Vehicle Reimbursement Options

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					                      Vehicle Reimbursement Options
                      for Employee-Provided Vehicles

Allowance Arrangements

In the United States, vehicle reimbursement programs, sometimes referred to as
“advances” or “allowances”, are all governed by the Accountable Plan Rules developed
by the IRS and found in Publication 463 – Travel, Entertainment, Gift and Car Expenses.
Therefore, in order to fully understand the impact of various vehicle reimbursement
programs on both the organization and the driver, it is important to have a general idea of
how Accountable Plans work.

Since reimbursements paid under Accountable Plans are excluded from gross income and
are not reported on an employee’s W-2, they are usually the most desirable type of
program from both the company’s and driver’s standpoints. Reimbursements paid under
a Non-Accountable plan are included in an employee’s gross income and must be
reported as compensation on their W-2.

Accountable Plans

So what’s it take to have an Accountable Plan? There are three rules that must be

1. The expenses must have a business connection. Therefore, the driver must be
   incurring expenses while performing services as an employee of the employer, and no
   payments can be made for a driver’s personal use.
2. The driver must provide adequate accounting for their expenses within a reasonable
   period of time (generally, within 120 days is considered “reasonable”). This is
   simply documentary evidence of the expenses supported by a statement, account book
   or mileage log, etc. The information generally required is date, place, business
   purpose, mileage and amount. Another way of describing this rule is
3. “Excess Payments” must be returned. An excess payment is any payment or advance
   that is greater than the expense substantiated by the driver.

Examples of Accountable Plans:

1. Flat rate
    Company pays a driver $800 to cover their vehicle expenses
    Driver has $600 in substantiated business expense and returns the excess $200

2. Cents per mile
    Company pays driver at or under the current IRS Optional Standard Mileage Rate

3. Qualifying FAVR (Fixed and Variable Rate) Plans. These are also sometimes referred
to as Fixed and Operating plans.
Non-Accountable Plans

These are plans that don’t meet one or more of the criteria required to be a tax-free
reimbursement, with the most common being “flat rate” vehicle reimbursement
programs. Flat rates usually pay drivers a weekly, bi-weekly or monthly amount (for
example: $500 per month) and do not require substantiation of specific vehicle related
expenses. Sometimes companies will pay a flat rate for fixed expenses and a cents-per-
mile rate to cover gas and other variable expenses.

Example of Non-Accountable Plan:

1. Flat rate
    Company pays a driver $800 to cover their vehicle expenses
    Driver does not substantiate their expense or return any excess funds

Reporting Vehicle Expenses (Accountable and Non-Accountable Plans)

        Plan Type               Employer Reports on W-            AND employee reports on
                                          2                               2106

Actual expense                  No Amount                       No Amount
reimbursement. Adequate
accounting and excess
Actual expense                  The excess amount as wages in   No Amount
reimbursement. Adequate         box 1
accounting and excess not
Per diem or mileage             No Amount                       All expenses and reimbursements if
allowance up to federal rate.                                   excess expenses are claimed.
Adequate accounting and                                         Otherwise form is not filed.
excess returned.
Per diem or mileage             The excess amount as wages in   No Amount
allowance up to the federal     box 1. Amount up to the
rate. Adequate accounting       federal rate in box 12 only.
and excess required but
excess is not returned.
Per diem or mileage             The excess amount as wages in   All expenses and reimbursements if
allowance exceeds federal       box 1. Amount up to the         excess expenses are claimed.
rate. Adequate accounting       federal rate in box 12 only.    Otherwise form is not filed.
up to federal rate and excess
not returned.
Either adequate accounting      The entire amount as wages in   All expenses
or return of excess, or both,   box 1
not required by the plan

No reimbursement plan           The entire amount as wages in   All expenses
                                box 1
Reimbursement Options

Flat Rates

      Easiest to administer
      Flexible
      Not tax-free
      Is not geographically sensitive
      Does not account for mileage (depreciation)
      Over-pays low mileage drivers
      Under-pays high mileage drivers
      Provides a disincentive to drive


Companies use flat rates when they want a vehicle reimbursement program that is simple
to administer and is under the control of the organization. It is also often the intent to be
“equitable” to drivers by paying them all the same amount.

