Executive summary:
Tax-advantaged arrangements for employee disaster assistance
Employers can provide tax-advantaged financial assistance to employees impacted by natural disasters through qualified disaster relief payments, donor advised funds, private foundations or public charities. Other methods include employer loans or retirement plan loans and distributions. Employers can also implement leave-donation or leave-sharing programs that allow their employees to help disaster victims.
Financial assistance for employees impacted by major disasters
In the wake of disasters such as hurricanes, tornadoes, floods and wildfires, many employers seek ways to financially assist employees who are impacted by these events. Co-workers of the disaster victims may also want to provide funds for the relief effort. Several tax-advantaged arrangements, discussed below, allow employers and fellow employees to financially assist affected employees.
Employer assistance
Qualified disaster relief payments
Employers can make direct payments to affected employees which are not taxable if the requirements for qualified disaster relief payments under Internal Revenue Code (IRC) section 139 are met. If qualified, the payments are not treated as wages and are excludable from federal income tax, employment taxes and Form W-2 reporting. The payments may or may not be excluded from state income tax since state laws vary.
The payments must be made due to a qualified disaster, such as a federally declared disaster or a disaster resulting from terroristic or military actions or other catastrophic events. The government will announce which events are qualified disasters for tax relief purposes.
Qualified disaster relief payments include amounts paid to or for the benefit of an individual to reimburse or pay personal, family, living or funeral expenses incurred as a result of the disaster. Expenses for medical care, temporary housing and transportation can also be covered. In addition, expenses incurred for the repair or rehabilitation of an individual’s residence, or for repair or replacement of its contents, may qualify.
For an employer’s direct payment to be excludable from an employee’s income, the employee’s expenses must be reasonable and necessary and cannot be compensated for by insurance or otherwise. Employees are not required to account for actual expenses to qualify for the exclusion, provided that the amount of the payments they receive can be reasonably expected to be commensurate with the expenses incurred. Employees are not entitled to any other tax deduction or credit on their individual income tax returns due to expenses for which they receive qualified disaster relief payments. Qualified disaster relief payments are deductible by employers as business expenses. For further details, see our article on qualified disaster relief payments.
Employer-sponsored funds, foundations and charities
Other ways employers can assist employees facing financial loss due to a disaster are through employer-sponsored donor advised funds, private foundations or public charities. Different requirements apply to each type of program so an employer would need to determine which program best suits its needs, and then work with appropriate advisers to establish the program. If the requirements are met, the payments to the affected employees are not taxable compensation to them.
- Donor advised funds. Employer-sponsored donor advised funds are created when an employer contributes to a separate account held by a community foundation or public charity to benefit the employer’s employees and their family members impacted by a disaster. The funds can only be used for a qualified disaster and not for other purposes. The account holder is required to maintain adequate records to demonstrate the recipients’ need for the disaster assistance provided.
- Private foundations. Employer-sponsored private foundations may provide assistance to employees or family members affected by a disaster, as long as certain safeguards are in place to ensure the assistance is serving charitable purposes rather than the business purposes of the employer. These private foundations can only make payments due to qualified disasters and not for non-qualified disasters or other emergency hardship situations.
- Public charities. Employer-sponsored public charities can assist employees with any type of disaster or emergency hardship situation, as long as the sponsoring employer does not exercise excessive control over the organization. Consequently, an employer-sponsored public charity can provide a broader range of assistance to employees than can be provided by employer-sponsored donor advised funds or private foundations.
Under each of these programs, the recipients must be in a charitable class and be selected based on an objective determination of need. The recipients must be chosen either by an independent selection committee or through other procedures which ensure that any benefit to the employer is incidental and tenuous. Additional information about these programs is available in IRS Publication 3833, Disaster Relief: Providing Assistance through Charitable Organizations.
Employer loans
Employers can loan money to employees without the loan being treated as taxable compensation if appropriate repayment terms are established and other requirements are met. If the aggregate of all loans made to a given employee is under $10,000, the loans can be interest-free. Loans above $10,000 in the aggregate are required to accrue interest. Since most states have specific requirements regarding employees authorizing payroll withholding for loan repayments, employers need to be certain they meet any applicable state law requirements.
Retirement plan distributions and loans
Employers that sponsor certain retirement plans have the option to allow distributions and loans from their plans for employees impacted by a disaster.
- Qualified disaster recovery distribution (QDRD). Historically, Congress would enact legislation after a disaster to provide special distribution rules. The SECURE 2.0 Act, enacted Dec. 29, 2022, provides ongoing relief for federally declared disasters, effective for disasters occurring on or after Jan. 26, 2021. A QDRD may be any distribution from an eligible retirement plan to an employee whose residence is in a disaster area and who suffers economic loss due to a disaster. The disaster area must be declared as such by the Federal Emergency Management Agency (FEMA) and the economic loss must occur during the incident period, also specified by FEMA, which can be one day or multiple days.
