FAVR Taxes Explained: A guide for program admins

FAVR Taxes Explained 

A guide for program admins 

Summary

Fixed and Variable Rate (FAVR) reimbursement programs offer the ability to reimburse drivers tax free. This can provide a significant benefit to businesses. However, FAVR programs have a set of tax rules that drivers must comply with to avoid being taxed retroactively. This article discusses the FAVR tax rules, including vehicle cost compliance, vehicle age compliance, the 5,000 mile rule, and supplemental FAVR tax rules. It explains the FAVR taxable income test and how to apply tax to drivers who are out of compliance with the tax rules. It also discusses some best practices for building a program that maximizes overall tax savings and explains why the optimal program may not have 100% tax compliance.

Intro

One of the main benefits of the Fixed and Variable Rate (FAVR) reimbursement program is the ability to reimburse your drivers without tax. This can unlock huge amounts of value for your business. But before you move forward with FAVR, it’s important to understand that a well-designed FAVR program is not necessarily 100% tax-free. 

FAVR reimbursements are always paid with no tax deducted at source, but FAVR has a set of tax rules with which drivers must comply to guarantee that they will not be taxed in the future. If a driver is out of compliance with one or more of these rules, their reimbursement will be tested for taxable income retroactively. Depending on the result of this tax test, they may owe tax on part of their reimbursement. 

Understanding the nuances of FAVR taxes is the key to building a program that makes sense for your employees and your business. On a thoughtful FAVR program, these taxes are small and don’t affect many drivers. But it is totally normal for some drivers to be in a taxable position, even on the famously tax-free FAVR. 

This guide explains when FAVR reimbursements can become taxable, how much taxable income your non-compliant employees will owe, and how and when to apply that tax as a program administrator. It also lays out some helpful tips for designing a program that maximizes tax benefits for your company and your employees. 

Let’s dive in. 

The FAVR Tax Rules

There are three main tax rules on the FAVR program: 

• Vehicle Cost Compliance, 
• Vehicle Age Compliance,
• The 5,000 Mile Rule. 

The first two rules compare the driver’s personal vehicle to their FAVR vehicle profile to prevent over reimbursement. The third is a simple mileage test. 

If drivers are in compliance with all three of these rules, they will not be assessed any taxable income on their FAVR reimbursements. But if they are out of compliance with one or more of these rules, an IRS formula will be applied to test their reimbursement for tax. 

Depending on their reimbursement and their mileage, each non-compliant driver may (or may not!) owe tax on part of their reimbursement. More on that in a later section. 

At a glance:

The FAVR Tax Rules

1. Vehicle Cost Compliance: The driver’s vehicle must have cost, when new, at least 90% of the cost of their FAVR Vehicle Profile. 
2. Vehicle Age Compliance: The driver’s vehicle must not be older than the retention cycle of their FAVR Vehicle Profile. 
3. The 5,000 Mile Rule: The driver must drive at least 5,000 business miles per year. This is prorated for the number of months that driver was on the program. For example, if a driver is added on July 1st, they will only need to drive 2,500 miles for the 6 months they are on the program. 

Vehicle Cost Compliance 

The first FAVR tax rule is vehicle cost compliance. To be in vehicle cost compliance, a driver’s personal vehicle must have cost, when new, at least 90% of the cost of their FAVR vehicle profile. 

To understand vehicle cost compliance, you must first understand the concept of a FAVR vehicle profile. On a FAVR program, all reimbursements are based on vehicle profiles. You can think of a vehicle profile as a hypothetical car that’s assigned to each driver and used to calculate their reimbursement. 

It is the cost of owning and operating this imaginary car, not their actual personal vehicle, that is paid to drivers each month. Choosing an expensive car as a vehicle profile leads to higher monthly reimbursement, and choosing an inexpensive car leads to lower monthly reimbursement. 

The IRS uses FAVR vehicle cost compliance to prevent over reimbursement. By comparing the MSRP of a driver’s personal car to that of their vehicle profile, vehicle cost compliance prevents drivers from being paid for a vehicle that is much more expensive than the car they actually drive. If a driver’s car was worth less than 90% of the value of their vehicle profile, when that car was new, that driver is considered out of vehicle cost compliance and their reimbursement will be tested for tax. 

Vehicle cost compliance creates a tradeoff for program administrators. More expensive vehicle profiles increase the reimbursement that drivers can receive, but they also increase the chance that some drivers will be pushed out of tax compliance. 

