As we head into 2021, many organizations are taking stock after a challenging and confusing 2020. Now is the time to re-evaluate your current car allowance and re-tool with a flexible and cost-effective plan.
Comparing 2021 car allowance options
Most organizations that give employees a car allowance pay a standard taxable stipend every month. All employees who qualify get the same amount to defray the costs of operating a personal vehicle for work.
The reason the car allowance is taxable is that the employer does not substantiate business use of the vehicle using an IRS-approved procedure. There are other types of car allowances that remain non-taxable using one of these procedures. The two non-taxable approaches we will feature here hold distinct advantages over a traditional taxable plan.
Mileage substantiation - aka mileage allowance
An employer can pay a car allowance tax free if they track employee business mileage and then subtract the difference between the car allowance amount and each employee's mileage multiplied by the IRS business mileage rate (56 cents per mile for 2021).
This may sound complicated, but it does allow employees to keep a greater percentage of their monthly allowance amount than they would if the entire amount were taxed. When the entire amount is taxed, it usually eats up around 30 to 40 percent of the allowance amount.
FAVR car allowance - aka fixed and variable rate
The fixed and variable rate car allowance follows a procedure based on actual vehicle expense data to keep the car allowance non-taxable. Rather than standardizing the allowance amount, the employer chooses a standard vehicle to base the monthly rate off of. Then, using data for each employee's zip code, a FAVR plan calculates the appropriate allowance amount for each employee as if they were driving that standard vehicle.
Employees get to keep the entire allowance amount tax-free. The company also avoids paying payroll taxes on the allowance. The biggest challenge is obtaining the appropriate data to meet IRS procedure requirements and administering the plan.
Taxable car allowance vs. non-taxable car allowances
If your organization currently pays a taxable car allowance, rather than focusing on whether to increase or decrease that amount for 2021, it is better to focus on figuring out how to adopt a non-taxable plan. By switching to a non-taxable plan, you can take the money that would have gone to federal and state taxes and invest it back into the employees and the company.
In many cases, a smaller allowance that employees get to keep in its entirety is a bigger benefit to employees than a larger allowance that is reduced significantly by taxes. This is a win-win situation for the employee and employer.
Which non-taxable car allowance is best for 2021?
A FAVR allowance will typically outperform a mileage allowance plan. This is because a mileage allowance can at times discourage productivity by essentially capping the mileage an employee can drive at the equivalent of the set allowance amount divided by the IRS mileage rate.
Furthermore, no vehicle reimbursement plan – not a standard car allowance, not a mileage allowance, not even the IRS mileage rate itself – can match the flexibility of a FAVR plan, which is very important in the current circumstances, when many employees are driving far less the normal due to COVID-19. That circumstance may change significantly as vaccines roll out, and it is important to have a plan that can fit both times of less driving and times of more driving.
Why a FAVR car allowance is best for both the company and the employee
The most important feature of a FAVR car allowance is its flexible ability to provide customized payments to employees. Different employees drive different amounts and incur expenses at different rates. Some work in expensive locations where prices of gas, insurance, and maintenance are well above average.
Given the variety of employee expense needs, a standard set car allowance does not present fair, equitable outcomes. Even after eliminating taxes with mileage substantiation (mileage allowance), you still have the issue of employees whose actual expenses exceed the allowable amount.
Because a fixed and variable rate plan is based on actual vehicle expense data, this problem is resolved. To learn more about why it's called "fixed and variable rate" or to learn what kind of data is necessary to derive a FAVR car allowance, read our guide.
To find out whether a FAVR allowance could prove cost-effective for your organization, use the calculator below.