A QDRD can be up to $22,000 and must be taken no later than 180 days after the latest of (1) Dec. 29, 2022, (2) the first day of the incident period, or (3) the date of the disaster declaration. Favorable tax treatment of a QDRD includes:
- taxation over three years instead of in the year received,
- exemption from the 10 percent early distribution penalty,
- exemption from the 20 percent withholding requirement on eligible rollover distributions, and
- no taxation if repaid within three years via contributions to a retirement plan.
- Loans. Many employers allow employees to take tax-free loans from their retirement plans. Due to the SECURE 2.0 Act, employers can expand the normal loan rules for federally declared disasters. The disaster provisions allow for an increase in the loan limit to the lesser of $100,000 or 100% of the employee’s vested balance. Furthermore, the loan repayment period can be extended up to an additional year for a loan existing at the time of the disaster or initiated because of the disaster.
- Hardship distribution. Even if an employer does not include QDRDs as a distribution option under the terms of the plan, the plan may include a hardship distribution provision allowing employees to withdraw funds when faced with certain financial needs. The rules allow a hardship distribution for expenses and losses incurred by an employee due to a federally declared disaster if the employee’s residence or place of employment is located in the designated disaster area. Although hardship distributions for disaster relief are subject to income taxes, the 10% early distribution penalty is waived on the first $22,000 withdrawn if the QDRD requirements noted above have been satisfied. Additionally, taxation can be spread over three years.
For more details related to QDRDs and expanded loan provisions, see the IRS’s recently released Frequently Asked Questions.
Employee assistance
Leave-donation programs
Employer-sponsored leave-donation programs allow employees to trade their paid leave for cash payments made by their employers to charities. When employees forgo vacation, sick or personal leave, the leave is not treated as wages if exchanged for employer payments to qualified charities by certain dates set by the IRS. Since the donated leave is not taxable income, it is not included in Boxes 1, 3 or 5 of the donor’s Form W-2. The IRS will announce the disasters that can be funded through leave-donation programs and the dates by which the donations must be paid to the charities.
Employees cannot claim a charitable contribution on their individual income tax returns for the donated leave. Employers making the charitable contributions can deduct these contributions as a trade or business expense without regard to the normal restrictions on charitable contributions.
Leave-sharing plans
Employers can also sponsor leave-sharing plans which allow employees to donate leave to their fellow employees impacted by a major disaster as additional paid time-off. Plans which meet the IRS requirements treat the donated leave as wages of the recipient, not of the donor, and thus allow the leave donor to avoid federal taxation on the donated leave. Donated leave received by a recipient is treated as wages subject to federal income tax and employment tax withholding. Leave donors are not entitled to a charitable contribution on their individual income tax returns for the donated leave.
The requirements for major disaster leave-sharing plans are detailed in Notice 2006-59 and summarized here:
- The plan must be in writing and apply only to an event declared by the President of the United States as a major disaster or emergency.
- The employee donating leave can deposit accrued leave (up to the maximum amount the employee normally accrues during the year) into an employer-sponsored leave bank for use by other employees who have been adversely affected by the disaster; however, the donor cannot designate a specific recipient.
- An employee can receive the leave if the disaster has caused severe hardship to the employee or a family member that requires the employee to be absent from work. The leave recipient is paid leave (at his or her normal rate of compensation) from the leave bank for purposes related to the disaster, and cannot convert the leave into cash in lieu of using the leave.
- The plan applies a reasonable limit on the period of time during which leave can be donated and used, and also imposes a limit on how much leave any one recipient may receive. Leave donated on account of one major disaster may only be used for employees affected by that disaster, and unused leave in the bank must be returned to the leave donors.
Other employee contributions
Employees may choose to contribute funds to qualified charities for disaster relief through programs sponsored by their employers. Employees can send their contributions directly to the charities or have them collected by the employer, such as via after-tax payroll deduction, and then forwarded to the charities. Employees cannot make pretax payroll deduction contributions for disaster relief. Employees may be entitled to a charitable contribution deduction on their individual income tax returns for these contributions.
Employees who make after-tax contributions to a non-exempt fund held by their employer to provide qualified disaster relief payments directly to affected co-workers are not entitled to a charitable contribution on their individual income tax returns since the contributions are not made to qualified charities.
Summary
Employers expecting to provide financial assistance to employees who are disaster victims should consider the various tax-advantaged programs available. Since the requirements of each program vary, it is important that employers properly structure their programs to obtain tax benefits for the donors of the assistance and the recipients.
