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Tax-Free Payments to Employees for COVID-19 Related Expenses... What’s the Catch?

December 3, 2020

After the terrorist attacks on September 11, 2001, Congress added a little-known tax provision, Code Section 139, to the tax law.  This provision exempts certain payments to employees from taxation during a disaster or terrorist attack.

The President’s COVID-19 national emergency declaration on March 13, 2020 triggered the disaster provisions of the tax law.  The IRS specifically states that this is a “federally declared disaster” for purposes of invoking Section 139 in its COVID-19 FAQs.

Tax-Free Payments to Employees

Under this code section, a business can make tax-free payments to its employees.  The qualified COVID-19 disaster relief payments are free from income tax, payroll taxes, and self-employment tax.  Not only are the payments tax-free to the employee, they are deductible to you as a business expense – the best of both tax worlds.  An employer can make payments for expenses incurred while the COVID-19 pandemic continues to be a qualified disaster, as determined by the President.

Expenses That May Qualify for Tax-Free Treatment

While the IRS has not provided any specific guidance on eligible COVID-19 expenses, there is IRS guidance from previous disasters, including the 2014 Ebola virus outbreak. 

The following are examples of COVID-related expenses that may qualify as tax-free payments under Code Section 139:

  • Out-of-pocket medical expenses not covered by health insurance.
  • Expenses necessitated by COVID-19 exposure, such as temporary housing, food delivery or home sanitizing services.
  • Telecommuting costs such as a computer, office equipment, telephone, supplies and increased utility costs.
  • Child-related costs incurred due to school closings or remote learning requirements so that your employees can continue to work while children are home from school.  Expenses such as childcare, tutoring, computer equipment, internet access and online educational resources should qualify.
  • Funeral costs for an employee or an employee’s family member.

Expenses That Do NOT Qualify for Tax-Free Treatment

  • Payments in the nature of income replacement, such as payments to individuals for lost wages, unemployment compensation, or business income replacement. Thus, payments for  sick pay or family medical leave remain fully taxable to the employee.
  • Year-end bonus payments to employees.
  • Payments to business entities.
  • Nonessential, luxury, or decorative items and services.

What is the Catch?

As with all tax matters, there are several factors to consider before implementing this strategy.  The IRS has NOT issued clear guidance directly related to the COVID-19 disaster, which leaves open some element of risk.  Another key consideration is to WHOM the benefits are offered.  It is unclear if the same program would need to be offered to all employees, or if you could offer different benefits to different employees, for example by job description or class.  As an example, different “classes” of employees could include:

  • Administrative Support Staff
  • Professional Staff
  • Shareholders/Owners

We would caution against any program that only covered owners or other highly compensated employees and is not offered to “rank and file” employees.  

Documentation

The disaster provisions stipulate that employees are NOT required to account for their expenses to the employer.  Therefore, no written plan or documentation is technically required if the payments received and treated as tax-free are reasonably expected to be commensurate with the expenses incurred.  At a minimum, you should have employees sign a written certification that the money received is necessary for COVID-19-related expenses and that those expenses are not otherwise reimbursable.

Despite this generous relief, we recommend you implement a formal, written plan in case of IRS audit that includes:

  • Beginning and ending dates of the program;
  • A listing of the types of expenses you will pay or reimburse;
  • Identifying which employees are eligible (taking potential discrimination claims into consideration);
  • The maximum payment per employee (there is no specific cap mandated);
  • The maximum total plan payments (there is no specific cap mandated);
  • How and when payments will be made; and
  • The procedure employees will use to request funds.

We also recommend the following:

  • Track the names of and amounts provided to each employee under the program terms.
  • While not mandated, to avoid abuse and limit any potential tax exposure, it is advisable to require that employees submit receipts or other proof of their expenses.

Example

During the COVID-19 pandemic, you established a plan to help employees with telecommuting expenses, allowing each employee to receive a $1,500 grant for equipment, supplies, and increased cost of home utilities.

Your employees John and Jane each apply and each estimate they will spend $1,500 on a form you provide.  The tax results are as follows:

  • You get a $3,000 tax deduction.
  • John gets $1,500 completely tax-free.
  • Jane gets $1,500 completely tax-free.

Conclusion

We have seen our clients go above and beyond to help their employees during this difficult time.  Section 139 relief can allow the help to go even further, with no taxes owed by the employee. If you are interested in pursuing this strategy for your company, please reach out to your Beaird Harris tax advisor and we would be happy to brainstorm ideas with you.   

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