This guide explains how to make tax-savvy choices when deciding how to compensate employees for using their personally-owned vehicles (POVs) for business purposes.
A. The difference between car allowance and mileage reimbursement
A car allowance is typically a flat lump-sum payment, usually delivered monthly or annually on top of an employee’s base pay. When structured in this way, car allowances can usually be found in the list of benefits for a job posting, or as an addendum to the posted salary. If a vehicle allowance is provided, it could be the same for all employees.
Mileage reimbursement, on the other hand, is a payment tied to the amount of miles your employee has driven for business purposes in a year. Employees that work in sales and distribution will put in many more miles than someone working in IT, for example.
B. The impact of tax compliance on take-home pay
One issue with providing a flat vehicle allowance is that a car allowance will be considered income and will be taxed at the end of the year — unless special measures are taken to ensure it gains a tax-free status from the Internal Revenue Service.
Failure to collect this tax from your employees in addition to their other taxes could result in a clawback or an audit.
C. The importance of informed decisions to minimize tax liability
No one enjoys paying taxes, especially if those taxes are unnecessary or could have been prevented. The IRS agrees, which is why they provide a staggering number of rules and regulations governing which deductions are acceptable or unacceptable.
It can be difficult to understand what expenses are permitted to be deducted for car allowances unless you consult with a tax professional or read through the public literature issued by the IRS.
Understanding what kind of vehicle reimbursement you’re providing to employees and all the regulations therein reduces your organization’s risk of exposure to tax fraud or any liability for uncollected or unpaid taxes.
Car Allowance: The Taxable Lump-Sum Payment
In nearly all instances, a car allowance—or a lump-sum payment provided to workers as an annual top-up to their base salary—is considered income and will be taxed as income.
While your drivers might be excited at the thought of an additional $7,000 per year to cover the costs of leasing a new car for work, this sum will be taxed at the personal tax rate, meaning that an average of 30% of it will be deducted. Moreover, this extra income could push them into a higher tax bracket, meaning that their tax rate will actually even become higher from the car allowance, all while it didn’t ever need to be.
Mileage Reimbursement: A Tax-Free Alternative
The IRS recognized long ago that not every business needs to lease a fleet of company cars. In cases where no specialty vehicles are required, that is, where normal personal cars like sedans and SUVs are all that is required, the IRS offers alternatives that allow employers to request their workers use their personally-owned-vehicles (POVs) for business purposes paired with incentives—in the form of tax breaks—for those businesses to compensate their employees for the costs they incur.
A mileage reimbursement is any method of reimbursement that covers employees business expenses for driving their personal vehicle for work.
Typically, for determining the tax-free rate for mileage reimbursements, most states defer to the standard cents per mile mileage reimbursement rate set by the Internal Revenue Service and the General Services Administration of the IRS. For 2023, that rate is 65.5 cents per mile, but that may change, depending on fuel cost fluctuations or whether we’re still in an inflationary economic environment.
Whether your business uses the flat Cents per Mile rate or a more complex structure such as a FAVR program, your employees will receive a payment per mile, usually retroactively, rather than a lump-sum payment on top of their salary.
Pros and Cons of the two Methods
The car allowance method detailed above offers employers a few benefits, as well as a few drawbacks.
Pros of the Car Allowance method
- Simplicity. Offering employees a fixed amount as a top-up to their base pay is much easier administratively than the complex requirements of a FAVR program. (That’s why an outsourced vehicle reimbursement partner is a wise choice for FAVR programs.)
- Appearance of fairness. Most business that offer a car allowance offer the same amount to all employees, regardless of position. (However, this appearance is spurious, since regional costs vary, therefore car allowances are actually not equitable, though they may be equal.)
- Fixed payments. Fixed lump-sum payments make budgeting easier, as your employees can expect a set amount, usually at the beginning or end of the fiscal year.
Cons of Car Allowances
- You lose an average of 30% to tax-waste when you don’t have to.
- Payments are inequitable: if everyone gets $600 a month, but one person lives in California and one person lives in Texas, they’re costs are going to be very different.
- Allowances could push people into higher tax brackets.
Pros and Cons of the Mileage Reimbursement Method
Mileage reimbursement offers more tailored solutions to managers and business owners, at the cost of additional administration requirements.
- Tax-free. Easily the number one reason to choose a mileage reimbursement method, whether cents per mile, FAVR, or another program, is that any payment made to your drivers is untaxed.
- Cost-effective. Offering a cents per mile rate ensures your drivers are paid for every mile driven, but not a cent above.
- Increased administrative burden. There’s no such thing as a free lunch. In order to take advantage of the Internal Revenue Service’s mileage reimbursement programs and provide these payments to your employees without any extra tax, you must satisfy very particular requirements.
Factors to Consider when Choosing Between Car Allowance and Mileage Reimbursement
In general, Cardata always recommends a mileage reimbursement program over a car allowance. There is just no case in which it is better to offer a car allowance, since you are basically throwing 30% of your money to the wind. With that in mind, here are some considerations that you might want to consider.
