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. 

How to Tell If Your Car Allowance Is Taxable

As an employer, if you require your employees to use their personal vehicles for business purposes, you have two options to address their driving expenses. You can either

1. Compensate employees (taxable allowance)

OR

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, since 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 the 2025 Car Allowance Audit: Calculate the Right Amount. Or let us calculate a sample rate for you.

Car Allowance and Mileage Rate Tax Implications

Treating employees fairly and complying with federal tax law will mean making a change. Here are your options:

Option 1: Compensation (taxable car allowance)

Compensation takes the form of a set vehicle allowance or stipend 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 taxpayers could claim a tax deduction for business mileage and expenses, many businesses assumed it was 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 (non-taxable mileage rate)

Reimbursement typically takes the form of a certain dollar amount for each mile driven on company business. A mileage reimbursement is not taxable as long as it does not exceed the IRS mileage rate (the 2025 rate is 70 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 employees manually report mileage on a log (often an Excel spreadsheet) that they update at specific 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 or their reporting to increase their reimbursement.

Option 3: Car allowance with mileage substantiation

To avoid treating car allowances as taxable income, some companies substantiate business mileage. As with reimbursement, this requires providing a mileage log or app to each employee to capture the business mileage. The mileage is multiplied by the IRS mileage rate and subtracted from the prepaid car allowance. The difference is treated as taxable income. This method can cause administrative headaches, especially if mileage is reported manually.

Taxable vs. Non-taxable Car Reimbursements

Here is a summary of the rules for determining taxable vs. non-taxable car allowances and mileage rates:

• 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.

Deciding between taxable and non-taxable plans

In 2025, with soaring inflation, insurance costs that are higher than ever, unpredictable gas prices, and vehicle prices soaring, employees who drive personal vehicles for work need a robust vehicle reimbursement policy.

Withholding taxes from a standard car allowance can take a considerable 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 non-taxable option – the Fixed and Variable Rate Reimbursement 

At mBurse, we specialize in crafting non-taxable reimbursements without the headaches of administrative tasks typically associated with mileage reimbursements.

The gold standard of tax-free plans is the fixed and variable rate car reimbursement, or FAVR. An FAVR car allowance is an IRS-accountable plan that accurately reimburses employees for using 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.

Contact us today to learn more about how switching to a FAVR car allowance could save you and your employees money by eliminating tax waste.