However, flat rates really tend to miss the mark in the key areas that hallmark a quality
vehicle reimbursement program. While easy to establish and administer, they do not
meet the accountable plan rules and therefore are treated as compensation – making them
taxable income to the driver and subject to employment taxes for the employer.

While seeming equitable on the surface, they do a poor job paying drivers for their actual
costs because they don’t take into account either geography or mileage. Is it fair for a
driver in Philadelphia to receive the same amount as another driver in Wichita? The
answer is clearly “no”, but what makes the “right” amount so difficult to determine is
there are many factors to consider. In this case, insurance, gas, maintenance and license
costs in Philadelphia tend to be higher, yet Wichita has a pretty hefty personal property
tax. Based on 2004 actual costs and assuming 20,000 annual miles, the driver in
Philadelphia will incur more than $1,500 in additional cost each year compared to the
driver in Wichita.

Depreciation is the other consideration that flat rates usually don’t accurately calculate.
A driver who puts on 35,000 annual miles has a much different depreciation structure
compared to a driver with only drives 10,000 miles. After three years the first driver has
over 100,000 miles on their vehicle while the second only has 30,000. Guess whose
vehicle is worth more? A high mileage driver needs to receive a higher reimbursement
than a low mileage driver; otherwise they have a disincentive to drive. Once a driver has
“spent” their allowance, all additional costs are out of their pocket and the last thing a
company wants is drivers questioning whether or not to get in their vehicle and make a
sales or service call because it’s costing them money.
Cents Per Mile Programs

      Easy to administer
      Tax free (if under the IRS Optional Standard Mileage Rate)
      Is a government approved rate
      Is not geographically sensitive
      Does not properly account for mileage (depreciation)
      Under-pays low mileage drivers
      Over-pays high mileage drivers
      Provides an incentive to report miles
      Lags the marketplace by a year
      Is not intended as an accurate reimbursement for business use of a personal


Although companies use many different rates, most stick pretty close to the IRS’s
Optional Standard Mileage Rate for Business (IRS rate) which is found in Revenue
Procedure 2003-76 for tax year 2004, and is updated each year with a new Revenue
Procedure number. Each year the IRS also publishes a series of Optional Standard
Mileage rates that are used for travel related to medical expenses, charitable activities and

Somewhere along the line companies have gotten the impression that since the
government publishes this rate, it makes sense to pay it to their drivers. In actuality, the
IRS rate is a safe harbor that can be used by tax payers to deduct un-reimbursed vehicle
expenses in cases where they are not writing-off their actual expenses – a significantly
different application than attempting to pay someone for their business expense
associated with driving their personal vehicle on company business.

The IRS rate suffers from the many of same flaws as flat rates, although has the distinct
advantage of being tax free. It is easy to administer and explain, and takes some of the
“randomness” out of the reimbursement program. After all, it is established by the IRS.
However, take a look at two drivers who both put on 10,000 miles but, again, one lives in
Philadelphia and the other in Wichita. Even though their costs are significantly different,
they each get the same reimbursement.

Because the IRS rate blends together ownership (fixed) and operating (variable) costs, the
fixed costs are not accounted for accurately. For example, your license and registration
does not change based on how many miles you drive. As a result, at lower annual
mileages, the IRS rate underpays drivers and at higher mileages, since it keeps paying for
fixed costs that have already been properly accounted for, it overpays drivers. Using the
2004 rate of 37.5¢ per mile, if the intention of your reimbursement program is to
accurately pay for the costs of driving a personally owned vehicle on company business,
then your 5,000 mile a year driver would get $1,875 and your 50,000 mile a year road
warrior would get $18,750. Neither amount is close to their actual costs.
The other reality about using the IRS rate is the temptation to over-report miles. At $1.12
for every three miles driven, a few extra miles here and there can really add up and cost
the company a fair sum of money.

