How to Qualify for a Non-Taxable Car Allowance

A car allowance is a payment from an employer to an employee to cover business-related vehicle expenses. These payments can be structured as either taxable income or as non-taxable reimbursements. The tax treatment depends entirely on whether the payment plan adheres to specific Internal Revenue Service (IRS) rules for what is known as an accountable plan.

Differentiating Taxable and Non-Taxable Allowances

The primary distinction between a taxable and non-taxable car allowance hinges on whether the employer’s program qualifies as an “accountable plan” under IRS guidelines. If a reimbursement arrangement meets all the IRS requirements for an accountable plan, the payments are not considered income and are not taxable to the employee. These reimbursements are treated as a repayment for business expenses incurred by the employee on behalf of the company.

Conversely, any payment plan that fails to meet one or more of the specific IRS criteria is automatically classified as a “non-accountable plan.” Under a non-accountable plan, all payments, such as a flat monthly stipend provided without any documentation requirements, are considered taxable wages. This means the allowance is subject to federal income tax, Social Security and Medicare (FICA) taxes, and federal unemployment (FUTA) taxes.

An allowance under a non-accountable plan can lose 25-40% of its value to taxes for the employee, while the employer must also pay its share of payroll taxes on the amount. The structure of the reimbursement plan dictates its tax status, so calling a payment a “reimbursement” does not make it non-taxable if it operates as a non-accountable plan.

Requirements for an Accountable Plan

For a car allowance to be non-taxable, it must be paid through an accountable plan that satisfies three core tests set by the IRS, as detailed in Publication 463.

• A clear business connection must exist, meaning the expenses are directly related to the employee performing their job duties. This includes using a personal vehicle for visiting clients or traveling between work sites, but commuting from home to a primary workplace does not qualify.
• The employee must substantiate expenses by providing documentation to the employer. This involves a detailed mileage log proving the amount, time, place, and business purpose of the travel, along with receipts for costs like tolls and parking.
• Any excess reimbursement must be returned to the employer within a reasonable period. If an employee receives a payment greater than their documented expenses, the difference must be returned. The IRS considers the return of excess funds within 120 days as reasonable.

Common Non-Taxable Reimbursement Methods

Once the framework of an accountable plan is in place, employers can use several common methods to calculate and pay non-taxable reimbursements.

One method is the cents-per-mile rate, also known as the standard mileage rate. The employer reimburses the employee a set amount for each substantiated business mile driven. The IRS establishes a standard business mileage rate annually, which for 2025 is 70 cents per mile. As long as the reimbursement rate does not exceed the IRS standard rate and the employee provides a compliant mileage log, the entire reimbursement is non-taxable.

Another method is the Fixed and Variable Rate (FAVR) allowance. A FAVR plan provides two separate payments: a fixed payment to cover stable costs like insurance and registration fees, and a variable payment based on miles driven to cover fluctuating costs like fuel and maintenance. FAVR plans have their own detailed set of IRS rules and can be tailored to local costs and individual driving amounts.

Tax Reporting and Record-Keeping

For employees, the primary requirement is maintaining a contemporaneous mileage log. This log should document for each business trip: the date, start and end locations, business purpose, and the vehicle’s odometer readings. If an employer’s reimbursement under an accountable plan is less than what the employee could have claimed using the standard mileage rate, the employee cannot deduct the difference on their personal tax return through the 2025 tax year.

For employers, non-taxable reimbursements made under an accountable plan are not subject to income tax withholding or FICA and FUTA taxes. Consequently, these amounts are not included as wages in Box 1 of the employee’s annual Form W-2. However, if a reimbursement exceeds the federal standard rate, the excess amount is considered taxable income.

In cases where part of an allowance is taxable, such as an excess amount not returned by the employee, that portion must be reported as wages. The non-taxable portion of the reimbursement, up to the amount substantiated under the federal rate, may be reported in Box 12 of the Form W-2 using code “L”. Employers are required to maintain records of employment taxes, which include such reimbursements, for at least four years.