What exactly are lump sum car allowances? Learn how taxation works, details on substantiated car allowance programs, and more.
Lump sum car allowances are vehicle reimbursements provided by employers to employees who use their personal cars for work-related purposes. They involve a fixed-rate payment — typically on a monthly basis — to cover the expenses incurred from business use of a personal vehicle. While lump sum allowances are often considered to be taxable fringe benefits, there are also ways to avoid unnecessary tax waste and ensure compliance with tax regulations.
Understanding lump sum allowances
A lump sum allowance is a broad term that covers fixed payments from an employer to an employee to compensate for business travel with a personal vehicle. Lump sum allowances could be designated by employers to help employees pay for business expenses like gas, maintenance, repairs, and more. The amount itself is flexible, and up to the employer to determine.
Compared to other vehicle reimbursement methods, lump sum car allowances are typically more simplistic. They’re a flat-rate amount given on a regular basis, while in comparison other solutions are generally more variable and dependent on actual business expenses. Lump sum allowances are also typically taxable, compared to tax-free vehicle reimbursement methods — like a fixed and variable rate (FAVR) reimbursement program or a Cents per Mile (CPM) program.
Note that lump sum allowances are also very different from company car programs or fleets, where employees who drive for work are provided with a company-owned or company-leased vehicle. In a lump sum car allowance program, employees use their personal cars and are responsible for the costs associated with that vehicle.
One common misconception with car allowances is that since they’re a simple and straightforward option, they’re the obvious choice. In reality, car allowances can actually present some significant downsides, both for the employee drivers and for employers. Since lump sum allowances are a fixed amount, they’re not always an accurate reflection of actual business expenses, which could vary from month to month. It’s likely that employees will have to drive different distances each month or will incur different costs each month — meaning the amount of the allowance could be either too much or too little, depending on the month.
Another potential issue with the fixed amount is that the allowance could run out before the end of the month. In a situation where this happens, an employee could be discouraged from driving for work until the allowance has renewed to avoid paying for business travel with their personal funds. This could have a negative impact both on employee morale and on company efficiency.
How are lump sum car allowances taxed?
Importantly, lump sum car allowances are also generally heavily taxed, which is a significant disadvantage compared to other tax-free reimbursement methods. When there isn’t any record-keeping to justify business expenses, the IRS treats the allowance amount as added income for employees, subjecting these payments to income tax. In turn, employers could also be subject to payroll tax.
When lump sum car allowances are unsubstantiated and considered taxable income, there aren’t any specific rules and regulations from the IRS beyond those that typically apply to regular income.
This tax waste of lump sum car allowances can be avoided by keeping detailed records to substantiate any business expense claims — more on this below.
Compliance with accountable allowance rules
Accountable allowances are a sanctioned program under IRS Publication 463. This type of allowance could be referred to as a substantiated lump sum allowance, since records are provided to back up business mileage and expense claims. Accountable allowances make it clear that the allowance payment was used just for work expenses through clear and detailed record-keeping.
To find out just how much of an accountable and substantiated allowance can be tax-free, it’s important to be aware of the IRS Standard Rate. This rate is the maximum mileage rate that can be reimbursed tax-free for business use of a personal vehicle. Note that using this rate is just an optional maximum — an employer might choose to reimburse at a lower rate. Any excess reimbursement will be taxed by the IRS.
For 2023, the standard mileage rate is 65.5 cents per mile driven for business use. Note that this rate regularly changes, and it’s important to ensure that you have the applicable rate for the relevant tax year.
To be compliant with an accountable and substantiated allowance program, all expenses must be business-related, and this needs to be justified through detailed mileage logs and records, which need to be submitted to their employer within a reasonable period of time, as defined in IRS Publication 463.
Comparing substantiated and unsubstantiated allowances
When compliant, substantiated lump sum allowances can help your business and your employees avoid tax waste. It’s all about providing records that justify expenses — this is the key to promoting tax efficiency.
Again, it’s important to note that any lump sum allowance that isn’t substantiated is considered to be a taxable fringe benefit — which could equal income loss to your employees and also present a tax waste scenario to the business.
To ensure that your lump sum allowance is compliant, it’s important to make sure your program is up-to-date, and thoroughly understand and follow IRS guidelines.
Advantages of substantiated lump sum allowances
The most significant benefit of a substantiated lump sum allowance is likely the tax savings. This is a big financial perk for employees (and employers), which could help to boost company morale. A strong vehicle reimbursement program can also be a feature in compensation packages, helping the company to recruit new employees.
Beyond the obvious financial benefits, substantiated lump sum allowances also generally offer a simplified reimbursement process. Since they’re a set and reliable amount, it’s simpler for employers to predict expenses for the program itself. Employers can add a lump sum allowance to an employees payroll, facilitating payment processing.
Lump sum allowances can also provide employees some flexibility, as they have the freedom to manage their business expenses and spend the allowance on what business expenses they think are best.
Challenges of unsubstantiated lump sum allowances
In turn, when lump sum allowances are unsubstantiated, it can present challenges. Even though they appear like the simpler option with minimal administration required, this benefit comes at a few costs — including that these payments are considered to be taxable income, creating potential tax wastage for both employers and employees.
Since these unsubstantiated lump sum allowances are considered as taxable income, the only compliance required is the compliance that’s required for typical income — reporting it to the IRS and paying relevant taxes.
This type of car allowance could also negatively impact employee morale and satisfaction. While at first glance a standard, unsubstantiated lump sum might seem like a great benefit for employees, they could be disappointed when they find out about the heavy taxation that seriously reduces the benefit. There could also be negative impacts on morale — as well as hiring and retention — when current and potential employees compare an unsubstantiated lump sum allowance program to companies with tax-free vehicle reimbursement programs.
How do you put together an effective car allowance program?
If you’re looking to put together a strong car allowance program, there are a few key things to keep in mind. For starters, it’s important to put together a policy with clearly set out guidelines and expectations. This will help ensure internal compliance with the program, set expectations for employees, define goals, and more.
Once you’ve put together a strong policy, the next step is to share it with your employees. It’s a good idea to be thoughtful about how you educate employees and share these communications, whether that be through training sessions, workshops, question and answer resources, and more. Be sure that there are ways for employees who have questions or concerns to address them, too. Employees need to clearly understand recordkeeping and compliance requirements.
One way to simplify your car allowance program? Consider outsourcing to a tech-powered solution. Vehicle reimbursement software, such as Cardata, can offer solutions like automated mileage tracking, expense management and payment, robust reporting, and more. The best software is already aligned with IRS guidelines, helping you have an accountable and substantiated allowance program and easing the administrative burden of ensuring your program stays compliant.
Lump sum allowances are just one of many approaches to reimbursing your employees for business travel. It’s a good idea to be aware of the costs and benefits of each — so you can choose the best program to suit the requirements and goals of the business. Regardless of which option you choose, be sure that you’re following any relevant IRS regulations for compliance.
And, if you do want to go with a fixed lump sum payment, it’s worthwhile to look into the benefits of substantiated lump sum allowances, also known as an accountable allowance program. By record-keeping and following other guidelines to justify business expenses to the IRS, you can avoid potential for tax waste to benefit both employees and the business itself.
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.