Tax Loophole Allows Tax-Free COVID-19 Payments to Employees
After the terrorist attacks on September 11, 2001, Congress added a little-known tax provision to the tax law. This little-known tax code provision exempts certain payments from taxation during a disaster or terrorist attack.
President Donald Trump’s national emergency declaration triggered the disaster provisions of the tax law, including this one. We’ll tell you how this can reap big benefits for both you and your employees during this COVID-19 pandemic.
What the Law Says
In general, you can’t provide cash or property to your employee and treat it as a non-taxable gift. Here, the cash or property creates income for the employee equal to the value of what he or she receives from you.
Under the loophole we discuss in this article, the tax code makes the following tax-free to your employees:
Payments they receive from you for necessary personal, family, living, or funeral expenses incurred as a result of COVID-19
Payments they receive from you for reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence, or for the repair or replacement of its contents, to the extent that the need for such repair, rehabilitation, or replacement is attributable to COVID-19
The qualified COVID-19 disaster relief payments are free of income tax, payroll taxes, and self-employment tax.
Not only are the payments tax-free to your employee, but they are deductible to you as a business expense, regardless of whether or not the payment ends up being tax-free to the employee.
Payments That Do Not Work
The exclusion from income does not apply to payments in the nature of income replacement, such as payments to individuals for lost wages, unemployment compensation, or payments in the nature of business income replacement.
Payments to business entities don’t qualify, either.
Qualified disaster relief payments do not include payments for any expenses compensated for by insurance or otherwise.
Does the COVID-19 Pandemic Qualify?
To trigger this loophole, there must be a qualified disaster, which includes
a disaster that results from a terroristic or military action as defined by Code Section 692(c)(2);
a federally declared disaster as defined by Code Section 165(i)(5)(A);
a disaster that results from an accident involving a common carrier, or from any other event, which is determined by the secretary to be of a catastrophic nature; or
a disaster that is determined by an applicable federal, state, or local authority (as determined by the secretary) to warrant assistance from the federal, state, or local government or agency or instrumentality thereof.
The IRS issued guidance that the COVID-19 pandemic is a Code Section 165(i)(5)(A) federally declared disaster under President Trump’s national emergency declaration in which he invoked the Robert T. Stafford Disaster Relief and Emergency Assistance Act, so the COVID-19 pandemic qualifies.
Payments You Can Make
Here’s an example: the IRS ruled that grants received by employees under an employer program to pay or reimburse reasonable and necessary medical, temporary housing, or transportation expenses incurred as a result of a flood qualified for this loophole.
With respect to the COVID-19 pandemic, you could reimburse or pay for the following employee expenses under this loophole:
Out-of-pocket medical not covered by health insurance
Teleworking costs, such as a computer, office equipment, telephone, and supplies
Funeral costs for an employee or an employee’s family member
Childcare costs so that your employees can continue to work while children are home from school
Planning note. Because of the Tax Cuts and Jobs Act, employees may not deduct employee business expenses during tax years 2018-2025, so your reimbursement of such expenses under the disaster rules is extra valuable.
For info on the disallowance of employee business expenses, see
Tax Reform Punishes W-2 Employees—Get Even!
Documentation
Here’s a surprise: Congress doesn’t think taxpayers can account for their actual expenses because they are going through a disaster, so taxpayers are in the clear provided the payments received and treated as tax-free are reasonably expected to be commensurate with the expenses they incurred.
Even if the IRS is generous with documentation requirements, we recommend you implement a formal, written plan with
starting and ending dates of the program;
a listing of the expenses you will pay or reimburse;
the maximum payment per employee;
maximum total payments through the plan; and
a procedure the employee will use to request funds.
You should also track the names and amounts provided to each employee under the program terms.
Example
During the COVID-19 pandemic, you establish a plan to help employees with telework expenses, allowing each employee to get a $1,500 grant for equipment, supplies, and use of home utilities.
Your employees Sam and Helen each apply, and each estimate they will spend $1,500 on a form you provide.
Sam and Helen each spend approximately $1,500 on telework equipment and supplies.
The tax results are as follows:
You get a $3,000 tax deduction.
Sam gets $1,500 completely tax-free.
Helen gets $1,500 completely tax-free.
Takeaways
During a disaster or terrorist attack, you and your employees need all the financial help you can get.
Congress gave us a tax loophole so you can pay your employees with tax-free money for
their necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster; and
reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence, or for the repair or replacement of its contents, to the extent that the need for such repair, rehabilitation, or replacement is attributable to a qualified disaster.
While the tax code does not require that you have a formal plan to give employees for the disaster-defined tax-free payments, we recommend you develop one that includes:
the starting and ending dates of the program;
a listing of the expenses you will pay or reimburse;
the maximum payment per employee;
maximum total payments through the plan; and
a procedure the employee will use to request funds.