With that in mind, you should consider the vehicles that your employees typically drive when you select your vehicle profiles. If your drivers are sales reps who drive sedans, you shouldn’t reimburse them for expensive pickup trucks. But if they are construction technicians or foresters, a heavy truck may be more appropriate. 

Many companies opt to use multiple vehicle profiles to reimburse different divisions or different categories of drivers. This approach manages the tradeoff between reimbursement and compliance by making sure that each group of drivers is assigned a vehicle profile that’s appropriate for their role. 

Still, you should always expect a portion of your drivers to be out of vehicle cost compliance. The freedom to choose your own vehicle is a core benefit of FAVR, and some drivers will always choose less expensive cars. Non-compliant drivers can still participate in the program, are always paid with no tax deducted at source, and, depending on their reimbursement and mileage, may still be completely tax-free after the FAVR tax test is applied. 

Considering vehicle cost compliance without letting it dominate your program preserves the flexibility of FAVR and maximizes your overall tax savings. If you try to design a program where every driver is compliant, you’ll end up under-reimbursing most of your population and missing out on the associated tax benefits. 

How is vehicle cost compliance measured?

When drivers register for a FAVR program, they complete a quick IRS vehicle declaration in the Cardata app. On this vehicle declaration, they enter the following information about the car they drive for work: 

• year, 
• make, 
• model, 
• odometer reading. 

They also self-report the MSRP of this vehicle. To determine their compliance status, this self-reported capital cost is compared to the value of the vehicle profile that they have been assigned. 

Importantly, vehicle cost compliance is based on what each driver’s vehicle cost when it was new; not the value of that car today, or what the driver paid when they bought it. There is no compliance penalty for buying used, or for getting a good deal on a new car. 

Vehicle Age Compliance

Vehicle age compliance is very similar to vehicle cost compliance. Both rules aim to prevent over reimbursement by comparing the car that each driver is being paid for with the car that they actually drive. But while cost compliance focuses on cars that are less expensive than the vehicle profile, age compliance focuses on cars that are older.

To be in FAVR vehicle age compliance, a driver’s personal car must not be older than the retention cycle used on their FAVR vehicle profile. 

You can think of the retention cycle as the number of years a vehicle is kept before it’s traded in. On FAVR, all vehicle profiles are assigned a retention cycle that’s used to calculate an appropriate reimbursement. This retention cycle can be anywhere from 3 to 7 years. 

Since cars depreciate faster earlier in their lives, shorter retention cycles lead to higher monthly reimbursements and longer retention cycles lead to lower monthly reimbursements. This makes sense because it would cost a driver more to replace their vehicle every three years then to replace it every seven. 

But for program administrators, age compliance creates another trade off. All else equal, selecting a short retention cycle for your vehicle profiles will lead to higher reimbursements, but it may push drivers with older vehicles out of compliance. Choosing a longer cycle will keep more drivers in compliance, but will lead to lower reimbursement rates. 

Just like vehicle cost compliance, vehicle age compliance can be managed by considering your employees’ cars when you select your vehicle profiles. How often do your employees tend to change their vehicles? Does it make sense to have one retention cycle on your program, or one for each group of drivers? There are no right or wrong answers, just what works best for your drivers and your company. 

As with cost compliance, vehicle age compliance should inform your choice of vehicle profile, but not dictate it. Some drivers will always choose to drive older vehicles, and that’s okay! Your program does not need to have a 100% compliance rate to save you and your drivers thousands in taxes. 

This is especially true for high mileage drivers. The more business mileage a non-compliant driver logs, the less likely they are to owe any tax on a FAVR program. This means that vehicle cost and age compliance can be largely irrelevant for high mileage drivers (more on this in a later section). Program administrators should always consider this fact when they select their vehicle profiles. 

What’s the difference between Vehicle Age Compliance and a Vehicle Age Policy?

You may have also heard of something called a vehicle age policy. A vehicle age policy is different from (but confusingly similar to) FAVR vehicle age compliance. 

The difference is that a vehicle age policy is not an IRS tax rule, it is an internal company rule about vehicle age. When a company chooses to enforce a vehicle age policy, they select a maximum vehicle age and withhold reimbursement from drivers with older cars. 

Companies often choose to do this for image or safety reasons, but since it is a company policy, it is entirely optional. Typically, the maximum vehicle age set by a vehicle age policy will be greater than the FAVR retention cycle. 

For example, imagine a company selects a 5-year retention cycle for their vehicle profiles and sets a vehicle age policy of 10 years. That company’s drivers will be 100% tax-free if their vehicles are 5 years old or under, they will be tested for tax if their vehicles are 6-10 years old, and their reimbursements will be withheld entirely if their vehicles are over 10 years old. 

