A car allowance is a fixed amount of money employers give employees to cover vehicle expenses. The IRS classifies most car allowances as taxable income unless they meet specific criteria.
The IRS considers car allowances taxable wages by default. Employers must withhold income taxes, Social Security, and Medicare from these payments. However, exceptions exist for accountable and non-accountable plans.
Accountable plans require employees to submit expense reports and return excess amounts. Non-accountable plans do not have these requirements, making them fully taxable. The IRS provides guidelines for both in Publication 463.
| Type | Tax Treatment | Requirements |
|---|---|---|
| Fixed and Variable Rate (FAVR) | Partially taxable | Combines a fixed payment for depreciation and a variable rate for operating costs |
| Cents-per-mile rate | Tax-free if IRS standard rate is used | Employees must document business mileage |
| Lump-sum allowance | Fully taxable | No documentation required |
Many people assume all car allowances are tax-free. This is incorrect. Only specific arrangements, like the cents-per-mile rate using the IRS standard rate, qualify for tax-free treatment. Other allowances are typically taxable.
Another mistake is confusing car allowances with company cars. Company-provided vehicles have different tax rules, often involving fringe benefit taxation based on the vehicle's fair market value.
Sarah receives a $400 monthly car allowance from her employer. Since it's a non-accountable plan, the entire $400 is subject to income tax withholding. If Sarah had used an accountable plan, she could deduct actual expenses, reducing her taxable income.
For the 2023 tax year, the IRS standard mileage rate is 65.5 cents per mile. If Sarah's employer paid her 65.5 cents per mile for 500 business miles, that $327.50 payment would be tax-free. Any excess over the standard rate would be taxable.