What’s the Best Way to Reimburse Employees for Mileage Expenses?
Using an Allowance vs. Reimbursement
What's the best way to reimburse employees for their business driving? The answer depends on your own business needs and income tax regulations. The two payment options are reimbursement or a car allowance.
Taxes and Your Business Driving System
Consider the tax implications of your decisions before you begin paying employees for driving expenses. Your expenses relating to employee business driving are deductible to your business, but you must be able to prove them. You'll need a system that requires employees to report driving costs.
Only business driving (not personal driving) counts for tax purposes. Whichever option you choose to pay employees, you must be sure that only business mileage and expenses, not personal expenses, are tracked.
You must have documentation of the business purpose for both your business tax return and for employee taxes. That means every trip.
Paying Employees for Business Driving Expenses
No matter who owns the car—you or the employee—most companies pay employees for their business driving expenses. No federal law requires employers to reimburse employees for driving costs, but some states, like California, do require employers to reimburse employees for mileage. Be sure to check your state before you decide on a driving reimbursement method.
For both options, you must have a specific type of IRS-approved plan, called an accountable plan, to make sure that the payments are not taxable to the employee and that you can deduct these business expenses.
The requirements for having an accountable plan are that:
- The expenses must be for business driving only.
- The employee must give you complete and detailed expense reports within a reasonable time.
- The employee must return any excess payments within a reasonable time.
An example of an excess reimbursement would be if you gave money to an employee before a trip and they didn’t spend all the money and didn’t return the excess.
The plan must be in writing and it must include all the details of how the plan works. You should date the plan and be able to show that your employees received and read it.
The Two Options for Employee Driving Expenses
Both options use the IRS standard mileage rate as a basis for payment. This rate changes each year.
Giving Employees a Car Allowance
You can give employees a car allowance to pay for estimated driving expenses. The allowance must be based on, and not more than, the IRS standard mileage rate.
For example, you could give a mileage allowance of $1,120 for that month (2,000 x the 2021 standard mileage rate of 56 cents) if you estimate that an employee will be driving 2,000 miles in the next month. The employee must give you details on the miles driven. You could add it to the next month if the employee drove more miles. The accountable plan rules require that the employee return the excess within 30 days after the expense if they didn’t drive 2,000 miles in the month.
You can also used an alternate fixed and variable rate (FAVR) for employee-owned vehicles. This rate combines the estimated cents-per-mile rate to cover variable costs, plus a flat amount to cover the employee's fixed costs, like depreciation or lease payments. The IRS sets the maximum for this method each year.
You can reimburse employees directly for their business driving costs by requiring them to turn in driving expense reports. You can pay for actual costs or the IRS standard mileage rate. All reports must show detailed mileage and business purpose for each trip.
For the standard mileage rate, use the IRS mileage rate for the year and multiply it by the actual business miles for the employee for the month.
You’ll need receipts for all expenses, including gas, oil, tolls and parking, repairs, insurance, lease payments, and registration fees for actual costs. You might have to prorate costs to include only the business use of the car. For example, if the employee drove the car 3,000 miles during the month and only had 2,000 miles of business use, expenses would have to be multiplied by ⅔ (0.66).
Which Is Better: Allowance or Reimbursement?
Every business is different, so it’s difficult to know which is a better plan for both the employees and for your business. Here are some things to think about:
- Having employees submit reports and reimbursing them creates more paperwork, but it gives you more control over what is paid. You can limit the excess miles because employees are only paid for miles actually driven.
- Employees appreciate an allowance rather than having to wait to be reimbursed, but there is more possibility for expense fraud with this method. You must be diligent in getting employees to give back excess payments.
Comparison of Payment Options for Tax Purposes
Actual expense reimbursement isn't taxable to the employee if you follow your accountable plan and if employees return excess payments within a reasonable time. If the amount of the reimbursement is more than the IRS standard mileage rate for the year, the excess amount is taxable to the employee.
Employees are no longer able to deduct unreimbursed expenses (business expenses paid by employees that your business doesn’t pay) on their personal tax returns under the terms of the Tax Cuts and Jobs Act.
A mileage allowance up to the federal mileage rate is not taxable to the employee if you follow your accountable plan. The employee must pay tax on any payments over the IRS standard mileage limit and on any excess payments they don’t return.
This article is a brief overview. The regulations are complicated and this is not tax or legal advice. Get help from your tax professional and attorney to set up an accountable plan and payment option before you reimburse employees.