The story of the past few years has been inflation. Everyone is experiencing higher costs. One way for your business to reduce costs is to switch from paying a standard car allowance to a tax-free allowance.
A monthly car allowance is a common way to pay employees for the cost of using a vehicle. This method is simple and does not require any paperwork or mileage log. However, car allowances are treated as taxable income by the IRS.
Due to inflation of costs, a tax-free allowance is a helpful tool. With car prices running high and insurance rates increasing, now is a good time to explore a non-taxable plan. The added accounting work is well worth it for many companies looking to save money and increase benefits.
Tax-free car allowances are more valuable than ever, offering a key way for businesses to boost employee take-home pay while reducing overall costs. But the key to a non-taxable allowance is a set of accounting procedures.
Let's explore why adding accounting procedures to a car allowance program is worth it – and how much both employers and employees could save by switching to a non-taxable allowance.
Taxes make car allowances a bad deal for many employees. With federal and state taxes, as much as 40% of the allowance may go to governments.
The average car allowance is somewhere around $600 per month. Let's say an employee gets taxed at a rate of 33%. (This amount includes income taxes and Social Security/Medicare.) That leaves only $400 per month after taxes. Or let's say that this employee lives in California, Oregon, or Minnesota, where the average state income tax is around 7%. Now they're only taking home $360 of that $600.
The average annual expense of owning and operating a new motor vehicle in the U.S. was $12,296 in 2024. (Bureau of Transportation Statistics.) This calculation was based on 15,000 annual miles over a five-year period. An employee driving five days every week for business should see at least 5/7 of that number as a business expense.
That leaves us with $8783 in annual business vehicle expenses. As a monthly amount, that equates to $732. With a $600 monthly allowance the math doesn't work. The employer is paying slightly more than that amount ($646 when you factor in their portion of FICA/Medicare). But the employee is only receiving around $400 or maybe less.
In 2020, the average annual cost of a vehicle was $9,561. That means the past five years have seen almost a 29% increase in the cost of having a car. Has your company car allowance increased in the past five years?
If your allowance amount has not increased at a similar rate during that period, workers may be feeling the pinch. One easy and inexpensive way to increase the amount is to remove the taxes from the allowance. This requires following IRS procedures, but the extra time is worth it.
To eliminate tax waste, some organizations switch to paying the IRS mileage rate. (For 2025, the business mileage rate is 70 cents per mile.) These payments are non-taxable and only require mileage tracking as an accounting procedure.
Paying a standardized mileage rate can have its own problems. This is because a vehicle becomes less costly per mile the more a person drives. AAA found quite a range, depending on annual mileage.
For a medium sedan in 2023:
10,000 miles annually = 96 cents/mi
15,000 miles annually = 73.6 cents/mi
20,000 miles annually = 62.4 cents/mi
For 2023, the IRS standard business rate was 65.5 cents per mile. This means that the IRS mileage rate only fully covered a medium sedan driven above the average amount of 15,000 miles per year.
The best way to help the company save money while beefing up each employee's car allowance is to institute a tax-free car allowance, rather than a tax-free mileage rate.
The IRS describes two different accounting procedures that can make a car allowance tax-free. One is the mileage allowance, also known as mileage substantiation. The other is the fixed and variable rate allowance, also known as a FAVR car allowance.
Both involve complicated accounting procedures, but FAVR in particular is well worth it, bringing a quick return on investment. The money saved in taxes is more than enough to pay for program administration, allowing your organization to outsource the accounting part and keep everything simple for both management and drivers.
You can easily calculate your organization's savings with a switch to a non-taxable car allowance. Our calculator compares the costs of your current car allowance with the costs of a FAVR car allowance:
Or if you'd like to take a deep dive into what FAVR is and how it works, follow the link below.