The 5,000 Mile Rule

The final FAVR tax rule is also the simplest. To be in compliance with the 5,000 mile rule, a driver must drive at least 5,000 business miles each year.

If they are not on a FAVR program for an entire year, this mileage requirement is prorated for the number of months they are on the program. For example, a driver that starts on July 1st will only need to drive 2,500 business miles to be in compliance with the 5,000 mile rule. 

FAVR is intended to reimburse frequent business drivers for the cost of owning and operating a vehicle for work. The 5,000 mile rule supports this goal by limiting FAVR’s full tax benefits to people who drive regularly. Without the 5,000 mile rule, anyone who owned a car would be eligible for tax-free auto reimbursement, whether they drove that car for work or not. 

The 5,000 mile rule presents a different set of challenges for program admins. Unlike vehicle age and cost compliance, 5,000 mile compliance can’t be managed by carefully selecting a vehicle profile. Drivers either reach 5,000 miles on FAVR or they do not. Additionally, since the FAVR taxable income test is based on business mileage, drivers that are out of 5,000 mile compliance are more likely to owe tax than drivers out of vehicle age or vehicle cost compliance. 

Because of this, while it generally makes sense to keep drivers with less expensive or older cars on FAVR, admins should consider moving low mileage drivers to a different type reimbursement program, like Cents per Mile.. 

Combining FAVR and CPM

Due to the 5,000 mile rule, it’s usually a good idea to pair your FAVR program with a Cents per Mile (CPM) program for low mileage drivers. On a CPM program, drivers are paid a flat rate for each mile they drive. CPM programs are simple, tax-free, and do not have the same compliance requirements as FAVR. 

Having both of these programs side by side lets you reimburse your casual and regular drivers on one convenient platform. It also lets you easily move drivers from one reimbursement program to another as their mileage or job requirements change. 

Supplemental FAVR tax rules

FAVR also has two supplemental tax rules: the Annual Vehicle Declaration and Insurance Tax Compliance. Like the three main tax rules, drivers must follow the supplemental rules to guarantee that they will not be taxed. However, it’s extremely rare for drivers to be assessed tax because of these rules due to the way that most FAVR programs are constructed. 

1. Annual Vehicle Declaration: Every year, drivers must submit the make, model, year, and current odometer reading of the vehicle they’re driving for work. This is the same declaration that appears when drivers first register for a FAVR program. In this declaration, they must also state whether they’ve claimed accelerated depreciation on their vehicle on their personal tax return (which fewer than 0.1% of drivers have). If a driver fails to submit this declaration, or declares that they have used accelerated depreciation on their personal taxes, they will be out of tax compliance until they submit another declaration. This whole process takes less than 5 minutes and drivers are prompted to complete it in-app, so very few drivers end up out of compliance because of their vehicle declaration.

1. Insurance Tax Compliance: Because FAVR reimbursements include the cost of insurance, the IRS requires drivers to carry at least the amount of insurance coverage they are being reimbursed for. This means that if a driver does not have insurance, or has insurance below their company’s required coverage level, they are out of FAVR tax compliance. In practice though, drivers with insufficient insurance are typically not taxed. This is because most companies have internal policies that withhold reimbursement from drivers with insufficient coverage. If drivers are not being reimbursed, there is nothing for them to be assessed tax on, so the insurance tax rule is usually moot. You can read more about setting a company insurance policy here. 

The FAVR Taxable Income Test

If a driver is out of compliance with one or more of the tax rules above, their reimbursement will be tested for taxable income. Importantly, this does not mean that their entire reimbursement will be considered taxable. Instead, it means that a portion of their reimbursement may be considered taxable, depending on their reimbursement and mileage. 

It is very common for non-compliant drivers to pay little or no tax on FAVR. Understanding the mechanics of the FAVR tax test will help you understand which of your drivers is likely to owe tax on FAVR, how much tax they will end up owing, and how you should apply that tax against their income. 

What is the FAVR Taxable Income Test? 

When a driver is out of FAVR tax compliance, their FAVR reimbursement is compared to what they would have received at the IRS standard rate. This amount is called their non-taxable limit. 

If a non-compliant driver’s FAVR reimbursement is less than their non-taxable limit, that driver will owe no tax. But, if their FAVR reimbursement is greater than their non-taxable limit, the difference between the two amounts will be assessed as taxable income. Tax on that amount should be applied as income on a future pay period. 

