Given the very trying times due to the COVID-19 pandemic, many employers are looking for ways to provide financial relief to their employees in a tax-advantaged manner. Discussed below are two options available to employers to provide direct payments or assistance to employees in a manner not subject to federal income or employment taxes.
Qualified Disaster Relief Payments
Section 139 of the Internal Revenue Code (the “Code”) allows employers (among others) to make tax-free payments to individuals impacted by qualified disasters, such as the COVID-19 pandemic, which was declared a disaster by President Trump (with such declaration subsequently confirmed by the IRS). Qualified disasters include those that are federally-declared (such as acts of nature, pandemics, etc.) in addition to those resulting from terrorist or military actions and accidents involving common carriers.
Employers are permitted to cover or reimburse certain employee expenses associated with such qualified disasters, subject to limitations, without such payments being taxable as income or subject to employment taxes/withholding.[i] To qualify for tax-free treatment, such payments must generally be “reasonable and necessary” and must be associated with expenses incurred as a result of the disaster. Such expenses, in the context of the COVID-19 pandemic, might include, among others, personal/living expenses, uninsured medical expenses, child care expenses, funeral expenses, etc. However, such payments cannot be used to cover expenses that are otherwise reimbursed by insurance or similar arrangements and, moreover, cannot take the form of income replacement payments related to lost income, profits, wages, PTO, etc.
Employer-Sponsored Disaster Relief Organizations
Employers also have the option to organize and sponsor affiliated disaster relief organizations that are tax-exempt under Section 501(c)(3) of the Code. Even if the employer is a taxable organization, the employer can form an affiliated disaster relief public charity/private foundation whose purpose is to provide need-based disaster/hardship assistance to current and future employees of the employer (and their families). Employees might also make charitable contributions to such affiliated tax-exempt organizations. These organizations could be used to help employees through the COVID-19 pandemic but could also be utilized more broadly to cover other hardships/disasters.
Nevertheless, such disaster relief organizations and their relationship with the employer must be properly-structured to ensure that grants and aid to employees is considered charitable in nature and tax-free to the recipient from a federal income tax perspective.
In summary, the organization must define a broad/open-ended charitable class of potential aid recipients (e.g., current/future employees and their families). Moreover, in order to ensure that the employer does not exercise excessive control over the organization (and that grants/assistance serve charitable purposes and not the business purposes of the employer), recipient selection/aid determination must be generally[ii] conducted by an independent selection committee comprised of at least a majority of individuals who do not have substantial influence over the employer (e.g., “rank and file employees”, independent community members, etc.). Recipients would need to be selected objectively based on documented financial or other need from having suffered a hardship or disaster. Assistance could be “one-time”, short-term or long-term as appropriate considering the recipient’s specific circumstances and could be in the form of funds, services, goods or other items to meet the recipient’s needs.
If the relief organization qualifies as a private foundation (as opposed to a public charity), then assistance would be limited to address only qualified disasters under Section 139 of the Code (see discussion above), whereas public charities can provide assistance in connection with a much broader scope of hardships and disasters.
In all cases, the organization should adopt policies and procedures addressing recipient selection, need determination, grant documentation/recordkeeping, etc.
[i] Consult state and local tax laws in advance to determine whether such laws conform to federal laws in treating such payments as tax-fee.
[ii] The IRS allows employer-sponsored tax-exempt disaster relief organizations to utilize “adequate substitute procedures” instead of an independent selection committee so long as those procedures ensure that any benefit to the employer is “incidental and tenuous”.