A car allowance is a regular payment to employees to offset work expenses associated with a personal vehicle. It is the simplest, easiest way to pay for employee vehicle expenses. But there are a few pitfalls to avoid.

What Every Employer Should Know About Car Allowances

Providing a car allowance to employees is an easy way to compensate their use of a valuable asset for work purposes. Once your organization decides on the appropriate amount per month or per pay period, you add it to each paycheck. Employees get to drive the vehicle of their choice, but they don't have to worry about paying for the extra expense of business use. 

Or do they? Here are a few things every employer should know about car allowances.

1. The IRS treats car allowances as taxable income.

It is vital to withhold taxes from the car allowance amount each pay period. This is because the IRS classifies standard car allowances as compensation. Essentially, you have added a stipend to the employee's salary in recognition that the employee is using a personal vehicle for the job. Only with an IRS-compliant method of substantiating business use can you avoid taxation of the car allowance payment.

2. Car allowance amounts should be regularly reviewed.

Many organizations set their car allowance amount and then go years without reviewing it to see whether it is an appropriate amount. How do they choose the amount? Sometimes it is based on a competitor's amount. Sometimes it is based on a reasonable guess of work-related car expenses. Sometimes it is chosen because it "sounds right." A regular review of the amount can make sure the allowance keeps up with inflation, changes in gas prices, etc.

3. A car allowance covers more than fuel, oil changes, and tires.

Because the wear-and-tear placed on a car is a cumulative process, a vehicle driven for work accumulates expenses that go beyond the obvious ones like gas. If a worker drives the vehicle five out of seven days for work, then those five days could arguably be the business portion of the employee's car insurance, depreciation, and maintenance costs. When you factor these expenses in, the car allowance amount that seems reasonable may fall short, especially when you consider the after-tax amount.

4. Some states require a car reimbursement that covers all expenses.

If you have employees who work in California, Illinois, Massachusetts, or six other jurisdictions, then you are required to prove that your car allowance is sufficient to fully cover all work-related vehicle expenses. For this reason, many employers in these states opt for a different approach, such as mileage reimbursement using the IRS business rate or a fixed and variable rate allowance.

5. Different employees can experience widely different vehicle expenses.

The larger your workforce, the more varied your employees' expense needs will be. Different regions experience significant price differences when it comes to fuel, insurance, and maintenance. Rural driving tends to cost less per mile than urban driving. The larger the differences between different employees' expenses, the more likely you will have employees whose car allowance does not cover their expenses. These workers may be more likely to leave the company in the future.

How to choose the best car allowance policy

It is important to get your car allowance amount right from the beginning and review it regularly. If your organization has employees with a wide variety of expense needs, you may need more than one allowance amount. Basing your amount on the expected expenses of your employees is the best way to go. It helps to have precise vehicle expense data, which can be obtained from vendors that specialize in business vehicle programs.

It is also worthwhile to explore other methods of paying for employees' vehicle expenses, such as mileage reimbursement and FAVR allowances. You can learn more about these options in our longer guide, Everything Your Business Needs to Know about Car Allowances.

If you would like assistance calculating the right car allowance amount for your organization, try our free car allowance calculator.