- Driving Habits and Work Requirements
The Internal Revenue Service only considers business use of personally-owned vehicles tax-deductible. It’s also important to structure your program based on the actual needs of your employees’ work duties. Florists, sales teams, and beverage distributors will put in a lot more miles making deliveries than a UX designer, for example.
With that in mind, you might want to consider the different types of mileage reimbursements. While a Cents per Mile program might be good for occasional drivers, a FAVR program might be better for outside sales reps.
- Tax Implications and Potential Savings
If you do offer your employees a lump-sum car allowance, be sure they understand that this amount will be taxed as income, and deduct the portion of tax they would pay at the end of year from their take-home pay each pay period.
A mileage reimbursement program can save your business a great deal of money by ensuring the efficiency of all payments. However, be sure it also has the resources to handle the additional administrative requirements.
- Policy Requirements
You may be in charge of administering or executing your business’s vehicle requirements or overseeing a fleet of drivers, but if your boss has set a specific vehicle policy, you may not be able to offer the program you want.
- Record Keeping
“Detailed, accurate, and timely” reports must be handed in regularly to whomever oversees the reimbursement program at your workplace. The IRS recommends that such records be collected at least every 30 days in order to remain compliant.
Real-Life Scenarios: Making the Right Choice
We’ve provided a few examples of common situations to help you determine which mileage reimbursement program, if any, is right for you and your business.
- Scenario A
You manage a small team of four employees at a startup. One employee, Felix, is responsible for sales. Felix drives thousands of miles per year visiting clients and providing product demos, whereas the other three employees at the office only use their vehicles to get to and from work.
Best setup: A FAVR program would provide all employees a vehicle allowance, providing a flat fixed rate to all four workers, and substantial additional monthly payments to Felix to reimburse for their additional mileage.
A Schedule 463 Accountable Allowance could also be considered for this scenario.
- Scenario B
You manage a team of forty employees who are responsible for customer service. There is no public transit out to the call center, and so all employees drive or carpool to work.
Best setup: Commuting expenses are never tax-exempt, whether under FAVR or any other program. In this instance, offering a taxable vehicle allowance to offset commuting expenses could be a clever idea to increase employee retention. It doesn’t bring your business any specific benefit, and the vehicle allowance will be taxed, but your employees will appreciate it—and it will help to increase retention in an industry with high turnover rates.
- Scenario C
You are the director of Human Resources at a non-governmental community food organization that provides free meals to those in need.
Most employees take public transit to work, as the main facility is located right by the central bus terminal. However, your head chef makes a trip at least once a week to a wholesale retailer, as she can get some foods in bulk cheaper than from your distributor. She also prepares frozen meals and baked goods that are sold at a local farmer’s market and delivers those herself each week.
Best setup: Since most employees don’t need to use their cars for work, but one employee does regularly makes local trips, a Cents per Mile reimbursement will cover the needs of the head chef without making additional unnecessary payments.
Strategies to Optimize Benefits
Implementing a policy change is rarely popular. Workers love stability, and tend to resist change even if it would benefit them. Here are three strategies you can use to ensure your mileage reimbursement program gets off to a smooth start.
- Stay Compliant with the IRS From Day One
Holding a meeting with your employees to carefully explain your new vehicle reimbursement strategy, and explain all the IRS requirements for reporting at the meeting. Let your employees ask questions to ensure everyone understands the requirements—and benefits—this policy change will bring.
- Standardizing or Automating Mileage Tracking
If you’ve decided to use paper logs to track mileage and driving expenses, make sure all your employees are provided a standard log template.
Or, if you’ve chosen to automate the process with a mileage tracking app, take the time to help your workers understand the functions and features of the app, and which are most important to ensure IRS compliance.
Providing your employees with resources and some sort of standardized or automated method of tracking expenses will reduce frustration and eliminate a potential source of resentment.
- Use Business Intelligence Tools
Mileage tracking apps can do more than just track miles.
Some of the newer-generation technologies incorporate machine learning or AI to offer suggestions for most efficient routes, or to monitor data as it comes in in real time.
They also make complying with FAVR regulations easier.
We hope you feel empowered with the information you need to choose the right vehicle reimbursement program for your business.
If you’d like to stay compliant with the IRS tax regulations for car allowances, or want to explore how a FAVR program can work for you, click this link to set up a demo call with Cardata to learn more.
Disclaimer: Nothing in this blog post is legal, accounting, or insurance advice. Consult your lawyer, accountant, or insurance agent, and do not rely on the information contained herein for any business or personal financial or legal decision-making. While we strive to be as reliable as possible, we are neither lawyers nor accountants or agents. For several citations of IRS publications on which we base our blog content ideas, please always consult this article: https://www.cardata.co/blog/irs-rules-for-mileage-reimbursements. For Cardata’s terms of service, go here: https://www.cardata.co/terms.