Paying a car allowance with mileage substantiation? The time is now to re-evaluate your policy as a result of changes in the tax code.
What is a mileage allowance, and should it be taxed?
A mileage allowance is shorthand for a car allowance plus business substantiation of mileage. The company pays a fixed monthly allowance to each employee who drives a personal vehicle for work purposes. The employee keeps track of business mileage to keep the monthly payment non-taxable.
In order for vehicle allowance payments to remain non-taxable, the driver cannot receive a greater amount than the equivalent of the reported business mileage multiplied by that year's IRS standard business mileage rate. If the monthly payment exceeds that amount, then the overage is considered taxable.
Typically the employer will just not pay more than the amount of mileage it takes to reach the set monthly payment. That essentially limits the amount of mileage an employee can drive each month and expect to be reimbursed for, hence the expression "mileage allowance."
Tax reform impacts on mileage allowances
In the past, implementing a mileage substantiation as a company car reimbursement program made good business sense, unless you had employees working in a state that indemnifies employees from company expenses, such as Massachusetts or California. But changes in the tax code could leave your organization at risk in any state if you do not properly address your car reimbursement policy to complement the new tax code.
Here’s how a typical mileage substantiation program works: You provide a set car allowance for employees that drive for work, say $500/month. Employees then record their mileage, which is multiplied by the current IRS mileage rate – $.575/mile for 2020 – and subtracted from the car allowance. If the product of mileage times the IRS rate exceeds $500, the employee is still only reimbursed the $500 amount. In the past, companies have taken the position that employees can write off the difference at tax time.
But that assumption – that employees can write off the unreimbursed amount – does not hold true for tax years 2018-2025. With the elimination of the unreimbursed expense deduction, employers paying a car allowance with mileage substantiation can no longer rely on this tax mechanism to make an employee’s compensation for work expenses complete. This new taxation situation creates problems for higher mileage employees.
Tax code case study: 3 employee mileage allowances, 3 outcomes
Let's compare three employees who receive the same $500/month car allowance but drive three different mileage amounts. This will show just how big a problem the 2017 tax law has created for an employee who drives a lot.
Mobile Employee A:
Drives 870 miles for the month
870 miles x $.575 = $500.25
Mobile Employee B:
Drives 1,500 miles
1,500 miles x $.575 = $862.50
Mobile Employee C:
Drives 500 miles
500 miles x $.575 = $287.50
All three employees receive a non-taxed benefit, which is great, but under the current tax system, Mobile Employee B cannot deduct the additional costs of owning and operating their personal vehicle – $362.50/month. The company has placed that employee in an unfair situation. If that employee works in a state with an employee expense indemnification clause, they certainly have grounds to file a complaint with the state labor board. Companies operating in California could be especially hard hit if employees gather to file class action suits under California Labor Code 2802(a). Of course, some employees may just look for new jobs.
But this isn’t the only problem that could result from using a mileage allowance under the current federal tax code.
Does a mileage allowance cap costs or productivity?
One of the great advantages of mileage substantiation (beyond avoiding taxation) is the ability to cap reimbursement costs and budget your costs. During the Great Recession, quite a few companies reduced their expenses by transitioning from paying either a taxable car allowance or the IRS mileage rate to paying a car allowance with mileage substantiation. By capping your costs, you are guaranteed not to let the monthly car allowance exceed budget.
But now that employees who exceed the amount capped by the combination of the IRS rate and the monthly allowance cannot write off additional mileage, you may be capping not costs but miles and therefore productivity. Paying a $500 monthly allowance under the 2020 IRS rate of $.575/mile means that any mile driven under 870 miles will go unreimbursed.
The problems with continuing to provide this type of policy are simple: Employees will figure out how to leverage the cap each month no matter if they are in high cost areas or have a large driving territory. Some may drive more than necessary to get to the cap. Others who typically drive more may resort to driving up to the cap and not driving until the following month. This will almost certainly result in productivity losses.
Re-evaluating your non-taxable mileage reimbursement program
The current tax code eliminates the ability of employees to write off additional business travel expenses. This will most seriously affect companies operating in states with indemnification codes, exposing them to the risk of labor code violations and law suits. But it will affect all companies to the degree that the car allowance caps miles and productivity now that employees cannot write off additional expenses. For at least the tax years 2018-2025 your employees will be looking to find ways to offset the loss of the unreimbursed expense deduction. If their costs are not being met, don’t be surprised if you see a dip in productivity and/or an increase in your attrition rate.
Now is the time to re-evaluate your policy. A great alternative that will keep your reimbursement non-taxable while fully reimbursing employees would be the Fixed-and-Variable-Rate reimbursement, or FAVR. This IRS accountable plan perfectly complements the new tax code. Download our FAVR data sheet to learn more about this highly effective business reimbursement tool.