Reimbursement of employees' business-related expenses can be a minefield dotted with tax rules and regulations. This article aims at providing a short overview of the methods defined by the IRS as "accountable plans" for reimbursement of employee vehicle expenses.
What is an Accountable Plan?
To be an accountable plan, the employer's reimbursement arrangement must meet all of the following rules.
- All reimbursed expenses must have a business connection.
- The employee adequately accounts to the employer for these expenses.
- The employee returns any excess reimbursement or allowance within a reasonable period of time.
Expenses that do not meet all of the above rules are generally treated as tax-liable.
Which Reimbursement Methods Can be Considered Accountable?
Today there are three alternative methods for reimbursing vehicle expenses to employees who drive their private car for business:
- Car allowance - this is a fixed amount paid to the employee every month. At first glance, this approach appears to be very simple and requires minimal administrative overhead. However, there are a couple of big drawbacks to the car allowance. Firstly, because the allowance is a fixed amount, it may be grossly inaccurate and result in over- or under-reimbursement. Secondly, in order for the car allowance to be considered an "accountable plan" by the tax authority (and therefore eligible to be reimbursed tax-free), it must be based on reasonably accurate and localized expense estimates, and/or on evidence (mileage log, receipts, etc.)
If the tax authority finds that this isn't the case, the allowance amounts will be challenged and may be regarded as tax-liable income. This approach is therefore strongly discouraged both from an employer and employee perspective.
- Standard Mileage Rate - this method sets a rate per mile that you can use to figure out the deductible car expenses. The rate incorporates all vehicle expenses, such as gas, insurance, depreciation, maintenance, etc. excluding parking and tolls. The standard deductible rate is usually updated once per year by the IRS.
This mileage rate method is much more accurate than car allowance, as it accounts for the actual business mileage incurred. In order to be considered accountable by the IRS, the employee must log every business trip and present evidence of the mileage incurred. This method is very simple to use, understand, and audit, and it scales easily across your organization, provided that you adopt a proven mileage tracking platform such as Psngr. Employees in different geographies can be assigned local deductible rates as published by the tax office in their state, province, or country.
- FAVR - stands for Fixed And Variable Rate. The employer pays an allowance that includes a combination of payments covering fixed and variable costs. The variable costs are reimbursed using a cents-per-mile rate to cover the variable operating costs of the vehicle, such as gas, oil, maintenance, etc. The fixed costs of the vehicle, such as depreciation (or lease payments), insurance, registration, etc. are reimbursed using a flat amount.
The FAVR method is potentially the most accurate as well as the fairest method for reimbursing employee vehicle expenses. FAVR accounts for actual, vehicle-specific fixed costs which may vary widely depending on the vehicle and region. Variable costs depend on mileage and must therefore be quantified based on the actual (business) mileage logged by the empoyee. Such costs are reimbursed either based on a mileage rate, or based on the actual expenses (gas, oil, maintenance, etc.), multiplied by the business-use percentage of the vehicle.
Which Method Should I Choose?
While Car Allowance may seem the simplest and most straight-forward approach, it is usually very inaccurate and therefore financially inefficient. The employer may be over-paying or the employee may be under paid. As such, this method does not scale well for many employees in a ditributed organization.
FAVR, in theory, is the most accurate and fair method. However, due to its more complex reimbursement structure, this method adds significant administrative overhead. Fixed and variable costs are logged and calculated differently, and each reimbursement claim will take some extra time to review and validate. Furthermore, the split structure of fixed and variable reimbursement componenets may introduce errors in calculation and, in more extreme cases, fraud.
Standard Mileage Rate is by far the most convenient and widely adopted method for vehicle expense reimbursement. This is because it provides a good combination of high accuracy and fairness, and low administrative overhead.
The mileage rate method is very simple and straight forward to use, it scales well for a large number of employees, and is fair for both employee and employer. Unless the standard mileage rate is grossly detached from actual local costs of gas, maintenance etc, we recommend adopting the mileage rate method for reimbursing employee vehicle expenses.
Psngr offers a free tier for self-employed and small teams to try out a best-of-breed mileage tracking platform. Sign up here and start logging mileage today.