Is your car allowance taxable? It depends on whether it's an IRS-accountable plan or a non-accountable plan. Let's look at the guidelines.
Accountable vs. non-accountable vehicle reimbursements
Car reimbursement policies that do not meet IRS guidelines to be tax-free are classified as “non-accountable plans.” These plans do not use procedures to prove that all payments to the employee go to expenses from business use of a vehicle. A standard monthly car allowance is thus treated as taxable income.
Vehicle policies that do meet IRS guidelines are called "accountable plans." These policies apply one or more accepted methods of proving business use of monies, making the payment a vehicle reimbursement rather than compensation. Examples include FAVR car allowances, mileage reimbursement at the IRS business rate, and mileage allowances.
What makes a car allowance taxable?
Generally speaking, a standard car allowance is considered taxable income because it does not substantiate business use. A mileage reimbursement, however, remains non-taxable as long as it does not exceed the vehicle reimbursement amount determined by the IRS business mileage rate.
Each December the federal government sets a reasonable reimbursement standard by averaging all vehicle costs from the previous year and releasing a standard business mileage rate. This rate is commonly referred to as the IRS rate. Unless you track and report business mileage, there is no way to prove that your car allowance remains within the standard set by the IRS rate.
Companies that pay a standard monthly allowance typically choose this method for its convenience and simplicity. It eliminates the responsibility of record keeping from the employer, it’s easy to understand, and it’s easy to administer. However, convenience comes at a heavy price for both employer and employee, as we will explore below.
How should a car allowance be taxed?
Because a standard car allowance is a non-accountable plan, it should be taxed fully as W-2 income. The employer should withhold federal income taxes, FICA/Medicare taxes, and (if applicable) state income taxes on the full allowance amount. The car allowance should be taxed at the employee's income bracket.
The requirement of taxation creates several problems for both the employee and the employer:
- Money intended to reimburse business expenses is significantly reduced by tax withholding – often by 30-40%.
- Because of taxes, the allowance may not fully cover vehicle expenses.
- The company also pays taxes via unemployment taxes and FICA/Medicare.
If a vehicle allowance cannot fully cover car expenses, an employee may drive less or look for work elsewhere, increasing attrition rates. Furthermore, if the employer fails to properly withhold all relevant taxes, an IRS audit could turn into a costly and painful process.
Can I deduct mileage if I get a car allowance?
Prior to 2018, the IRS offset the taxation of car allowances by allowing employees to deduct business mileage as an unreimbursed business expense, provided the amount exceeded 2% of their adjusted gross income.
Due to tax reform, for tax years 2018-2025, you cannot claim mileage on your tax return to offset a taxable car allowance. The new tax law eliminated all miscellaneous itemized deductions for those eight years. This applies to all W-2 income, including a standard vehicle allowance.
For employers this poses a significant risk. Now that employees cannot write off business mileage and other unreimbursed expenses, they will feel increased pressure to protect their income. Employers will face pressure to increase benefits or switch to an IRS-accountable plan. Because a number of states (California and Illinois, among others) have labor codes that require full reimbursement of business expenses, you could face legal ramifications if you do not fully cover employees' vehicle costs.
What makes a car reimbursement non-taxable?
In short, a non-taxable or IRS-accountable plan demonstrates that all money paid by the plan goes to reimburse vehicle expenses incurred as part of the job. Because the payment is a reimbursement of an expense rather than compensation, it is not subject to taxes or withholding.
IRS guidelines for accountable (non-taxable) plans
An accountable plan must fulfill all the following criteria:
- Business connection: The car allowance or reimbursement must address expenses incurred for business purposes, which makes the payment 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.
- Defensibility. The allowance amount or reimbursement rate must be:
- reasonable, 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.
Are mileage reimbursements taxable?
Non-taxable vehicle reimbursements come in many forms. The most common is mileage reimbursement at the IRS business rate, which is $.575/mile for 2020. As long as the company pays the IRS rate or less, the mileage reimbursement remains non-taxable, meeting IRS criteria for an accountable plan.
The other two most common accountable plans are a mileage allowance and a fixed and variable rate car allowance, also known as FAVR reimbursement.
Offering one of these non-taxable plans eliminates the various problems that come with a taxable vehicle allowance. However, each of the three approaches has its own challenges, which we will explore below.
Examples of IRS-accountable vehicle plans
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 was designed to be a tax deduction tool, not a reimbursement tool. An employer can end up underpaying low mileage drivers and overpaying high mileage drivers because the rate does not derive from actual expenses. This mileage rate also is notorious for creating cost control problems.
A mileage allowance is a monthly car allowance with business mileage substantiation. Employers avoid taxation by tracking business mileage, multiplying it by the IRS rate, and comparing it against the allowance amount. Employees are only taxed on any overage. This approach, however, is challenging to administer and essentially caps employee mileage.
Fixed and variable rate allowance
Fixed and variable rate, or FAVR, is an IRS-supplied model for reimbursement. The employer issues two payments. One is a fixed amount that addresses fixed expenses (insurance, depreciation, registration, etc.). The other is a variable rate that addresses variable expenses (gas, oil, maintenance, etc.). Both the fixed and variable amounts are based on the driver's garage zip code, increasing the accuracy of the payments.
FAVR allowance guidelines include 21 data, program, and driver tests, which all must be met for the program to be considered "FAVR compliant." For example, the predicted expense data must be derived from a base locality, reflect retail prices, and be statistically defensible while approximating costs of a standard vehicle.
A FAVR vehicle program can provide the most precise and equitable reimbursements, but it is also difficult to implement and manage. Many organizations outsource their FAVR vehicle program to a third party that specializes in auto reimbursements.
Which vehicle reimbursement plan is best?
Because tax reform has eliminated mileage deductions, paying a taxable car allowance carries a lot more risk than it used to. Switching to the IRS mileage rate is the easiest option, but it will likely drive up company expenses.
The best option is to eliminate the tax waste of a traditional allowance and reinvest it in a fixed and variable rate program administered by a third party. This vehicle reimbursement approach will both protect employees' income and save the company money and time.
The bottom line is, to pay a tax-free reimbursement, 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.