The car allowance is one of the most overlooked business tools within most organizations. It seems simple enough and easy to maintain. But the simplicity of a standard monthly payment carries hidden costs for both employers and employees, especially in times of inflation.

How much is a typical car allowance?

The annual mBurse Car Allowance Survey found that most companies (68%) paid employees between $500 and $700 per month to defray vehicle costs incurred as part of their jobs. The average was around $600. This monthly stipend is meant to cover such costs as gas, maintenance, insurance, depreciation, and more. (See also "What Does a Car Allowance Cover?")

For many organizations, this is a relatively small cost, given the importance of the work these mobile employees use their vehicles to accomplish: sales calls, service calls, client visits, deliveries, etc. Even when adjusted to match inflation, car allowances amount to a fraction of an operations budget.

But the hidden costs of a typical car allowance can add up in ways that reduce the true value of the stipend. Most organizations, however, leave their allowance amount unreviewed and unchanged for years, and the additional costs remain hidden and unaddressed.

What do they do when gas prices suddenly spike (like in 2022), or insurance premiums rise 20% (as they did in 2023)? These are the visible costs. The hidden costs are greater.

The hidden costs of a typical car allowance

The true cost of a car allowance falls under two categories: taxes and undesirable employee behavior. An improperly calibrated vehicle reimbursement creates liabilities in both areas. Let's explore.

The true cost of a taxable car allowance

Most standard car allowances are considered taxable income by the IRS. Unless the company pursues an accounting procedure that proves business use of every dollar paid to employees to offset vehicle costs, the car allowance is considered a non-accountable plan and subject to both federal and state taxes. (Find out how to make your car allowance accountable.)

When you add up federal income taxes, FICA, and state income taxes, a car allowance can be reduced by as much as 40%. A $600 monthly payment suddenly is worth only $360. Unless an employee drives a minimal amount each month, it is unlikely that $360 will cover the business portion of his or her vehicle expenses.

Remember also that the employer must pay its portion of FICA for each employee. So not only do the taxes cost the employee, they also cost the company.

It is important to remember that, under the current tax code, employees cannot deduct business mileage on their tax returns. Only self-employed drivers can do that. Employees that receive a taxable car allowance have no recourse to recover lost income – unless they work in a state that allows them to sue their employer for insufficient vehicle expense reimbursement. (California, Illinois, Massachusetts, and a handful of other states.)

When workers realize they are not receiving an equitable vehicle allowance or reimbursement, they often take steps to minimize their losses. And these steps typically carry additional costs for the company.

How car allowances create costly employee behavior

Employees who receive a taxable auto allowance often take steps to maximize their benefits to the detriment of the company. They may forgo face-to-face meetings and replace them with phone calls, webinars, and other sales tactics that aren’t as effective as in-person meetings. This reduced effort with clients costs the company over time.

Some companies try to remedy this problem by reimbursing employees per mile driven instead. But this still often doesn’t provide a cost-effective solution. When employees are asked to record and report their mileage, they may provide estimates instead or exact figures. And these estimates can be conveniently rounded up, adding significant costs over time.

Similarly, morale can dip when employees do not feel that they are treated fairly. Because they each receive the same monthly car allowance, regardless of how many miles they drive or whether they work in a more expensive region, some employees may be under-reimbursed while others are over-reimbursed. 

When a car allowance is perceived as insufficient or unfair, the following costly consequences can ensue:

• Reduced productivity 
• Increased attrition (rehiring costs are quite high)
• Labor code lawsuits (in employee friendly states)
• Reduced insurance coverage (creates liabilities when an underinsured employee causes an accident on the job)

These various costs can add up and cost a company millions of dollars over time. But most businesses don’t notice the connection with their car allowance policy and fail to realize that some relatively inexpensive changes could prevent significant long-term costs. One fairly easy step is to obtain benchmarking data from similarly sized organizations and competitors.

The importance of a non-taxable, data-driven car allowance

One of the simplest ways to eliminate the hidden costs of a standard car allowance is to switch to a non-taxable plan. Many organizations think it is as simple as switching to a mileage reimbursement program, since reimbursements at the IRS business rate or less are non-taxable.

However, mileage rates carry hidden costs as well and often prove even more expensive for companies while not always sufficiently reimbursing low-mileage drivers, and mid-mileage drivers who work in expensive locations.

The most cost-effective way to reimburse employees tax free is what's called a FAVR allowance. Two key distinctives of a FAVR allowance make it fairer and more accurate:

1.) Uses a standard vehicle to generate reimbursements, rather than a standard rate or amount.

2.) Uses vehicle expense data for each employee's garage zip code to accurately predict each employee's vehicle expense needs.

With the right tools, your organization can offer a data-driven car allowance that increases productivity and cuts costs. You can start by using our policy assessment tool, which offers benchmark data to offer a sense of what your car allowance should be, and how much you could save by going tax-free.