What Is an Auto Allowance and How Is It Taxed?

An auto allowance is a fixed, regular payment from an employer to an employee to cover the business-related use of a personal vehicle. This amount is added to the employee’s regular compensation and is intended to offset costs such as fuel, maintenance, and insurance. Companies provide this benefit as an alternative to offering a company-owned vehicle or reimbursing actual expenses, providing a predictable sum to the employee.

Tax Treatment of Auto Allowances

A standard car allowance falls under what the Internal Revenue Service (IRS) defines as a “non-accountable plan.” This is an arrangement where the employee is not required to provide detailed proof of their expenses to the employer. Because there is no formal substantiation, the IRS treats the entire allowance as supplemental wages.

The full amount of the auto allowance is added to the employee’s gross income. It becomes subject to federal and state income taxes, as well as Social Security and Medicare taxes (FICA). For example, an employee receiving a $600 monthly car allowance will not receive that full amount. The $600 is added to their taxable income and then reduced by tax withholding and the employee’s 7.65% share of FICA taxes, making the take-home amount significantly less.

Employee Financial Considerations

An employee receiving a car allowance is personally responsible for all vehicle-related expenses. These costs include fuel, insurance, routine maintenance like oil changes, tire replacements, and depreciation. To determine if the allowance is adequate, employees should track their business mileage and actual vehicle operating costs for comparison against the after-tax allowance received.

A significant consideration for employees is the inability to deduct unreimbursed vehicle expenses on their federal tax returns. The Tax Cuts and Jobs Act of 2017 eliminated the miscellaneous itemized deduction for unreimbursed employee business expenses for W-2 employees through 2025. While a federal deduction is not possible, some states have not conformed to this change, so a deduction may still be available on a state income tax return.

Employer Financial Considerations

From the employer’s standpoint, providing a car allowance offers administrative simplicity. This method avoids the complexities of collecting, verifying, and storing mileage logs and expense receipts. The payments are a tax-deductible business expense for the company, reducing its overall taxable income.

While the allowance payments are deductible, they also increase the employer’s payroll tax liability. Because the allowance is treated as taxable wages, the employer must pay its share of FICA taxes (7.65%) and federal and state unemployment taxes on the payments.

Alternatives to a Standard Auto Allowance

An alternative to the taxable auto allowance is a reimbursement structure known as an “accountable plan.” To qualify as an accountable plan under IRS rules, a reimbursement arrangement must meet three conditions:

• The expenses must have a clear business connection.
• The employee must adequately account for these expenses to the employer in a timely manner, such as by submitting a detailed mileage log.
• The employee must return any reimbursement in excess of the substantiated expenses.

The most common example is reimbursing employees based on the IRS standard mileage rate, which for 2024 is 67 cents per mile. When an employer uses this rate and the employee substantiates their mileage, the reimbursement is not considered income. Payments made under a compliant accountable plan are non-taxable to the employee and are not subject to the employer’s share of payroll taxes, resulting in tax savings.