Car Allowance or Mileage Reimbursement for 2021?

Written by mBurse Team Member   |   Nov 16, 2020 7:00:00 AM

2020 has been a rough year for everyone. As you head into 2021, your business may be weighing whether to pay a car allowance or mileage reimbursement to employees. Our answer to this question may surprise you.

Differences between a car allowance and a mileage reimbursement

A standard car allowance is a monthly fixed payment to compensate employees for the use of a personal vehicle. A mileage reimbursement uses a standard mileage rate to reimburse employees for the use of a personal vehicle.

In other words, a company paying a car allowance will set a fixed stipend, such as $600/month, and pay it to all employees who meet certain criteria for vehicle use on the job. A company paying a mileage reimbursement will set a cents-per-mile rate (such as the IRS business rate of $.575/mile for 2020) and pay employees that rate multiplied by their reported mileage each month. So an employee who drives 1000 miles in a month would receive $575 using the federal rate.

The biggest difference between the two approaches? A car allowance is taxable compensation while a mileage rate is a tax-free reimbursement, as long as the employer complies with a few IRS rules.

Computer mouse on desk selecting step 1

Why tax a car allowance but not a mileage reimbursement?

The IRS treats a standard car allowance as taxable income because the business use of payments is not substantiated. There are ways to substantiate the mileage for a car allowance amount, and each is complicated. However, eliminating the taxation of a car allowance is a key way for a company to save money while boosting employee benefits.

The IRS treats a mileage reimbursement as non-taxable as long as the mileage rate does not exceed the federal business rate, and the company keeps up-to-date records of employee mileage. The IRS business mileage rate is derived from the average vehicle expenses across the United States from the previous year, which means that it works better for some drivers than others, depending on how close their expenses are to the average.

There are other non-taxable approaches to vehicle allowances and reimbursements, such as fixed and variable rate reimbursement, also known as a FAVR car allowance. This approach requires more administrative work than a standard car allowance or mileage reimbursement but also holds key advantages.

Car allowance vs. mileage rate for 2021

When it comes to choosing between paying a standard car allowance or a mileage rate in 2021, the right answers are NEITHER and BOTH.

How's that?

While we recommend NEITHER approach on its own, we do recommend an approach that combines the strengths of BOTH.

Car allowance strengths and weaknesses

The strengths of a car allowance are its simplicity and its ability to adequately address fixed vehicle costs, especially for lower-mileage drivers. This is a distinct advantage in 2021 when many employees are working more often from home and putting less mileage on their vehicles due to the COVID-19 pandemic.

Receiving a payment that helps maintain their vehicle for business use but is not dependent on accruing mileage is helpful when a worker drives less than usual. This is because vehicle expenses like insurance and depreciation do not decrease very much when driving decreases. Property taxes and license/registration fees do not decrease at all. Yet employees must continue to pay these even when driving less.

The big weaknesses of car allowances are taxes and inequitable outcomes. Many employees see around 30-40% of their car allowance eaten up by taxes. The employer also must pay taxes on this compensation, whereas the employer could write off the payments if they qualified as reimbursements. Furthermore, because different employees incur different expense amounts because some drive more than others and some work in more expensive parts of the country than others, it is guaranteed that some will be under-reimbursed even if others are over-reimbursed.

Mileage reimbursement strengths and weaknesses

The strengths of a mileage reimbursement are simplicity and being tax-free. Just like a car allowance, it is easy to administer, though the mileage tracking process adds more time. But making and receiving tax-free payments more than offsets administrative costs. And with today's automated mileage tracking apps, the administrative aspects are minimized further.

However, equity remains a challenge for a standard mileage rate. This is because a worker must drive a particular amount each month in order to cover his or her fixed vehicle costs, which constitute the majority of vehicle expenses. This is particularly a challenge under pandemic conditions that prevent many employees from driving enough to cover those costs (in which case the employer should explore remote work reimbursement options).

On top of this, employees that drive a lot can end up exceeding the amount needed to cover all their costs and can actually end up being over-reimbursed.

But what if there was an approach that could combine the strengths of both car allowances and mileage reimbursements? There is, and that is the approach we recommend. This does not mean simply adding a mileage rate on top of a car allowance. In this case, you still have taxation of the car allowance plus the added expense of the mileage rate. No, the solution is a non-taxable blend of the two approaches.

Traffic and FAVR

FAVR reimbursement, best of both car allowances and mileage reimbursements

The fixed and variable rate method can be seen as both a car allowance and a reimbursement. This approach, like a car allowance, pays a fixed stipend each month to address the fixed expenses, regardless of how much an employee drives. As long as this fixed amount is calculated using IRS-approved methods based on the employee's zip code data, this fixed amount, unlike a car allowance, remains tax free.

A FAVR program also pays a mileage rate that adjusts based on changing mileage-based vehicle costs, such as fuel prices. This rate, like the fixed amount, is derived using local cost data. This approach helps to address the differences in travel-based costs between different employees, eliminating equity problems and ensuring that high-mileage drivers and low-mileage drivers, as well as both those working in expensive regions and those working in inexpensive regions receive appropriate payments.

The only challenge of a FAVR program is administration. However, the administrative costs are more than covered by the savings when a company switches from a standard allowance or mileage rate.

To learn more about how combining the strengths of a car allowance with the strengths of a mileage rate could work for your organization in 2021, contact mBurse or try our FAVR savings calculator.

Car allowance vs. FAVR Reimbursement

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