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How does a car allowance work?


This article summarizes the various forms of car allowances that businesses can provide to their workers, and their tax implications for fleet managers.


In the twentieth century, when American manufacturing reigned supreme as the world’s economic engine, it was common for employers large and small to have company vehicles leased for their workers to drive on business hours. Whether that was a single marked van or large fleet of sales and distribution trucks, having business vehicles was business as usual.

However, things have changed heading into today’s dynamic work environment. Because company use of personally-owned vehicles (POVs) can bring so much financial benefit to both workers and business leaders, it’s commonplace to offer some sort of financial incentive, like a car allowance, in order to attract and keep quality employees.

While it’s not mandated by law except by regulation-heavy states like California, it is becoming as common as seeing health benefits in a job listing: not technically required, but so standard it might as well be.

Car allowances in theory and application 

Essentially, a car allowance is any incentive that an employer offers in exchange for the use of an employee’s personally-owned vehicle for work. That is a general definition, and a great deal of complexity can be found under the hood, so to speak. Car allowances further break down into three different categories:

1. Fixed lump-sum payments or installments

A car allowance typically takes the form of a fixed, regular payment made to employees, such as a monthly or annual stipend. This payment can be provided in cash via direct deposit, be issued as a cheque, or added onto an employee’s regular biweekly deposit.

Unless they meet very special conditions, these fixed payments are taxed fully as income by the Internal Revenue Service. That means a portion of the car allowance must be held back by payroll every pay period in order to meet state and federal taxes and to avoid an audit.

2. Variable repayments as Cents per Mile figures

Car allowances tend to offer broad coverage for your employees, while lacking in specificity.

They are not linked to actual driving expenses, and so can overpay employees who don’t need to drive very much for work if every position at your firm comes with the allowance, for example.

This means that employees receive a predetermined amount regardless of how much they actually drive for work. Consequently, this can lead to some employees getting overpaid and others underpaid, depending on their driving habits and the roles and responsibilities they have.

However, the IRS – and thus, some operations – do allow employees to claim actual expenses incurred. They must be documented and justified in full and paired with documentary evidence, such as original receipts, plus records of the business purpose of each trip.

Tracking actual expenses is by far the most labor-intensive, but it’s also pretty even-handed, and ensures drivers aren’t getting over- or underpaid. The main difficulty is ensuring compliance and prompt reporting.

3. A structured program that incorporates elements of both

The FAVR program considers fixed costs (e.g., insurance, registration) and variable costs (e.g. fuel, maintenance) to calculate a personalized reimbursement rate that combines a regular monthly payment with an additional ‘top-up’ payment to cover the variable portion.

While the FAVR program may require more administrative effort, it can lead to significant tax savings for all involved. And a mileage tracking app may make it easier to satisfy the IRS’ requirements.

Tax implications for car allowances

Lump-sum car allowances will be taxed as income, so it’s important to talk to employees when onboarding to ensure they understand how this will impact their net pay on their first pay period.

For example, if an employee receives a $600 monthly car allowance and falls under the 30% tax bracket, they would only take home $420 after taxes. Over time, this reduction in take-home pay can add up, impacting an employee’s overall financial well-being and job satisfaction.

This additional taxation is why Cardata recommends most clients choose another method for making their employees whole on their vehicle costs. It’s almost never the most economically sound choice, although if you are your business’s sole administrator, there is something to be said for making choices that reflect your ability to administer them. It will vary from business to business.

However, when the IRS offers alternatives deliberately to provide business owners with lower taxes, it seems prudent to take advantage of them, and the savings from a structured program like FAVR can be significant.

Car allowances vs FAVR programs

FAVR programs are a specialized vehicle program designated by the IRS as a tax-saving strategy for employers. One key distinction between a car allowance and the FAVR program is that FAVR is always exempt from taxation if it stays within the guidelines provided by the IRS, whereas a lump-sum car allowance can be either accountable or fully taxed.

In layman’s terms, FAVR combines a fixed rate element – a value per mile driven – with a variable rate element that takes into account local factors, like fuel cost and the average price of a new vehicle in the area, in order to produce a monthly payment.

FAVR has many complex requirements that go beyond the scope of this article. But what you need to know is that they require some sophistication to set up, but tend to pay for themselves in the long run, especially for larger operations.

Unlike a traditional car allowance, the FAVR program requires employees to maintain detailed records of their driving expenses. This includes keeping track of mileage, receipts, and other relevant documentation. But with this program being both tax-free and potentially fairer to employees who log the most miles, it’s worth investigating.

Making informed choices: factors to consider

The needs of every business are different. If you have a small team of three employees, it may not be practical or cost-effective to invest the time and money required to set up a FAVR program. A taxed car allowance may be fine, and managing the payroll remittances for the additional taxation for three employees is not burdensome. This may not be the year your startup needs to disrupt the good thing you’ve got going, although it’s something to keep in mind when you do start changing the world and need to upscale operations.

Similarly, if you have a large workforce, offering a flat car allowance may be less cost-effective than a FAVR program if some employees log more miles than others. Switching to FAVR promotes equity when business use needs vary greatly among a large workforce, especially if your business has logistical needs, which most do.

In either case, it’s almost certainly going to be cheaper than maintaining your own fleet of company cars, and is therefore a good choice for most businesses.

Here are the most important factors to consider when designing a car allowance program for your team:

  • Employee Driving Habits. Consider the frequency of work-related travel and the distance covered. Do you have a sales team of pharmaceutical reps making visits to clients regularly? Or are work-related trips made by your employees limited to occasional trips to pick up supplies?
  • Tax Implications. Have you taken the time to understand the various options the IRS offers? Have your employees?
  • Administrative convenience. It’s not the most important factor by any means, and there are solutions to make the administrative side of things less burdensome, but if you manage a larger team it’s something to consider. Tracking down forty expense logs a month isn’t exactly a picnic.


Car allowances are a part of doing business in America in the twenty-first century. But like most tax-related topics, they can feel like a minefield to those unaccustomed to the IRS and its various loopholes and exemptions.

Ultimately, employers and employees should collaborate to select the best reimbursement method that meets the company’s budget and ensures employees are properly compensated for their work-related travel expenses. A fair balance means happier employees, and a more productive quarter. Your shareholders will also be thankful you spent the time reading this article and familiarizing yourself with the wide world of car allowance programs that the IRS permits.

Understanding how a car allowance works and its tax implications empowers individuals to make informed choices and maximize financial benefits to their organization and to themselves.

If you’d like to talk with a vehicle program expert at Cardata to talk about your options, and to see what solutions we’ve developed to help fleet managers make empowered and data-driven decisions, click here.

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: For Cardata’s terms of service, go here:

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