Nontaxable Payments to Employees? A New Way to Help Employees in the Age of COVID-19
On March 13, 2020, the President issued a determination under the Robert T. Stafford Disaster Relief and Emergency Assistance Act (the “Stafford Act”). A consequence of that action is that payments from employers to employees that meet the requirements of a qualified disaster relief payment under Internal Revenue Code Section 139 are excludible from income, a rather unusual result, for the reasons discussed below.
Although Section 139 cannot be used to exempt income replacement payments (wages), other amounts may be considered exempt.
Background – The tax law has long wrestled with the issue of when various payments are subject to income tax in light of the general rule that gross income means all income from whatever source derived. Various exceptions to taxation have existed over the years for payments in disaster-related situations. A “general welfare” exception, for example, excludes from income payments made by a governmental unit under a social benefit program designed to promote the general welfare. This exception has been relied on in excluding federal and state payments to disaster victims. In a similar vein, relief payments made by charities are generally not taxable because the tax law views those payments as gifts.
Payments by employers to employees, in contrast, are almost always viewed as compensation, absent a specific statutory exclusion from income (for certain welfare and fringe benefit subsidies, for example). In the aftermath of September 11th, however, Congress enacted a new exemption from income under Section 139 for “qualified disaster relief payments,” which could cover certain payments by employers to employees.
What does Section 139 cover? – A qualified disaster relief payment is an amount paid “to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster.” As noted, a qualified disaster includes a federally declared disaster triggered by a declaration by the President under the Stafford Act, and the exclusion applies as long the expense is not covered “by insurance or otherwise.”
While Congress did not intend for the new provision to exclude an amount received as an income replacement (wages) or unemployment compensation, qualified disaster relief payments could include other amounts paid by employers, provided that the amounts paid are not within the realm of what the employer would otherwise have paid to an employee but for the disaster. For example, one published ruling provides that amounts paid by an employer to employees affected by a flood that was a federally declared disaster were excludible to the extent the amounts assisted employees with medical, housing and/or transportation expenses, as long as the employee was not receiving insurance reimbursements or other replacement payments. The program at issue in this ruling did not require proof of expenses incurred, although the program was designed to ensure that the amount paid reasonably reflected the amount an individual might otherwise incur.
Amounts intended to be excluded from income under Section 139 need not be reported on Form W-2 and are exempt from withholding (income and employment tax) requirements. As a result, an employer making these payments will need to work closely with their payroll provider to ensure those results if amounts are distributed through that channel.
The legislative history also notes that the exclusion under Section 139 is not intended to affect the deductibility of a payment. Thus, it appears that the general principles for a business deduction would apply to a payment by an employer to an employee, as long as the amount is reasonable in scope.
Application to the COVID-19 pandemic – There is virtually no guidance on how Section 139 might work in a non-natural type of disaster situation with respect to payments between employers and employees. Nevertheless, we believe that the provision is available to employers that decide to make payments to employees in the current environment that are not otherwise wage-type payments — for example, to reimburse housing or other personal expenses. We also believe that best practice would be to formalize the arrangement through adoption of a written plan document, but employees are not required to provide documentation of how the money is used. If properly established, any such payments should be fully deductible by the employer and excludable to the employee recipient for federal income and Social Security and Medicare tax purposes. (Whether or not the amount is excludible for state or local income tax purposes will likely vary from state to state.)
Although it has not yet been updated to address this situation, the Internal Revenue Service maintains a website with additional information on tax relief available in disaster situations. At some point in the coming weeks, this website may provide additional information on Section 139 but for now, please feel free to reach out to any member of our Employment and Benefits Practice Group if you have any questions.