COVID-Related Payments to Employees

Providing Tax-Free Assistance to Employees

The holiday season is a time when many employers opt to show their appreciation for their employees. From holiday parties to Christmas bonuses, employers often make discretionary payments to reward a year of hard work or high profits. While most bonuses are likely not reporting record profits this year, they may still wish to spread some holiday cheer to their employees. Employees, in turn, may be in greater need of assistance than ever before. For those fortunate enough to remain employed during COVID-19, many have incurred additional expenses. Those working from home may have had to foot the bill for a home office, from buying a webcam to shelling out for a better internet package. Those working on-site may have had to budget for childcare in light of school closures, and everyone has had to buy personal protective equipment like masks and hand sanitizer. Fortunately, the tax code contains two provisions which may allow employers to offer assistance on these fronts in a tax advantaged way.

Disaster Payments Under Section 139

Section 139 of the Internal Revenue Code allows employers to provide cash assistance or direct payment of expenses incurred by employees as a result of a qualified disaster, even where such expenses don’t directly relate to their employment. The employer is allowed to deduct such payments, much as they would wages or bonuses, but unlike wages or bonuses, the employee does not have to report such payments or include them in taxable income. While this Section was originally created to empower employers to help employees get back on their feet after disasters such as tornados or hurricanes, the COVID-19 is in fact a qualified disaster such that Section 139 can be invoked.

The most relevant type of disaster relief payments during the COVID-19 pandemic are laid out in Section 139(b)(1) as payments “to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster.” This could include a reasonable cash payment for, or direct provision of, personal protective equipment such as masks and hand sanitizer, whether the equipment is meant for use at work or personal use outside of work. It could also include more significant payments to reimburse for childcare expenses which would not have been incurred if not for the school closures caused by the pandemic. For employees unfortunate enough to have contracted COVID-19 or lost a family member to the disease, it could also potentially cover out of pocket medical and funeral expenses. While Section 139 does not require specific documentation, and a flat, reasonable payment for smaller items (such as giving all employees $50 per month for personal protective equipment) may be justifiable, it may be wise to document more significant expenses (such as funeral expenses) to protect against a future audit.

Note that wages are not qualified disaster payments, and qualified disaster payments are not wages. That is, an employer cannot just “re-classify” a portion of an employee’s wages as non-taxable disaster payments. Instead, such payments should be made in addition to, not in substitution of, normal employee wages or salaries. The relation to entirely discretionary end-of-year bonuses is less clear, considering that while disaster payments are not a substitution for bonuses, they would affect the cash balance of the company, which may affect the employer’s normal process for determining bonuses.

Employees should be made aware that due to the double benefit prohibition of Section 139(h), any tax-free payments made under such section cannot be used to claim the child and dependent care tax credit.

Reimbursable Work from Home Expenses

The COVID-19 pandemic has seen a trend of employees who previously worked in a traditional office setting transition to working from home. Upon transitioning to working from home, many such employees found themselves lacking the tools they required, and having to pay out of pocket for expenses directly related to their job. Most employees working from home found themselves requiring an internet connection, and a telephone (whether cell, landline, or IP) in order to do their job. They may also have needed to purchase equipment such as webcams, scanners, and shredders. Even basic supplies such as pens and paper, normally obtainable at work, may have found their way on to employees’ shopping lists.

Such expenses are, ultimately, expenses incurred for the benefit of the employer, not the employee. In an office setting, such expenses would be borne directly by the employer without a second thought. With the quick, and for many companies unprecedented, shift to work-from-home earlier this year, many employees nonetheless found themselves paying such expenses.

Fortunately, the Internal Revenue Code recognizes that expenses incurred by employees on behalf of their employers are actually business expenses, and as such a company should be able to deduct their reimbursement without the employee having to recognize income, essentially creating the same tax treatment as if the employer had paid such expenses directly.

The IRS, however, does not want to create a situation where the employer is actually paying personal expenses disguised as business expenses. Therefore, the employer must have an “accountable plan” in order to reimburse employee expenses. An accountable plan is an arrangement that follow three rules: (1) reimbursed expenses must be incurred by an employee in the course of performing a service for the employee (i.e., they must be expenses that if the employer had paid directly, would have been deductible business expenses), (2) such expenses must be substantiated within a reasonable period of time after being incurred (note that reasonableness is based on facts and circumstances, though certain safe harbors exist), and (3) in the case of an advance or overpayment, the employee must return, within a reasonable period of time, any excess payment above actual expenses.

Reimbursable expenses may include home office expenses such as a portion of internet and phone bills, as well as equipment like webcams and printers, or supplies like paper and pens. It will not cover items such as child care which are for the benefit of the employee and not the employer.

Employee reimbursement arrangements under accountable plans existed before the pandemic, but were often under-utilized and only covered items such as business travel, professional dues, and other large ticket items. Such arrangements will also likely continue to remain available long after the pandemic ends. As such, employers may wish to familiarize themselves with the rules laid out in Regulation 1.62-2, and contact their accountant or tax attorney to determine what they need to do to ensure that employees are reimbursed when they cover business expenses. Whether or not such reimbursements are legally required to be made (as is the case in states such as California), doing so will help ensure that employees can obtain the tools necessary to do their jobs without incurring an undue tax burden.