Ask the Expert: How Should Employee Car Allowance Be Paid?

Can a car allowance be paid on a standalone check without any receipt? Or should this be paid via payroll and to be taxed?

Thank you for your inquiry on car allowances paid by employers.

The answer to this question is surprisingly complex, so we strongly recommend consultation with an accountant or a tax attorney.

In very general terms, if an employee is paid without any receipt (either with a standalone check or via payroll), the amount is reported as wages on Form W-2.

According to the IRS publication 463 on Travel, Entertainment, Gift, and Car Expenses, how an employer treats an allowance on the employee’s Form W-2 depends in part on whether the employer has an accountable plan or a nonaccountable plan.

Accountable plan

To be an accountable plan, the employer’s allowance arrangement must include all of the following:

1. The expenses must have a business connection.  They are paid or incurred deductible expenses while performing services as an employee.
2. The employee must adequately account to the employer for these expenses within a reasonable period of time.
3. The employee must return any excess allowance within a reasonable period of time.  Excess allowance is any amount paid to the employee that is more than the business-related expenses accounted for to the employer.

As you can see from the above rules, the employee must account to the employer (e.g., provide receipts) for the expenses.  Details on “adequate accounting” are available in Publication 463.

If the employee complies with the rules, the employer should not include any reimbursements in the income in box 1 of Form W-2.

When an employer uses a car allowance, the employee can generally use the allowance as proof for the amount of the employee’s expenses only if the following conditions apply:

• The employer reasonably limits payments of the expenses to those that are ordinary and necessary in the conduct of the business.
• The allowance is similar in form to and not more than the federal rate (details on the federal rate are in Publication 463).
• The employee proves the dates, place, and business purpose of the expenses to the employer within a reasonable period of time.
• The employee is not related to the employer.

If the employee’s allowance is less than or equal to the federal rate, the allowance is not included in box 1 of Form W-2.  If the allowance is more than the federal rate, the employer must include the allowance amount up to the federal rate under code L in box 12 of Form W-2.  This amount is not taxable.  However, the excess allowance is included in box 1 of Form W-2 and is treated as wage income.

Nonaccountable plan

Under a nonaccountable plan, where adequate accounting or return of excess allowance are not required, the entire amount of the allowance is reported as wages in box 1 of Form W-2.  The employee then reports all expenses on Form 2106 and itemizes deductions to deduct the expenses.