Is my car allowance taxable? It all depends on whether it's an IRS-accountable plan or a non-accountable plan. Let's look at the guidelines.
Reimbursement policies that do not meet IRS guidelines to be tax-free for the employee are classified as “non-accountable plans.” These types of plans include flat dollar amounts as well as cents-per-mile reimbursements that exceed the reasonableness standards established by the IRS.
A flat dollar amount has some obvious advantages: It eliminates the responsibility of record keeping from the employer, it’s easy to administer, it’s easy to understand, and it’s convenient. However, convenience comes at a heavy price for both employer and employee.
The true costs of taxable, non-accountable plans
- Everyone gets taxed. Taxable auto allowances must be classified as income to the employee and must be included on their W-2 statements. This means the allowance is subject to employment taxes for both the employee and the employer, which includes the federal income tax, FICA, and federal and state unemployment taxes. All those taxes add up—for both your company and your employees.
- An audit can cost you. If you are not properly withholding all relevant taxes, you could find yourself in a bind in the event of an audit. You cannot rely on your employees to claim the allowance on their expenses during tax time. Your organization provides the auto allowance and is custodian of record. An audit may seem unlikely, but it’s not just a random IRS travel and expense audit that you have to worry about—if an employee is audited, the trail leads back to your company.
Offering an accountable plan will avoid these costs. However, the IRS-supplied criteria for accountable plans require additional administrative tasks that your organization must fulfill. You must weigh the addition of these tasks against the tax burden leveled at employees and the organization by a non-accountable plan.
IRS guidelines for accountable (non-taxable) plans
An accountable plan must fulfill all the following criteria:
- Business connection: The auto allowance or reimbursement that is paid to the employee must be incurred for business purpose, which is a deductible business expense for the employer.
- Substantiation: The employee must submit a log supporting the elements of time, use, amount, and business purpose to be reimbursed. The trips should be recorded at or close to the time of expense.
- Employer reimbursement: Employees must pay back any excess reimbursement over the substantiated expenses. Under IRS Safe Harbor rules, the employee may provide substantiation within 60 days or return unsubstantiated amounts within 120 days after an expense is paid or incurred.
- Defensibility. The allowance amount or reimbursement rate must be:
- reasonably calculated, not to exceed the amount of the expenses or the anticipated expenses.
- based on a uniform and objective basis with respect to expenses.
- periodically paid at a rate that combines a fixed rate and a variable rate.
- consistently applied in accordance with reasonable business practices.
An accountable plan can take a variety of forms. Each comes with its advantages and disadvantages. Consider the approaches employed by different companies:
The IRS mileage rate
The IRS rate is viewed as a defensible rate for reimbursement because it is set by the government and easy to calculate. However, the IRS rate is a tax tool. The intended use is a deduction guideline for taxpayers that elect not to track detailed business expenses. An employer can end up underpaying and overpaying employees within the same organization because the rate does not derive from actual expenses.
Auto allowance with mileage substantiation
This reimbursement option allows employers to provide an auto allowance and substantiate the business use against the allowance provided. Employees are only taxed on the overage. This approach, however, is challenging to administer.
Fixed and variable rate allowance (FAVR)
This IRS-supplied model for an accountable plan allows an organization to address both fixed expenses (insurance, registration, etc.) and variable expenses (gas, depreciation, etc.). FAVR guidelines include 21 data, program, and driver tests, which all must be met for the program to be considered "FAVR compliant." FAVR has very specific parameters as to who can qualify for the FAVR approach, and how data can be applied in determining allowance and reimbursement amounts. For example, this data must be derived from a base locality, reflect retail prices, and be statistically defensible while approximating costs of standard vehicles.
The FAVR program can provide the most precise and equitable reimbursements, but it is also difficult to implement and manage. Many organizations outsource their FAVR program to a third party that specializes in auto reimbursements.
The bottom line is you must substantiate business use with an accountable plan. You cannot push the responsibility of substantiating business mileage to employees to avoid taxing your car allowance. Contact mBurse today for more information on the type of accountable plan that would work best for your organization.