Tax Consequences Under Different Reimbursement Methods
Employees who operate their vehicles for business use are compensated under either taxable or non-taxable reimbursement plans, but employers and employees often overlook differences in tax consequences between the two types of reimbursement methods.
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Today's leading organizations are leveraging multiple modes of transportation to minimize their total cost of moving people and delivering goods and services. Well-run organizations are integrating both employer- and employee-provided vehicles in fleet programs as part of their vehicle allocation methodology.
As a general rule when considering total cost of ownership (TCO), employees with high-mileage needs should be provided with a company vehicle; those with low-mileage needs should have their job function reviewed to determine if personally owned vehicles (POVs) would produce the lowest TCO through a business reimbursement program.
The fleet manager or other company leader should have authority over both programs to properly control costs and successfully provide fair, safe, and equitable transportation for all employees.
Rather than focus on the pros and cons between the different means of providing business transportation, we'll review the importance of understanding the differences between taxable and non-taxable business reimbursement plans for use of POVs.
In one case, reimbursement is considered income to the employee and must be included on his or her W-2 statement. As such, the reimbursement is subject to employment taxes, both for the employee and employer, and can include withholding taxes, FICA, and federal and state unemployment taxes. The employee has the option to deduct the business expenses personally, depending on the individual's tax situation.
In the second case, reimbursement is tax-free for both the employer and employee.
Employers should consider the advantages and disadvantages of each type of plan when deciding how to structure the reimbursement of employee business expenses.
Understanding Taxable Reimbursement Plans
Reimbursement plans that do not meet IRS guidelines to be tax free for the employee are categorized as "Non-Accountable Plans." These include flat-dollar allowances and cents-per-mile reimbursements that exceed reasonableness standards accepted by the IRS.
In these cases, the employer is responsible for including the reimbursement amounts as taxable income. The employee has the option to claim actual vehicle business expenses on his or her itemized tax return.
The advantage of this arrangement is that it minimizes the record-keeping responsibility of the employer and simplifies the administrative procedure; however, this convenience comes at a cost to the employer and employee.
Reviewing the Consequences of Taxable Reimbursement Plans
The table below illustrates the tax consequences to both the employer and employee for a $500 monthly ($6,000 per year) taxable POV allowance.
In the example, the employee's $500 monthly reimbursement produces a net amount of $282 per month (56 percent of the allowance). Theoretically, employees can deduct all business-related expenses and business mileage on their federal and state personal income tax returns and receive the incremental monthly tax cost of $218. Notwithstanding, this may not hold true in all cases.
For example, the employee must itemize deductions and a 2 percent of adjusted gross income (AGI) threshold must be met before the expense can be deducted. If the employee is married and files a joint income tax with a combined annual income, the allowable itemized deductions will be diminished. Even if the employee overcomes the AGI floor limitation, tax benefits may be curtailed by the alternative minimum tax, which disallows the deduction of "employee business expense" in its calculation. Finally, unlike employer-provided vehicles, any employee interest expense to finance the POV is not tax deductible.
With respect to the true cost to the employer, 107.65 percent of the allowance amount is actually paid and, in this example, reflects a total additional cost of $459 per year. Employers should utilize the fully burdened expense of a taxable plan when comparing costs against non-taxable reimbursement plans and company-provided vehicles.
It is also logical to presume that some employees may attempt to recover some or all of the "lost" monthly $218 tax cost back by inflating other business expenses.
Offering Non-Taxable Plans
As a result of the unfavorable tax implications, companies may elect to offer tax-free POV reimbursement programs to their employees. These include cents-per-mile reimbursement based on the IRS Standard Mileage Rate and tax-free structured allowance programs that qualify as IRS Accountable Plans. Employers should weigh the disadvantages of the additional paperwork associated with Accountable Plans against the added tax burden expense with the Non-Accountable Plans.
Using IRS Standard Mileage Rate
Many organizations use the IRS mileage rate because employers perceive it as easy, tax-exempt, and defensible. In reality, the Standard Mileage Rate is intended to be a deduction guideline for taxpayers who opt for a standard deduction in lieu of tracking business vehicle expenses diligently.
The rate is derived from weighting and blending cost factors from across the U.S. It is not representative of vehicle ownership and operating costs for any specific vehicle in any specific geographic area of the country. Some vehicle costs (e.g., insurance, financing, fuel, vehicle registration, and vehicle sales taxes) vary substantially by geographic area and can drive wide variances in vehicle ownership and operating costs between low- and high-cost locations, particularly those areas with higher insurance costs.
Therefore, depending on the types of vehicles driven and where employees are driving, the true per-mile ownership and operating costs for employees' vehicles actually may be greater than the IRS rate, particularly when fuel costs are volatile.
Fairness of IRS Standard Per-Mile Reimbursement Plan
Using the IRS Standard Mileage Rate for all drivers — regardless of territory type, location, or number of miles driven — is a common reimbursement method. On the surface, the per-mile reimbursement approach appears to work best, because treating employees equally is often perceived as synonymous with treating employees equitably; however, when employees have widely varying travel or expense patterns, they are treated inequitably under a uniform reimbursement structure.
For example, assume two drivers (Driver A and Driver B) work for the same employer, live in the same community, own the same year/make/model vehicle, purchase the same type of insurance coverage at comparable prices, and incur the same type of miscellaneous ownership expenses (tax and registration fees). Further, assume both drivers are reimbursed using the 2014 IRS Standard Mileage Rate of 56 cents per mile for business miles. Driver A is assigned to service a territory that has a high density of business within a relatively confined area and, therefore, drives 12,000 business miles per year. Driver B, however, is assigned to service a broad territory and must drive further between business calls, traveling around 24,000 business miles per year.
At 56 cents per mile, Driver A will receive $6,720 for POV reimbursements in a year, while Driver B will receive $13,440. If we presume both drivers incur the same fixed annual ownership costs of $5,000, Driver A is reimbursed $1,720 or 14 cents per mile in addition to the $5,000, while Driver B receives $8,440 or 35 cents per mile plus $5,000. It is reasonable to presume that Driver B experiences a higher rate of vehicle deprecation due to the greater number of miles driven; however, it is unlikely as large as the disparity of 21 cents-per-mile difference between Driver A and Driver B. Instead, Driver B is overpaid due to the inequity of a fixed cents-per-mile plan.
Meanwhile, employees such as Driver A may attempt to maximize reimbursement for mileage and vehicle expenses if they feel they are not being adequately reimbursed. One common way is to overstate business mileage.
An often-quoted statistic claims that companies switching from a POV reimbursement program to a company-provided vehicle program experience declining reported business mileage by an average of 30 percent. This is not because employees drive less — the business miles no longer generate reimbursement monies, so employees are reporting actual miles.