In 2023, the IRS standard rate is 65.5 cents per mile. This means that the maximum amount that a non-compliant driver can receive without incurring taxable income is equal to their business mileage multiplied by $0.655. If a driver is out of FAVR tax compliance, and is paid more than 65.5 cents per mile in FAVR reimbursement, the overage will be considered taxable income.

The example below shows a FAVR taxable income calculation for two non-compliant FAVR drivers: 

The first driver would be assessed no taxable income because their reimbursement was lower than their non-taxable limit. Since this driver was effectively paid less than 65.5 cents per mile on FAVR, their reimbursement is still non-taxable. The second driver however would be assessed $136.06 of taxable income because their reimbursement was higher than their non-taxable limit. 

Business Mileage and Taxable Income

The example calculation above illustrates an important feature of FAVR taxes. In general, the higher a driver’s business mileage, the lower their taxable income on FAVR. 

This is a side effect of the IRS standard rate. All drivers have the right to be reimbursed tax free at the standard rate, regardless of their personal vehicle or total mileage. Because the standard rate tends to over reimburse high mileage drivers, drivers with high business mileage are unlikely to owe tax on FAVR, even when they are out of tax compliance. 

This feature makes FAVR programs more flexible and forgiving. Effectively, drivers on FAVR have two ways that they can substantiate their reimbursements as tax free. The first is by being in compliance with all of the FAVR tax rules. The second is by driving enough business miles to justify their reimbursement under the standard rate. 

This is also helpful because it avoids an all or nothing approach to taxable income. Instead of drawing an arbitrary line between compliant drivers that pay no tax and non-compliant drivers who are fully taxable, FAVR allows each non-compliant driver to pay tax in proportion to their business mileage. 

This makes FAVR taxes feel more reasonable, and makes them much easier to explain to drivers. 

When is the Taxable Income Test Applied? 

The taxable income test is applied quarterly for drivers out of compliance on vehicle cost vehicle age and annually for drivers that are out of compliance with the 5,000 mile rule. 

The test is applied annually for mileage because we only know whether a driver reached 5,000 business miles at the end of the year. 

At the end of every calendar quarter, you will receive a report called the Quarterly Tax Adjustment Report. This report is automatically generated by Cardata and can be exported as a CSV. It lists all of your non-compliant drivers and their assessed taxable income for the quarter ended. 

In Q1, Q2, and Q3 this report will only include taxable income calculated quarterly for drivers out of compliance on vehicle cost and vehicle age. In Q4, this report is called the Annual Tax Adjustment Report and will also include taxable income calculated annually for drivers that did not reach 5,000 miles. 

There is no double taxation on FAVR, so quarters that a driver has already been assessed tax for will be excluded from the annual calculation in Q4. 

For example, if a driver is out of compliance for vehicle age all year, they will be assessed tax in Q1, Q2, and Q3. If at the end of Q4 they have also failed to drive 5,000 business miles, the Q4 report will only include the tax they owe on their reimbursement in Q4. However, if a driver is in compliance all year but fails to drive 5,000 business miles, the Q4 report will calculate taxable income on their reimbursement in all four quarters. 

How should taxable income be applied to drivers?

Cardata recommends applying taxable income quarterly through payroll deductions. Applying taxable income through payroll is the simplest process for drivers and administrators, and the best way to comply with IRS guidelines. It can also be done through your payroll system in minutes. 

At the end of each calendar quarter, simply increase each employee’s taxable income by the amount listed in the Quarterly Tax Adjustment Report and deduct the tax owed on that amount on the following pay cycle. This can be done manually, or by uploading the Quarterly Tax Adjustment Report to your payroll system as a CSV. For simplicity, we recommend uploading the report to your payroll system. 

Summary and Conclusion

While FAVR reimbursements are typically tax-free, there are always exceptions. Understanding when drivers can become taxable, how their taxable income will be calculated, and how to apply that income as a program administrator is an important part of running a FAVR program. Understanding the nuances of FAVR taxes can also help you build a program that maximizes your overall tax savings. By following the guidelines outlined in this article, you can design a FAVR program that maximizes tax benefits for your company and your employees while ensuring compliance with IRS regulations. 

Disclaimer: nothing contained in this blog post is legal, accounting, or insurance advice. Consult your lawyer, accountant, or insurance agent and do not rely on the information contained herein for any business or personal financial or legal decision making. While we strive to be as reliable as possible, we are neither lawyers nor accountants nor agents. For several citations of IRS publications, on which we base our blog content ideas, please always consult this article: https://www.cardata.co/blog/irs-rules-for-mileage-reimbursements. For Cardata’s terms of service, go here: https://www.cardata.co/terms.