As summer arrives and many employees return to their normal places of work, it can be easy to overlook the large numbers of employees who will remain unable to return to full-time work, as a result of social distancing or other COVID-19-related restrictions. For many such employees, Section 139 of the Internal Revenue Code can serve as an important lifeline, as Code Section 139 permits employers to reimburse certain living expenses of employees without triggering federal income taxes.
Prior to the September 11, 2001 attacks, employers were more limited in their ability to provide emergency relief payments to their employees. Payments made by employers directly to their employees were generally fully taxable to the employees, and employers were generally required to pay the employer’s portion of FICA taxes, on top of any taxes withheld from the employees. The taxability of such payments reduced the amount that employees could ultimately use to pay living expenses. While Section 501(c)(3) charities could make tax-free grants to individuals, and while employers could contribute funds to such charities, there were significant restrictions on the class of people that such charities could benefit. In particular, charities generally had to select beneficiaries based upon their financial need, and not based upon who employed them.
The September 11, 2001 attacks created a great need to get funds into the hands of victims of the attacks, and the obstacles to making relief payments became more prominent. Congress responded by enacting Code Section 139, as part of the Victims of Terrorism Tax Relief Act of 2001.
Code Section 139(a) provides that gross income does not include any amount received by an individual as a “qualified disaster relief payment.” A qualified disaster relief payment generally includes a payment to or for the benefit of an individual if:
- The payment is to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a “qualified disaster,”
- The payment is to reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or repair or replacement of its contents to the extent that the need for such repair, rehabilitation, or replacement is attributable to a qualified disaster,
- The payment is by a person engaged in the furnishing or sale of transportation as a common carrier by reason of the death or personal physical injuries incurred as a result of a qualified disaster, or
- The payment is made by a federal, state, or local government (or agency or instrumentality thereof) in connection with a qualified disaster and in order to promote the general welfare.
Qualified disaster relief payments may not, however, reimburse recipients for expenses that are compensated for by insurance or otherwise. In addition, the IRS has taken the position that qualified disaster relief payments do not include: (1) amounts intended “to replace wages or compensation that an individual would otherwise earn” or (2) “income replacements such as sick leave or other paid time off paid by an employer.”
A qualified disaster includes: (1) a disaster resulting from certain terroristic or military actions, (2) certain federally declared disasters, (3) a disaster which results from an accident involving a common carrier, or from certain other events determined to be of a catastrophic nature, or (4) with respect to certain payments by certain governmental authorities, certain disasters determined by the applicable authority to warrant government assistance. In an FAQ related to tax credits for mandatory paid leave under the Families First Coronavirus Response Act, the IRS confirmed that the COVID-19 pandemic is a qualified disaster.
For employers and employees, qualified disaster relief payments provide several federal income tax advantages over other types of relief payments:
- Qualified disaster relief payments are not subject to federal income tax. In addition, such payments are generally not treated as net earnings from self-employment, wages, or compensation subject to tax for federal tax purposes, so federal estimated tax payments and federal wage withholding are not required on such payments.
- The state and local tax treatment of qualified disaster relief payments may vary from jurisdiction to jurisdiction. Qualified disaster relief payments are excluded from New York State adjusted gross income to the extent that they are excluded from federal adjusted gross income, and such payments are not subject to New York State or New York City withholding.
- Qualified disaster relief payments may be made directly by an employer to an employee.
- The recipient does not have to be financially needy.
- Qualified disaster relief payments are deductible by employers to the extent that they are deductible under general tax rules. The legislative history for Code Section 139 indicates that the exclusion of qualified disaster relief payments from the income of employees should not prevent their employers from deducting such payments.
- Although the reimbursed expenses must be reasonable and necessary, the employee generally does not have to produce receipts for, or otherwise substantiate the payment of, such expenses, and there is no fixed cap on the amount of such expenses.
Qualified disaster relief payments come with only a few drawbacks. In particular, recipients of qualified disaster relief payments may not claim deductions for expenses reimbursed by such payments.
In making qualified disaster relief payments to employees in connection with the COVID-19 pandemic, employers should keep in mind the following points:
- The payment amounts should be for reasonable and necessary personal, family, living, or funeral expenses incurred by the employee as a result of the pandemic. The payment amounts should neither be based upon, nor be calculated by reference to, the wages or other compensation that would have been paid to the employee but for the pandemic.
- While it is not necessary for an employer to establish a formal plan before making qualified disaster relief payments, it may be prudent to establish a written policy governing the making of such payments.
- Employees should be asked whether claimed expenses have been reimbursed by another source. If an employee were to receive reimbursement of an expense from an insurance company, for example, the reimbursement of the same expense by the employer would not qualify as a qualified disaster relief payment, and the employer’s payment could become fully taxable.
- Although employees are generally not required to substantiate expenses reimbursed by qualified disaster relief payments, employers should maintain records sufficient to substantiate the employers’ entitlement to any resulting deductions.