Both employers and employees often ask us whether their car allowance or mileage reimbursement should be taxed. Here’s a typical question and how we answer it:
We have 38 employees that drive their own vehicle for business and they each receive a car allowance. We don’t tax our employees' car allowance. We have taken the stance of leaving it up to them to address their allowance on their personal taxes. Is this ok?
The answer? No, it’s not ok.
Why it's not ok to leave that car allowance untaxed
As an employer if you require your employees to use their personal vehicles for business purpose you have two options to address their driving expenses. You can either
1. Compensate employees (taxable allowance)
2. Reimburse employees (non-taxable method)
You cannot leave it up to employees to calculate and pay taxes themselves. Nor can you tell them to deduct business mileage or expenses. In fact, as of 2018, no one can write off unreimbursed business expenses. That means you can't deduct mileage if you receive a car allowance – and you shouldn't expect your employees to.
Not sure how high to set your car allowance?
Find out from our annual car allowance survey what other companies said they pay. Or read 2021 Car Allowance Policy: How to Determine the Right Amount.
Option 1: Compensation (taxable car allowance)
If a business elects to compensate employees, this comes in the form of providing a set allowance each pay period based on what the company thinks is fair for using a personal vehicle for business. Because there is no documented business use that can be measured against the amount, the employee car allowance must be treated as taxable income.
Under IRS rules, compensation must be taxed. However, because in the past many tax payers could claim a tax deduction for business mileage and expenses, many businesses have assumed that it’s up to employees to address their car allowance on their tax returns. To the contrary, the employer should be withholding payroll taxes on the allowance.
Option 2: Reimbursement (mileage rate)
If a company elects to reimburse employees, the company will provide a certain dollar amount for each business mile driven while on company business. A mileage reimbursement is not taxable as long as it does not exceed the IRS mileage rate (the 2020 rate is 57.5 cents per business mile). If the mileage rate exceeds the IRS rate, the difference is considered taxable income.
This approach requires employees to record and report mileage. Many companies use manually reported mileage using a log (often an Excel spreadsheet) that employees update at certain intervals. Others, however, use a more automated method, such as a GPS mileage app. The downside of mileage reimbursements is that they can get costly as employees increase their driving in order to increase their reimbursement.
A third way: Allowance with mileage substantiation
To avoid treating car allowances as taxable income, some companies add mileage substantiation. As with reimbursement, this requires the company to provide a mileage log or app to each employee to capture the business mileage. The mileage is then multiplied against the IRS mileage rate and subtracted from the prepaid car allowance. Employees are taxed on the difference. This method can cause administrative headaches for the organization, especially if they use a manual mileage reporting method.
Let's review car reimbursement options:
- You must either compensate employees (car allowance) or reimburse employees (mileage rate) – no tax write-offs.
- Car allowances are taxable income and subject to withholding – unless you substantiate business use (see the rules for accountable plans).
- Mileage reimbursements are not taxed – unless they exceed the IRS business mileage rate.
After tax reform: Time for a new approach
Up until 2018 employees could either deduct the standard IRS rate for work related mileage or fill out a form 2106 to deduct expenses like fuel, maintenance costs, and depreciation. But even then this deduction did not absolve employers from taxing car allowances.
Now that tax reform has eliminated the deduction (at least until 2026), it is more crucial than ever that organizations pay a fair car allowance or mileage reimbursement that fully covers each employee's business vehicle costs.
Withholding taxes from a standard car allowance can take a huge chunk out of an employee's take-home pay – as much as 30-40%. If you haven't been withholding the taxes, do you really want to start withholding them now?
You could switch to paying a mileage rate, but that can lead to uncontrollable costs. You could try mileage substantiation, but that involves serious administrative headaches.
Another reimbursement option – the FAVR car allowance
At mBurse, we specialize in crafting non-taxable reimbursements without all the headache of administrative tasks typically entailed by mileage reimbursements.
The gold standard of non-taxable plans is the fixed and variable rate car reimbursement, or FAVR for short. A FAVR car allowance is an IRS-accountable plan that accurately reimburses employees for the use of a personal vehicle without subjecting the expense offset to taxes.
Switching from a traditional car allowance to a fixed and variable rate allowance is typically a win-win situation. You can leverage all of the wasted money going to taxes into a better benefit for the employee while saving the company money in the long run.
To find out more about how switching to a FAVR car allowance could save you and your employees by eliminating tax waste, contact us today.