 – 40% of their monthly payment to taxes.

  • The company tends to save money as well because this eliminated tax waste will be more than sufficient to fund the new program.

Anatomy of a Professional Reimbursement

A professional reimbursement plan does more than just reimburse employees for the use of a personal vehicle. A professional plan is comprehensive and scalable, balancing company expense, company risk, and equitable reimbursement.

Diagram of the anatomy of a professional reimbursement

Committing to a professional vehicle reimbursement plan

When it comes to car reimbursements, few companies take the time to develop a robust, professional plan. This is a mistake. Taking into account company risk, long-term scalability, and fairness to employees is crucial.

If an organization's leadership is not willing to look at vehicle reimbursements through that lens, they are missing a huge opportunity. They also increase the chances that their car allowance or mileage reimbursement will eventually cause harm to the organization and its employees.

This is why, as you re-evaluate your current car allowance or mileage rate, you need to think about everything from tax codes and labor codes to attrition rates and employee car insurance.

Conclusion:

Now is the time to re-evaluate your car allowance or mileage reimbursement

Let’s recap

The new tax code has eliminated a popular business expense deduction. Employees who drive on behalf of their employer often relied on that deduction. A number of states have passed laws to require companies to fully reimburse their employees for expenses, including vehicle costs.

If you fail to act on this information, employees may leave the company or take other measures to recoup the loss of income.

On top of this, your taxable car allowance or your mileage reimbursement cannot equitably address the variety of expense needs within your organization. Raising the car allowance will increase costs while continuing this inequity. Paying the IRS mileage rate will compromise cost control while over-reimbursing high mileage drivers and under-reimbursing low-mileage drivers. Adding a fuel card or fuel reimbursement to an existing plan only adds more expense and administrative headaches.

Implementing a tax-free FAVR reimbursement program, however, will pay for itself quickly and treat employees equitably. Using a third-party administrator will allow both management and drivers to focus fully on their jobs fulfilling the company’s mission.

That’s what a good vehicle reimbursement policy does – it facilitates the company’s mission.

Re-evaluate your current plan, and consider what both the organization and your employees stand to gain by switching to FAVR.

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