Not everyone realizes that the IRS treats car allowances as taxable income. If your organization does not withhold taxes on employee car allowances, it's time to start.

How to Calculate Taxes on a Car Allowance

Calculating taxes on a company car allowance is pretty simple: you just apply the same taxes that are applied to the employee's salary. Using the employee's W-4 form, you withhold taxes at the same rate you withhold them for their salary.

If you are an employee, you can expect that you will have state and federal taxes withheld from your car allowance, as well as FICA/Medicare taxes. It is important for both employers and employees to consider the after-tax amount of a car allowance when calculating the sufficiency of the policy.

Is your car allowance enough after taxes?

If an organization has not been properly withholding taxes from a car allowance, then switching to proper administration of the plan will leave employees feeling like they received a pay cut. It is always important to determine whether the after-tax amount still covers all reasonable vehicle expenses related to work.

As we have reported before, it is typical for all the various taxes to eat up 30–40% of a car allowance after withholding. Will there still be enough left over after this to cover work-related gas, insurance, maintenance, depreciation, and other vehicle costs? Chances are, the allowance will need to be recalculated, especially if it has not been increased during the last three years in response to inflation.

When does a car allowance qualify for tax exemption?

There are some kinds of car allowances that can be paid tax-free. It is worth exploring these more cost-efficient options rather than diverting so much of the allowance toward taxes. The key principle is operating an IRS-accountable plan that offers proof of business use of the allowance payments, which requires an IRS-compliant mileage log.

Here are the three most common tax-free, accountable plans:

FAVR car allowances

A fixed and variable rate allowance (aka FAVR) uses localized vehicle expense data to calculate car reimbursement rates. This IRS-recommended plan is complicated to administer but offers the most accurate payments and avoids pitfalls commonly associated with standard allowances and mileage rates. Increasingly this approach is becoming the preferred, best practice for companies seeking to provide tax-exempt payments.

Car allowance with mileage substantiation

Also known as a "mileage allowance," this plan pays a typical monthly car allowance but then multiplies each employee’s mileage by the IRS business mileage rate ($0.67/mile for 2024). The employee then receives the lesser of the car allowance amount and the mileage rate multiplied by the mileage. Employees are discouraged from driving any miles beyond the mileage amount that equals the car allowance when multiplied by the IRS rate.

Mileage reimbursement at or below the IRS rate

Instead of paying a car allowance, many organizations opt for a mileage reimbursement plan. If the rate used is equal to or less than the IRS business rate, then all payments are delivered tax-free. This approach is easy to administer but tends to over-reimburse high-mileage drivers and under-reimburse low-mileage drivers. Organizations may also experience significant cost control problems.

Switching from a taxable car allowance to a tax-exempt plan

Switching from one business vehicle policy to another can create stress and anxiety among both managers and drivers. But if the switch results in a net benefit for most employees then it may be greeted positively. If the organization currently pays a car allowance but has not been withholding taxes properly, then it is especially important to choose a plan that will not feel like a significant reduction in benefits.

The first step is to compare the current plan with any new plan you would explore both in terms of what different employees' benefits would be and how it would affect the operations budget. Another element to keep in mind would be the addition of mileage tracking. Because entering mileage in a log can be tedious it is best to adopt an app-based tool that automatically tracks mileage and uploads it into the reimbursement system.

Read more about our preferred tax-exempt car allowance, FAVR. Or try this plan comparison tool to see how your current plan compares with a typical FAVR car allowance.