Your standard auto allowance plan probably isn’t IRS-compliant. In this Q&A we'll tell you why, and how to create an accountable auto allowance plan.
Q & A: Should our auto allowance be taxed?
We frequently receive questions about car allowances and reimbursement 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 and eligibility rules for non-taxable car allowances:
Q: We provide our employees with a flat auto allowance program. We pay $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 (Reimbursements and other expense arrangements), you do have exposure to the IRS, and the $500 paid to drivers needs to be taxed, when paid, as compensation.
In order for a car allowance to be non-taxed, it must be part of an “accountable plan.”
What makes an auto allowance IRS-accountable?
To be considered for “accountable plan” status, a program must meet two initial requirements.
- The plan must require paid employees to substantiate the reimbursable expenses.
- The plan must require that dollars in excess of substantiated expenses be addressed.
Without these two requirements, any payments made to employees are considered non-accountable, and therefore must be taxed as normal compensation when paid.
If you meet the two requirements, then you still must meet three more rules in order for your payment plan to be considered an accountable plan.
What are these rules for accountable, tax-free auto allowances?
To qualify as tax-free, all car allowances 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 anticipated expenses.
The third requirement is the one most flat allowance programs fail to meet. Car allowance amounts are typically the result of negotiation sessions or an employee’s title within the organization. Rarely are internally developed auto allowance programs linked to geographically-sensitive employee expenses. This leads to unfair car allowance policies.
Another problem is what the IRS calls a “pattern of over reimbursements.” If you find that employees typically receive more allowance dollars than they should, then your program allowances must be adjusted down. However, most internally developed allowance plans go years without adjustment.
Conclusion – Your auto allowance is non-accountable, and therefore taxable
A plan is either accountable and non-taxable, or non-accountable and taxable. (Learn the differences in greater depth as well as how much you should pay employees.) Even checking the amount paid against the actual mileage at the end of the year and taxing the excess does not make the plan accountable.
Your allowance therefore is subject to all employment taxes, including the employer’s matching FICA amounts – when paid – not at the end of the year.
Taxable auto allowances and labor codes
Something else to consider: If you have mobile employees that reside in certain states your car allowance could easily violate expense indemnification labor codes. California has the strictest language defining their labor codes and a simple car allowance or mileage reimbursement might not be compliant with California Labor Code 2802 (a). Making a decision about your car allowance or reimbursement policy should be defined by data as opposed just to going with whatever is simple or easy.
Furthermore, once you start properly taxing an auto allowance, you realize that it can reduce the take-home amount by as much as 40%. This is especially a problem when employees cannot deduct their business mileage or vehicle expenses on their own tax returns (at least not until 2026). A non-taxable, accountable plan is the key to addressing this issue, but as you can see, following all the IRS rules can get complicated.
Contact us to find out about our non-taxable, IRS-compliant and labor-code-compliant car allowance plans.