Fixed and Variable Rate Allowance (FAVR)

      Can be paid tax-free
      Accurately calculates the cost of vehicle ownership and operation
      Accounts for geography
      Accounts for mileage
      Uses current costs
      Takes administrative support
      Drivers must adhere to the FAVR guidelines


   FAVR (Fixed and Variable Rate) plans offer an opportunity for an organization to set
   up a fair and defensible reimbursement program for their drivers. The payments are
   tax-free, can exceed the IRS rate (if supported by the data) and account for both
   geography and mileage. However, the IRS has established a number of guidelines
   that must be followed by both the company and the driver in order to have a
   compliant program.

   First, the IRS sets the following four criteria for all FAVR programs.

       1.   Performance of services as an employee of an employer
       2.   Data derived from the base locality
       3.   Reflects retail prices
       4.   Reasonable and statistically defensible in approximating actual expenses that
            the employee would incur as owners of the standard automobile.

Obviously, a FAVR plan can only be paid to employees of the organization, thereby
excluding other individuals such as family members. The data used to calculate the
reimbursements, such as insurance rates, costs of license and registration, gas prices,
maintenance, must all be gathered in the areas where drivers live and drive, and must be
based on retail prices, thereby reflecting the costs that drivers actually pay. Lastly, there
must be a methodology behind the reimbursements that is statistically defensible and
results in reimbursements that approximate the actual expenses that the driver would

Once the data has been gathered it must be paid to drivers as both fixed and variable
payments, so that there is none of the over- or under-payments that occur with either a
flat rate program or a straight cents-per-mile program. Fixed payments must be made at
least quarterly, but most companies will make their payments in sync with their normal
payroll cycle – such as monthly, weekly, 1st and 15th, etc. Variable payments are made
for each business mile driven and submitted by the driver.
Fixed payments cover such costs as:

1.   Insurance
2.   Depreciation
3.   Registration
4.   License
5.   Personal property taxes

Variable payments cover the costs of:

1.   Gas
2.   Oil
3.   Maintenance
4.   Tires

Program parameters

To set up a FAVR allowance, the organization must establish the parameters that they
will use in their plan. To start, they must choose a “base vehicle” from which
reimbursements will be calculated. This base vehicle is usually representative of the type
of vehicle that the employee would be expected to drive based on their job function and
title. For example, it’s common for companies to use vehicles such as the Ford Taurus or
Dodge Intrepid for their sales force. Companies may also set up “tiered” FAVR
programs, using other vehicles as appropriate for differing groups of employees.

Once the vehicles are selected and accessorized, they are priced using the IRS formula of
95% of dealer invoice plus sales tax and then used as the basis for all reimbursement
calculations. The maximum price that can be used in a FAVR plan is $28,100 for 2004
and is adjusted each year. Therefore, luxury vehicles are excluded from FAVR plans, but
since most senior executives receive vehicles as compensation and don’t tend to drive
significant numbers of business miles, this is rarely an issue. Executive programs can
still be set-up using a fixed and variable format, but may be partially or fully taxable.
The vehicles prices in FAVR plans are updated each year and reimbursements adjusted to
reflect any increases.

Other parameters that need to be decided upon include the level of insurance that the
driver should carry, length of the retention period, and type of fuel, as well as if there are
any “special driving circumstances” that need to be factored in, such as off-road driving.

The depreciation component of a FAVR plan is subject to § 280F limitations, however, if
it exceeds those limits, you may compare the total fixed and operating payment to 80% of
the annual business mileage multiplied by the standard mileage rate and remain tax free.
The employer must report the depreciation component paid to the employee at year’s end.

