Q & A: Is our auto allowance taxable?
We frequently receive questions about auto allowance policies that could be helpful to other organizations. Here's a great question we received a couple of years ago from a potential client regarding IRS compliance. This question focused on rules for tax-exempt car allowances:
Q: We provide our employees with a flat auto allowance program that pays $500 per month. We have paid the same amount for the last seven years. I do not tax this amount when it is paid, but we do check paid amounts against mileage at year-end. We then treat any excess payments as taxable income to the drivers on their next pay period after the calculation. Are we doing the right thing? Do we have any exposure to the IRS?
A: According to Federal Publication 463, you do have exposure to the IRS. The $500 auto allowance is taxable income and should be treated as compensation.
In order for a car allowance to be tax-free, it must be part of an “accountable plan.” Read on for a detailed look at how to keep an auto allowance tax free.
How to make a car allowance non-taxable
IRS rules for accountable plans
To qualify as an accountable plan, an auto allowance for employees must meet two initial requirements from the IRS.
- The plan must require employees to substantiate their reimbursable expenses.
- The plan must tax or require the return of dollars in excess of substantiated expenses.
Additionally, payments for reimbursable expenses cannot exceed the equivalent of the federal mileage rate. This rate can take the form of either the IRS standard business rate or a fixed and variable rate. Employees must repay any excess above the rate equivalent, or that portion of the allowance is taxable.
IRS rules for mileage logs
To demonstrate the business use of the payments for vehicle expenses, most organizations use a mileage log. A compliant mileage log should include the following pieces of information:
- Date of each trip
- Destinations and business purpose
- Actual mileage to and from destination
Many organizations no longer use a paper log or Excel spreadsheet. Today's businesses prefer the ease and automation of GPS-based mobile apps for tracking mileage. These mileage trackers remove the guesswork and streamline the process.
Additional rules for an auto allowance to be an accountable plan
If you substantiate expenses and keep payments at or under the federal mileage rate, you still must meet three more rules. All auto allowance payments must be
- Related to services for the employer and identified separately from normal compensation payments.
- Applied to allowable business expenses in accordance with the IRS sections and codes.
- Calculated not to exceed the amount of expected expenses.
Why most auto allowances are taxable
Most often, auto allowances are a fringe benefit rather than a reimbursement. A fringe benefit does not fit within the salary category and does not clearly pay for a reimbursable expense. This keeps the payments in the taxable compensation category.
Most flat allowance programs fail to account for business use and fail to prevent excess of expected amounts. Car allowance amounts are typically the result of negotiation sessions or an employee’s title within the organization. Rarely do auto allowance programs link the rate to localized employee expenses.
Another problem is what the IRS calls a “pattern of over reimbursements.” If employees typically receive more allowance dollars than they should, then your company allowance should be lower. However, most internally developed allowance plans go years without adjustment.
If your car allowance is taxable, what should you do?
Getting back to the original question, what should the potential client do? Comparing payments to actual mileage at year's end and taxing the excess does not make the plan accountable. This means the organization should either properly tax payments or switch to a non-taxable plan.
Taxing a non-accountable auto allowance plan
An allowance that does not meet all IRS rules is subject to all employment taxes. These taxes include not only incomes taxes but also payroll taxes. And these include the employer’s matching FICA amounts.
To properly tax an auto allowance, follow these rules:
- Create a clearly written policy that identifies the amount, time of payment, and which roles qualify. Explain that the car allowance counts as a taxable fringe benefit.
- Pay the allowance regularly as part of the paycheck, but identified separately.
- Withhold taxes from the allowance payment based on the employee's W-4 status.
Switching to a non-taxable car allowance
Once you start properly taxing an auto allowance, you realize that it can reduce the take-home amount by as much as 40%. Remember that employees cannot deduct their business mileage or expenses on their tax returns. Some states, including California, Illinois, and Massachusetts, require full reimbursement. Taxes on an auto allowance get in the way of fully covering expenses.
A tax-exempt, accountable plan is the key to addressing these issues. Multiple non-taxable options exists that your organization can explore. This guide will examine each option below.
Non-taxable methods to reimburse a personal vehicle for work
You can pay a car allowance as part of a mileage allowance plan to keep it tax-free. In other words, you keep your $500 allowance the same but compare the payment to reported mileage each month (not each year). Then any excess above the equivalent of the IRS mileage rate gets taxed.
What if you find that drivers consistently drive above the $500 amount?
You can increase the allowance to an amount closer how much people are driving. But the math gets complicated each month when comparing the payment to actual mileage multiplied by the IRS rate. Here are three other options to consider:
Auto allowance vs. company car
Offering a company car is a much bigger benefit than paying an allowance for a personal vehicle. A company car is also more expensive. Similar problems with IRS tax rules show up because a company car also requires substantiation of business use.
Auto allowance vs. mileage reimbursement
A mileage reimbursement is a relatively simple way to provide tax-free payments for a personal vehicle. As long as the organization proves business use of the vehicle and pays a rate at or below the federal mileage rate, payments remain tax-free. But cost control often becomes an issue as employees drive more or report more mileage to boost earnings.
Auto allowance vs. fixed and variable rate
The IRS lists a fixed and variable rate allowance as a specific way to pay expenses tax free. Also known as FAVR, this approach like the others requires a compliant mileage log. A FAVR program uses localized costs to determine rates, avoiding cost control problems and ensuring fair payments.
Choosing a better auto allowance plan
Following all the IRS rules for accountable plans can get complicated. Contact mBurse to find out about our non-taxable, IRS-compliant and labor-code-compliant car allowance plans. We offer FAVR plans and Smart 463 mileage rates, and can support a mileage allowance program with our mileage tracking app, mLog.
