As the COVID-19 pandemic continues and unemployment increases at an unprecedented rate, employers throughout the US are looking for different ways to assist their employees. Many employees even if they remain employed are in dire need of immediate financial assistance. The glimmer of good news in this grim situation is that there are several ways in which employers can provide tax-free payments to their employees while generating a tax deduction.
Direct Assistance – Code Section 139
On March 13, 2020 the president declared the ongoing COVID-19 pandemic to be a national disaster under the Robert T. Stafford Disaster Relief and Emergency Assistance Act (commonly referred to as the Stafford Act). This declaration not only increased federal support provided in response to COVID-19, but also made available to employers Section 139 of the Internal Revenue Code. Although the IRS has not formally announced that the COVID-19 pandemic is a qualified disaster for purposes of Section 139, it would be astonishing if this were not the case.
Under Section 139, qualified disaster relief payments made by an employer directly to an employee are not taxable to the employee and are not subject to employment taxes or withholding. However, the income exclusion only applies to employee expenses that are not compensated by insurance.
Section 139 recognizes four different types of qualified relief payments. The most relevant type for the COVID-19 pandemic is the reimbursement or payment of reasonable or necessary personal, family, living, or funeral expenses related to a qualified disaster. This type of qualified relief payment could include payments made by an employer to an employee for medical and health-related expenses due to COVID-19, additional expenses relating to childcare and home schooling as a result of school closures, expenses incurred due to quarantine enforcement, and funeral expenses for an employee or family member who dies from COVID-19. However, qualified relief payments do not include income replacement payments, such as payments for lost wages, lost business income, or unemployment compensation.
An employer making direct qualified disaster payments to its employees is not expressly required to maintain a written policy. Nor are employees required to account for the actual expenses which may be reimbursed under Section 139. However, to ensure fairness and consistency, it is strongly recommended that an employer adopt a detailed written policy before making payments. The written policy should set forth the purpose and the parameters of the policy, including the qualifications for reimbursable expenses, a method to verify qualifying employee expenses, limitations for reimbursement amounts (if any), and the procedures for requesting a reimbursement.
Even though the qualified disaster payments made under Section 139 are not taxable to the employee and are not subject to employment taxes or withholding, employers may reasonably take the position that such payments are deductible.
Indirect Assistance – Employee Assistance Funds (EAFs)
EAFs in General
Another way for an employer to provide its employees with tax-free financial assistance is to establish an employee assistance fund. An EAF is generally an employer-sponsored tax-exempt charitable organization established to provide emergency, need-based financial assistance to the employer’s work force. Benefits provided by an EAF may be restricted to the employees of a specific employer so long as the EAF also benefits employees affected by future disasters or emergencies. Employer contributions to an EAF may be deductible as a charitable contribution under Section 170 of the Code. Helpfully, the charitable deduction amount under Section 170 for certain taxpayers was increased by the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act).
The EAF may be set up as a public charity, a donor advised fund, or even a private foundation.
An EAF that is set up as a donor advised fund or a private foundation is generally subject to more stringent rules, because these two structures are disfavored by the Internal Revenue Service (the IRS). A public charity is subject to fewer rules. But a public charity must receive a substantial portion of its contributions from the general public which subjects it to greater public scrutiny. A public-charity EAF usually receives the majority of its contributions from individual employees of the sponsoring employer.
Public Charity EAF
Because of perceived public oversight, a public charity EAF generally can provide a broader range of assistance to employees than can be provided by donor advised funds or private foundations. An employer can establish a public charity EAF to respond to any type of disaster or employee emergency hardship situations, so long as the employer does not exercise excess control over the EAF. To avoid excess control, rank-and-file employees generally must constitute a significant portion of the EAF’s board. To ensure that the EAF is not impermissibly serving the employer, the following requirements must be met:
- The class of beneficiaries must be large or indefinite (e., a charitable class);
- The recipients must be selected based on an objective determination of need; and
- The recipients must be selected by an independent selection committee, or adequate procedures must be in place to ensure that any benefit to the employer is incidental and tenuous.
If these requirements are met, the public charity EAF’s payments to an employee and family members in response to a disaster or emergency hardship are presumed to be made for charitable purposes and do not result in taxable compensation to the employee.
EAF as Donor Advised Fund
A donor advised fund is essentially an irrevocable charitable investment account within a public charity. The fund is usually funded by an individual donor, who holds advisory privileges over investment and/or distribution of the donated funds. In general, a donor advised fund can make grants to public charities and certain organizations for charitable purposes, but it usually cannot make grants to individuals. However, there is an exception to this rule for EAFs.
A donor advised fund is allowed to make grants to employees and their family members if all the public-charity EAF requirements are met, plus the following requirements:
- The fund serves the single identified purpose of providing relief for a qualified disaster as defined by Section 139 (which includes a presidentially declared national disaster such as the COVID-19 pandemic);
- No payment is made from the fund to, or for the benefit of, any director, officer, or trustee of the sponsoring community foundation or public charity, or members of the fund’s selection committee; and
- The fund maintains adequate records to demonstrate the recipients’ need for the disaster assistance provided.
EAF as Private Foundation
A private foundation, unlike a public charity, is not required to be supported by the general public, and is generally viewed as less transparent due to the lack of public scrutiny. The IRS historically took the position that an EAF structured as a private foundation helped employers in recruiting and retaining a stable workforce, and therefore provided significant private benefits to the sponsoring employer, thereby disqualifying the foundation from tax-exempt status. The IRS has since changed its position.
An EAF structured as a private foundation may provide assistance only to employees or family members affected by a qualified disaster (as defined by Section 139), but not for other disasters or emergency hardship situations. A private-foundation EAF is required to take steps to ensure that the assistance provided is serving charitable purposes rather than the business purpose of the sponsoring employer. Qualified relief payments are presumed to serve an EAF’s charitable purposes if they meet all the public-charity EAF requirements. This presumption, however, does not apply to payments that would otherwise be self-dealing, such as payments made directly or indirectly to directors, officers, or trustees of the EAF.
Employers looking to help their employees through these difficult times are actively exploring EAFs because of the tax advantages they provide. EAFs are complicated. But if structured properly they can provide a win-win to both the employer and employee and help stretch the financial assistance just a little further.