To calculate the depreciation component of a FAVR plan, the payor must determine the
residual value of the base vehicle. The depreciation component therefore becomes:

Depreciation = Price of vehicle – Residual value

If researched data is unavailable, a company may use the IRS safe harbors for the residual
value. They are:

Retention Period          Residual Value
     2 year                    70%
     3 year                    60%
     4 year                    50%

Retention Period (Cycle)

The retention period is the time in calendar years selected by the employer during which
they expect the employee to drive a standard automobile, not to be less than 2 years. The
term of the retention period and the retention mileage (annual mileage multiplied by the
number of calendar years in the retention period) are used to come up with what is termed
the “retention cycle” or “depreciation cycle”. Examples of retention cycles include; 3
year/60,000 miles,
3 year/90,000 miles, 4 year/80,000 miles, etc.

The mileage portion of the retention cycle is based on the individual driver’s annual
mileage and should be adjusted periodically based on actual reported mileage as well as
the organizations knowledge of projected driving experience (changes in territory, etc.)

Business Use Percent

The business use percent is calculated by dividing the annual business mileage by the
annual total mileage. The business use may not exceed 75%, however it is important to
note that this cap only applies to the fixed cost payment. Why a cap at 75%? Fixed costs
are different in that, in many ways, they are time related. Your license and registration
costs don’t change based on the number of miles driven. Likewise for tax, title and

Most companies are comfortable with paying for the business use of these types of items
by looking at the percentage of time involved. A very common business use percentage
in FAVR plans is 71.4% - based on 5 days out of 7. Weekends are then considered
personal time and are not covered under the plan. If you want to go a little above the
5/7ths approach, you can go up to the IRS limit of 75%.
Companies can also set the business use percentage above 75%, but the amount of
payment that exceeds 75% may be subject to taxation if the total payment made to the
driver (both fixed and variable) exceeds the calculation of the drivers business mileage
multiplied by the current IRS rate on a quarterly basis.

The following are safe harbors set by the IRS for establishing the business use percent in
a FAVR plan:

Annual Business Mileage       Business Use Percent
     6,250-10,000                   45%
     10,001-15,000                  55%
     15,001-20,000                  65%
     21,001 and above               75%

FAVR allowance limitations

In order to have a FAVR program, both the company and driver must follow the
guidelines set by the IRS. These guidelines help the company control one of the most
common misconceptions of FAVR plans, namely that employees can drive beat-up older
model vehicles. As a result, drivers have safe, reliable vehicles and companies have
employees in vehicles that project the proper image. Guidelines include:

1. Participants must drive 5,000 business miles to qualify for a FAVR plan.

2. There must be at least five employees covered by FAVR programs.
   There could be three FAVR plans in place for the five drivers.

3. A FAVR allowance may not be paid to a control employee, such as a
   major shareholder (1% or more of total stock), board appointed officer,
   director or board member.

4. Management employees may not make up a majority of the employees
   covered by a FAVR program. This refers to executive management, not
   such positions as Sales or District Managers.

5. A FAVR allowance may be paid only with respect to an automobile that
   costs, when new, at least 90% of the standard automobile cost used in
   determining the FAVR allowance for the first calendar year the
   employee receives the allowance with respect to that automobile.
   Drivers may purchase used vehicles and pay less than 90% of the
   standard automobile cost as long as the vehicle price was within 90%
   when new.

6. The model year of the vehicle driven must not differ from the current
   calendar year by more than the number of years in the retention period.
   This means that an employee who purchases a 2004 vehicle, reimbursed
   from a program based upon a 4 year rentention cycle, may operate that
   vehicle up to December 31, 2008 (2004 plus four years).
7. The driver’s insurance coverage must be at least equal to the insurance
   limits used to compute his/her reimbursement.

8. A FAVR allowance may not be paid with respect to an automobile for
   which the employee has claimed depreciation using a method other than
   straight-line, such as accelerated depreciation.

9. The vehicle can be owned or leased by the employee.

Employee reporting

The following must be provided to the employer within 30 days after a driver is added to
the program:

   1.   The make, model and year of the vehicle
   2.   Written proof of insurance coverage limits
   3.   The odometer reading of the vehicle
   4.   The purchase price (if owned) or the capitalized cost (if leased) of the vehicle
   5.   Type of depreciation claimed, if any