If your company pays a monthly vehicle stipend, 40% or more of that money could go to federal and state coffers this tax season. With tax returns on everyone's minds, now is a great time to review tax withholding for employees who receive a car allowance or stipend.
Why 40% of a car allowance goes to taxes
First of all, let's be clear – unless an employer uses an IRS-accountable vehicle plan, any funds that go to offset employee vehicle expenses are taxable. This includes federal income taxes, FICA, and state income taxes, if applicable.
Let's do some simple math. A standard monthly stipend for the use of a personal vehicle is subject to a worker's federal filing status. Because that stipend or allowance is additional compensation on top of a salary, you have to think of it as taxable at the recipient's highest tax bracket.
If an employee receiving a $600/month car allowance is subject to the 24% federal tax bracket ($84,201–$160,725 for single filers), that $600 is now worth only $456. State income taxes could take an additional 6%, so now the allowance is worth $420. Then there's FICA (Social Security and Medicare), taking 7.65%, reducing the amount to $374.
That's 37.65% going to taxes. That's a lot, though it's not quite 40%. But don't forget the employer's share of FICA taxes (another 7.65%). That increases the overall payment by $46, with the employee only receiving $374 out of that $646. So 42% of that overall payment goes to federal and state taxes – more than 40%!
What if the employee earns more than $160,275, and they're filing in the 32% tax bracket? Now we're looking at another 8% of the monthly vehicle stipend going to taxes, bringing the total to 50% when you include the employer's tax portion.
Why pay a taxable car allowance at all?
If a typical vehicle stipend is worth less than 60% of what the employer actually pays, why pay a taxable allowance at all? There are non-taxable plans available, such as the IRS mileage rate, mileage substantiation, and a FAVR car allowance.
The issue is accountability. The IRS rules for accountable plans set up hurdles that many employers would rather not face. Accountable plans all involve time-consuming accounting procedures that prove business use of vehicle expenses. For starters, all of these methods require the company to keep detailed mileage logs.
It's easier to just pay the taxable monthly stipend and view the tax waste as the cost of keeping everyone focused on their jobs rather than on extra administrative tasks.
But does it really make sense to send almost half of the investment in that employee's productivity to federal and state governments? Does either the company or the employee really benefit? Is it fair to the employee to lose so much income to taxes?
Unfair taxation of employee vehicle allowances
The fact is, that $374 left over from the $600 monthly vehicle stipend will probably only cover gas and insurance. Other reimbursable costs such as maintenance, depreciation, oil, and tires will come at the employee's own expense. And if that employee works in a state with strict labor laws, then the company could face a lawsuit for insufficient reimbursement.
In the past, employees could write off their business mileage on their federal tax return to compensate for the income tax on their vehicle allowance. But the 2017 tax reform eliminated this tax deduction for the tax years 2018-2025. As our 2019 Car Allowance Survey showed, over 60% of workers who received a car allowance complained of a loss of income due to their change. Now as they file 2019 tax returns February through April of 2020, they will again have no way to recoup unreimbursed expenses.
Switching to a non-taxable reimbursement
Let's do the math again. If companies and employees are losing around 40% of standard car allowances to taxation, why not reinvest that money into a fairer reimbursement method that benefits both parties?
The IRS mileage rate has its own challenges because it tends to over-reimburse high mileage drivers and under-reimburse low mileage drivers. Mileage substantiation involves some tedious accounting methods. FAVR allowances, or fixed and variable rate reimbursements, provide the best mix of accuracy and cost-effectiveness.
A number of organizations provide low-cost FAVR program administration so that employers can take all of the tax waste and leverage it into a better benefit for employees and save money in the process. It's not unusual to save 20-30% in the first year of the running the non-taxable reimbursement program.