Storm clouds warn of potential disaster

Tax code section 139 enables employers to make nontaxable qualified disaster relief payments to employees for reasonable and necessary expenses resulting from the coronavirus pandemic.

Generally, payments made by an employer to, or for the benefit of, an employee must be included in the employee’s taxable income and cannot be treated as a nontaxable.

Section 139 was enacted in the aftermath of the Sept. 11 terrorist attacks. When triggered, it overrides the broad income inclusion principles and allows employers to provide direct financial assistance to employees impacted by a qualified disaster without adverse tax consequences

On March 13, 2020, the president declared a national emergency concerning the COVID-19 outbreak. The magnitude and rapid spread of the illness temporarily closed businesses, leaving employers little choice but to lay off certain employees for the foreseeable future. Merely a few weeks into this unprecedented “new normal,” employers want to know about the types of hardship assistance they can provide to their employees in this difficult time.

With the elevation of the outbreak to a federally declared disaster, employers can explore a few avenues.

Section 139 payments

Traditionally, section 139 has been used by employers whose businesses and employees have been affected by a natural disaster, such as a hurricane or tornado. Section 139 defines qualified disaster relief payments to include the quoted items noted above but also those that are reasonable and necessary for the repair of a personal residence or the replacement of its contents. With a natural disaster, it is not hard for employers to prove that the payments were made, for example, for housing costs.

Employers have not historically relied upon section 139 during a pandemic (except in Notice 2014-65, which designated the Ebola virus outbreak in Guinea, Liberia and Sierra Leone as a qualified disaster), resulting in little guidance from the IRS. In a pandemic, employees are in need, but direct payments to employees without proof of how the payments were spent by the employees could result in regulators deeming the payments taxable wages.

A revenue ruling from 2003, Revenue Ruling 2003-12, 2003-1 C.B. 283, also confirms that relief grants received by individuals, which are intended to pay or reimburse medical, housing or transportation needs incurred due to a disaster, are not includible in gross income.

The types of expenses covered by section 139 payments are somewhat unclear. Individuals are not required to account for actual expenses in order for the payments to be excluded from gross income. However, employers may want to consider a requirement that employees account for the use of the section 139 payments. The default for regulators on these payments may be that “undocumented payments are the equivalent of taxable wages.”

It is important to note section 139 payments do not include income replacement wages (such as lost wages, lost business income or unemployment compensation) or expenses otherwise paid for by insurance or other reimbursement. The COVID-19 pandemic does not have the visible disaster evidence of an earthquake or a hurricane. A best practice for employers is to document need by the employee and have the employee document the use of the section 139 payment.

With the passage of the Families First Coronavirus Response Act, some employers may be required to provide emergency paid sick leave to employees affected by COVID-19. Those employers are then eligible to receive a credit against payroll taxes. Paying sick leave to those employees would disqualify them from receiving disaster relief payments because their expenses would be deemed otherwise covered.

Charitable aid to individuals

From a different angle, charitable organizations can serve disaster victims and those facing emergency hardship situations in a variety of ways. Except for employer-sponsored foundations, the disaster or hardship situation need not be a presidentially declared disaster, as outlined in section 139.

In contrast to public charities, private foundations typically have a single major source of funding that usually comes from one family or corporation. Historically, private foundations are created as a way for one family to continue its legacy for many years. They are often formed to make grants to other section 501(c)(3) organizations to address community needs and other charitable goals. In some cases, private foundations can provide assistance to individuals.

Generally, a private foundation that intends to make grants to individuals must obtain advance approval from the IRS (typically on the private foundation’s Form 1023, Application for Recognition of Exemption). The private foundation must also maintain meticulous records to support the charitable purpose of grants paid to individuals and that the grants were in furtherance of the private foundation’s exempt purpose.

In the most common scenario, a private foundation is formed as a classic grant-making foundation, thus the intention from inception is to provide funds to other section 501(c)(3) organizations. In the unfortunate circumstance that a disaster strikes the local community, private foundation managers often question whether they can provide financial assistance directly to individuals affected by the disaster.

An organization that is qualified under section 501(c)(3) may engage in other activities that accomplish charitable purposes even though those activities were not described in its exemption application, without having to obtain permission from the IRS. However, the private foundation should report these new activities on its annual return. Specifically, private foundations should describe the services provided in its summary of direct charitable activities if the disaster relief activities are one of the private foundation’s four largest programs.

In the case of a disaster or hardship situation, the private foundation may provide assistance in the form of funds, services or goods to ensure that victims have the necessities [such as food, clothing, housing (including repairs), transportation and medical assistance (including psychological counseling)]. The type of aid that is appropriate depends on individual need and resources.

