The Hidden Costs of Car Allowances: Unraveling the Tax Conundrum for Employers

In the hustle of today’s job market, many companies offer car allowances to employees who drive a personal vehicle as part of their work. They seem like an easy, straightforward benefit to offer. But if you don’t fully understand the tax implications for you or your employees, allowances are likely costing more than they need to.

First, the good news:

Allowances can be tax-free or marginally taxable because they are considered a reimbursement for the cost and wear & tear on an employee’s vehicle that they drive for work. 

But of course, there’s a catch:

To be no or low-tax, allowances must fall within specific IRS guidelines.

Otherwise, car allowances can cost employees 25-40% in taxes and cost you another 7-8% in employer taxes on top of that. And you have to ensure you properly report the allowance on an employee’s W-2.

Taxable or not? How to tell.

When reviewing your car allowance program, it’s vital to grasp the nuances between accountable and non-accountable plans. Accountable allowances are not taxable, whereas non-accountable allowances should be reported as taxable income.

To qualify as accountable, the payment must meet the following IRS requirements:

• Expenses must be job-related
• Employees must substantiate these expenses within a reasonable timeframe (typically 30 days)
• Any reimbursement overages must be returned

Miss these criteria, and the IRS sees that allowance as taxable income, leaving the employee with only 60-70% of that allowance in their pocket.

Take Beck, for example, who works in medical device distribution and receives a monthly car allowance of $500. 

After subtracting $125 for marginal taxes (25%), $25 for state taxes (5%) and $38.25 for the Driver FICA/Medicare tax (7.65%), Beck's take-home amount shrinks to only $311.75. All these taxes mean that nearly $189 per month - or $2,268 annually - goes to the IRS rather than Beck’s wallet.

What can employees provide to substantiate expenses?

Proving expenses for a car allowance is a bit different than other types of reimbursements because there is no “receipt” for the wear and tear on an employee’s personal vehicle. Instead, the IRS requires a mileage log.

An IRS-compliant mileage log should include the following key elements:

• Date of each trip
• Starting location
• End destination
• Total mileage for each trip
• Purpose of the trip (business-related)

Automatic mileage tracking apps like Everlance make it easy for employees to keep logs and submit them for tax-free reimbursement. Download the app for free to

How does the IRS determine reimbursement overages?

In addition to understanding how documentation requirements affect taxability, you should also know how overpayment relates to taxable income. Employees must return any overpayment, or else it will be taxed.

Overreimbursement is calculated by applying the Safe Harbor test. Every year, the IRS sets a standard mileage rate. If an employee is paid an amount that exceeds what they would have received by simply applying the standard mileage rate to their work mileage, the difference is considered taxable income.

For example: 

• In 2023, Sally, a sales representative, received $8,040 in total mileage reimbursement for driving 12,000 miles
• If Sally had been reimbursed at the IRS standard rate, she would have received $7,860 (12,000 miles x 0.655)
• Sally’s reimbursement of $8,040 exceeded the equivalent IRS standard rate ($7,860) by $180.00, which is considered a reimbursement overage
• Sally either needs to return the excess $180 or Sally’s employer should report the $180 as taxable income

In this case, only the overage is taxable, not the entire allowance amount, as long as the other requirements for an accountable plan are met. This way, employers can offer a larger, more attractive allowance while still minimizing taxes.
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How to report taxable amounts

[.blue-line][.866]If your car allowance or stipend is not part of an accountable plan, it should be treated just like regular wages.[.blue-line][.866]

The taxable income should be reported in Box 1 (Wages, tips, other compensation) and Box 3 (Social Security wages) of an employee’s W-2 form.

If there are reimbursement overages that are not returned on an otherwise accountable plan (expenses are substantiated), it is taxed as ordinary income. Employers should report the amount using Code L on Box 12 of an employee’s W-2.
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No and low-tax reimbursement options

In addition to a set monthly allowance that meets the criteria for an accountable plan, there are two other options to provide tax-free reimbursement to employees who drive their personal vehicle for work. As long as all IRS parameters are met, they’re tax-free and do not need to be reported on the W-2. 

• Cents per Mile (CPM) Program: In a CPM program, reimbursement is based on a set amount paid per mile driven for work. As long as the per-mile rate does not exceed the IRS Standard Rate and other IRS parameters for mileage documentation are met, CPM reimbursement is tax-free.
  
  
• Fixed and Variable Rate (FAVR) Program: This program is regarded as the fairest because it best reflects the actual cost of vehicle ownership and operation. Both fixed costs such as insurance, depreciation, and taxes, and variable costs like maintenance or fuel are considered. Reimbursement consists of a fixed monthly payment and a variable payment to reflect that breakdown. 

In addition to mileage documentation, there are a number of other IRS FAVR guidelines that must be met for the program to be considered compliant. In that case, FAVR reimbursement is tax-free and does not need to be reported on the W-2.

If you feel overwhelmed with the nuances of IRS compliance for your reimbursement program, you’re not alone!

Many companies partner with Everlance to facilitate tax compliance and design tax-free vehicle programs. By eliminating tax waste from car allowances, you can increase the amount of take-home pay drivers receive without spending more out of pocket. It’s a win-win strategy!

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