Many employees are facing potentially catastrophic personal economic circumstances as a result of COVID-19. Employers who want to support their employees financially should consider making “qualified disaster relief payments” which, if properly structured, can provide significant tax benefits to both the employers and the employees. Qualified disaster payments are free from federal taxes to employees and are fully deductible to the employer. An explanation of these alternatives is described below in the form of questions and answers.
Q: Can Employers Make Nontaxable Hardship Relief Payments to Employees?
A: Yes, consistent with Section 139 of the Internal Revenue Code (“Code”). As a general rule, employers are required to withhold income and employment taxes from payments to their employees. An exception to this tax treatment is available if the payments qualify as “qualified disaster relief payments” (“QDR Payments”) under Section 139 of the Code, enacted after the terrorist attacks of 9/11 (2001) to respond to “federally declared disasters.” The IRS has determined that President Trump’s emergency declaration related to the COVID-19 pandemic invokes the provisions of Section 139.
Q: What Types of Payments by Employers Constitute QDR Payments?
A: Reasonable and necessary personal, family, living or funeral expenses incurred as a result of a qualified disaster, paid to or for the benefit of employees. With regard to the Pandemic, such expenses should include food, shelter, child care, costs to rent additional space or equipment to facilitate telecommuting and unreimbursed medical assistance (including psychological counseling). Payments that would not be qualified include (i) income replacements such as for sick leave or other paid time off, (ii) reimbursements from insurance or otherwise, (iii) amounts not incurred in connection with the pandemic, and (iv) nonessential, luxury or decorative items or services.
Q: Is Proof of the Employees’ Expenses Required?
A: Employers do not need to require proof of actual expenses as a condition of QDR Payments as long as the payments are reasonably expected to be commensurate with the amount of unreimbursed personal expenses incurred by the recipients as a result of the disaster.
Q: Must Employers Provide QDR Payments to all of Their Employees and for all Losses?
A: QDR Payments are based on actual expenses incurred because of the disaster. An employer’s reimbursement program (which should be recorded in writing) can be functionally selective and does not have to indemnify against all disaster-related losses. However, if an employer provides QDR Payments to employees, the grants must be available to all workers regardless of length or type of service with the employer. There is no cap on the amount of QDR Payments an employer can make.
Q: Are Employers Entitled to Deduct QDR Payments for Tax Purposes?
A: Yes, QDR Payments are deductible in the same manner as payments of regular wages.
Q: Besides Employers, What Other Parties Can Make QDR Payments?
A: QDR Payments can come from any source. Other methods of payment that may be relevant to employers include the following:
- Non-exempt fund. An employer could establish and subsidize a non-exempt fund, with optional contributions from employees and others, and make QDR Payments consistent with the Section 139 requirements described above.
- Employer-sponsored public charity. An employer may opt to form a public charity that provides assistance to employees in any type of disaster or in employee emergency hardship situations. Usually employees contribute to the entity (often with employer matching amounts) and, because the employer cannot exert excessive control, rank and file employees constitute a significant portion of the board of directors. As long as certain other requirements (beyond the scope of these Q&A’s) are satisfied, a public charity that has been approved by the IRS can make payments to employees in response to a disaster or emergency hardships.
- Employer-sponsored donor advised fund (DAF). A DAF organized by an employer can make QDR Payments to employees and family members if the DAF serves the single identified purpose of providing relief from a qualified disaster, it meets similar requirements as in item number (2) above not addressed here, and no payments are made to any director or officer of its “sponsoring organization” or members of its independent grant selection committee.
- Employer-sponsored private foundation. An employer sponsoring a private foundation can make QDR Payments to its employees (and not for other disasters or hardship situations) and avoid triggering a self-dealing excise tax if it meets similar standards as in item number (2) above not addressed here, no payments are made to any director or officer or members of its grant selection committee, and any benefit of payments to the employer is “incidental and tenuous.”
Q: How Can Employers Take Advantage of Options Described in the Previous Question?
A: Employers can (i) structure stand-alone non-exempt funds very quickly; (ii) create a DAF with any of a large number of sponsoring organizations very quickly; (iii) organize nonprofit corporations under state law, apply to the IRS for a determination of public charity or private foundation status, and use these entities to make QDR Payments (and in the case of public charities, other hardship payments) consistent with the standards summarized above. Applicants to the IRS for exempt status can request, and often obtain, expedited processing of their applications by justifying an immediate and compelling need.
Bruce L. Olson is a member of the firm’s Tax Planning and Tax Controversies practice group. He advises taxpayers concerning their rights and duties under Utah state law and represents their interests before administrative tribunals and in court. His counsel extends to both profit and nonprofit entities and includes all types of state and local taxes.