Sometimes a monthly car allowance isn't enough to offset employee vehicle costs, so the company adds a mileage reimbursement. A similar but more cost-effective approach is the fixed and variable rate car allowance, also called FAVR ("favor"). Let's compare.
What is a fixed and variable rate allowance?
A fixed and variable rate allowance is an IRS accounting procedure that pays non-taxable business reimbursements for personal vehicle use. Also known as a FAVR car allowance, this model makes both periodic fixed payments and periodic variable payments.
The fixed payments are based on projected fixed costs (depreciation or lease payments, insurance, registration and license fees, personal property taxes). The variable payments are based on projected variable costs (gasoline, oil, tires, routine maintenance and repairs).
This description may sound complicated, but a fixed and variable rate plan does basically the same thing as a car allowance combined with mileage reimbursement – but better.
Car allowance plus mileage rate vs. fixed and variable rate
Both vehicle reimbursement approaches pay a fixed monthly stipend along with a mileage reimbursement. This makes sense because employees who operate personal vehicles for work incur both fixed and variable expenses.
A fixed car allowance makes sense to pay for fixed vehicle costs (insurance, depreciation, registration, etc.) since these are predictable and stay roughly the same every month. It also makes sense to add in a mileage rate to help cover variable costs that increase the more you drive (fuel, oil, tires, maintenance, etc.).
The basic difference between paying a car allowance with a mileage rate and paying a FAVR car allowance is the way the payment amounts are derived. But that basic difference has significant effects. Let's start with how the rates are derived.
Calculating car reimbursement rates for both fixed and variable costs
When determining an allowance amount plus a cents-per-mile rate, most organizations start either with what they've paid in the past or what a competitor is paying. They will typically pay a standard monthly amount to all employees who drive for work, regardless of territory size or location. They will also pay the same mileage rate regardless of location.
Paying the same stipend along with the same mileage rate, however, does not result in accurate or equitable reimbursements. If one employee works in California, and another in Oklahoma, their expenses will be different, even if they drive the same number of miles. This is because California has higher vehicle costs than Oklahoma (gas, insurance, etc.).
To avoid paying an equal amount for unequal expenses, a FAVR vehicle plan takes a data-driven approach to determining rates, following three important steps:
1. Use a standard vehicle to compute FAVR allowance rates.
This is key. Most companies standardize their rates. Smart companies standardize the vehicle used to generate the rates. This ensures that the rates reasonably fit job responsibilities, rather than the vehicle choices of the drivers. You don't want to set the rate based on a Hummer just because that's what some employees choose to drive.
2. Calculate an appropriate fixed allowance for each employee's zip code.
Using the selected vehicle, geographically-sensitive allowances are derived. An employee who lives in a zip code with higher insurance rates and higher taxes or registration/license fees will receive a higher monthly payment than an employee who lives in a less expensive part of the country.
3. Calculate an appropriate mileage rate for each employee's zip code.
Again, using the selected vehicle, geographically-sensitive rates are derived. An employee working a territory with higher gas prices and maintenance costs will receive a higher mileage rate. The rate also adjusts over time as gas prices change.
Because the fixed and variable rates are based on localized vehicle expense data, employees receive accurate reimbursements. This approach is equitable, with no one getting shortchanged or overpaid. The same cannot be said for a car allowance plan with a mileage rate attached. This has consequences for taxation as well as long-term costs to the company.
IRS tax rules and standard car allowances vs. FAVR allowances
A car allowance plus mileage rate is partly taxable, whereas a fixed and variable rate allowance is entirely non-taxable. Let's compare.
IRS rules treat a standard car allowance as taxable income. A mileage reimbursement, on the other hand, is tax-free as long as the rate does not exceed the IRS standard business mileage rate ($.575/mile for 2020), and the company keeps track of each employee's business mileage.
A FAVR vehicle reimbursement remains non-taxable because its data-driven approach makes it easy for the employer to prove that all payments are going to business vehicle expenses. The employer must keep track of each employee's business mileage.
The costs of a taxable car allowance
When you add up federal and state income taxes along with FICA/Medicare, most employees see 30-40% of their car allowance going to the IRS. This deficit is what places pressure on the company to add a mileage rate. (Plus the company also pays payroll taxes on the same amount.)
Consider this – instead of adding a mileage rate to offset the taxes going to the IRS, what if you cut the government out of the equation and just paid that amount one time, and only to the employee? This is essentially what a FAVR plan allows you to do.
How expensive is a FAVR vehicle plan?
Tax-free reimbursement is what ultimately sets FAVR apart from other plans. By taking the same money that was going to taxes and re-investing most of it into the employees and company, you save money, supply a more sufficient car allowance plan, and create a cost-effective and sustainable policy.
Tax-free reimbursement is also what makes FAVR difficult to administer. In order to keep the payments tax-free, the company has to follow specific procedures set by the IRS. Most of these rules are designed to ensure that the data modeling used to derive payments is accurate.
Because of the challenges of administration, most organizations outsource their FAVR vehicle plan to a third-party administrator that does all the work. But by eliminating the tax waste, the company is able to afford this while still reimbursing employees sufficiently and saving money in the long run.
To learn more about what it might look like to switch to a fixed and variable rate reimbursement, use the calculator below or contact mBurse to discuss options. You may also find it helpful to read our Ultimate Guide to FAVR Reimbursements.