The following types of assistance, if based on individual need, are consistent with charitable purposes:

  • Assistance to allow a surviving spouse with young children to remain at home with the children to maintain the psychological well-being of the family,
  • Assistance with elementary and secondary school tuition and higher education costs to permit a child to attend school,
  • Assistance with rent, mortgage payments or car loans to prevent loss of a primary home or transportation that would cause additional trauma to families already suffering, and
  • Travel costs for family members to attend funerals and to provide comfort to survivors.

As outlined in Publication 3833, the IRS defines specific guidelines and safeguards a private foundation must follow when providing financial aid to individuals:

  1. The potential pool of beneficiaries (the charitable class) must be large enough or sufficiently indefinite that no preselected group of individuals can be identified. In other words, the private foundation’s disaster relief or emergency hardship organization cannot target or otherwise limit its assistance to specific individuals.
  2. Charitable funds must be distributed to individuals based on a “needy or distressed test.” While individuals do not have to be completely insolvent in order to be financially needy, the private foundation must make an objective evaluation of the individual’s needs at the time the grant is made.
    a. It is important to note that charitable funds cannot be distributed to individuals simply because they are victims of a disaster.
  3. The private foundation must maintain adequate records to support that financial aid paid to individuals furthers the private foundation’s exempt purpose. Generally, the private foundation should maintain records of the following:
    a. Complete description of the assistance provided
    b. Costs associated with providing the assistance
    c. Purpose for which the aid was given
    d. The objective criteria used for disbursing assistance
    e. How the recipients were selected
    f. Name, address and amount distributed to each recipient
    g. Any relationship between a recipient and officers, directors or key employees of, or substantial contributors to, the private foundation
    h. The composition of the selection committee approving the assistance

The private foundation cannot make payments to (or for the benefit of) individuals who are directors, officers, or trustees of the private foundation or members of the private foundation’s selection committee.

Employer-sponsored private foundations

With respect to employer-sponsored private foundations, providing disaster relief payments to employees of a certain employer are subject to more intense scrutiny by the IRS.

Prior to Sept. 11, 2001, the IRS ruled that having an employee relief fund aided employers in recruiting and retaining potential employees, resulting in a significant private benefit to the sponsoring companies. There were concerns, however, that employers could exercise undue influence over the selection of recipients. These employer-sponsored private foundations could not make payments to individual employees. However, after the Sept. 11 terrorist attacks, Congress took the position that employer-sponsored private foundations should be able to provide assistance to employees in certain situations. These provisions were codified in section 139; a presidentially declared disaster is one of those situations.

Unlike non-employer-sponsored private foundations described above, employer-sponsored private foundations can only make payments to employees or their family members affected by qualified disasters as defined by section 139. They cannot make payments to their employees in nonqualified disasters or in emergency hardship situations — like other private foundations can.

In addition to the requirements listed above as outlined by Publication 3833, the IRS added an additional layer of requirements that must be adhered to when an employer-sponsored private foundation provides disaster relief payments to its employees:

  1. If the group of eligible beneficiaries is limited to, for example, employees of a particular employer, the group of individuals eligible for disaster assistance (the class) must be indefinite. Otherwise, the charitable class would consist of a group of preselected individuals, which is prohibited.
    a. To be an indefinite charitable class, the relief program must be open-ended and include employees affected by the current disaster and those who may be affected by a future disaster.
    b. It is important to note that if the facts and circumstances indicate that a newly established disaster relief program is intended to benefit only current beneficiaries without any intention to provide for future disasters, a charitable class would not be present.
  2. The selection of beneficiaries is made using either an independent selection committee or adequate substitute procedures to ensure that any benefit to the employer is incidental and tenuous.
    a. The private foundation’s selection committee is independent, if a majority of the members of the committee consist of persons who are not in a position to exercise substantial influence of the affairs of the employer.

Even though an employer-sponsored private foundation meets the presumption described above, the IRS may still review the facts and circumstances to ensure that any benefit to the employer is tenuous and incidental.

Whether the private foundation is employer-sponsored or not, and assuming the private foundation was not formed specifically to provide disaster relief, the ability of the private foundation to provide evidence that it has met the requirements listed above will be enhanced if the private foundation develops a disaster relief policy and commits the policy to writing.

If a private foundation was formed by a business owner and/or family, but not formed specifically as an employer-sponsored private foundation and that business owner wants to use the foundation funds for that owner’s employees, the foundation should follow the employer-sponsored private foundation rules.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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