For employers who are looking to help out their employees who are struggling in the wake of COVID-19, there is a way to make tax free payments to employees during the COVID-19 pandemic.
What is Section 139 and how does it apply?
I first came across this specific area of our tax code courtesy of Tony Nitti, a tax practitioner who regularly writes for Forbes magazine. I will share a snippet of what Section 139 is and how it applies to business owners and their employees facing hardship from COVID-19. From Nitti’s blog directly:
Section 139, however, provides that in the worst of circumstances, an employer can make a tax-free payment to an employee. In addition to contemplating the type of terrorist attack for which it was originally designed, Section 139 also applies to any “federally declared disaster” as defined in Section 165(i)(5)(A). Section 165, in turn, defines such a disaster as any disaster determined by the President to warrant assistance by the Federal Government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act.As outlined earlier in this article, when employing Section 7508A to delay the April 15th tax deadline in Notice 2020-18, the IRS stated that the President’s emergency declaration constituted a federally declared disaster for purposes of Section 165. Thus, the COVID-19 pandemic satisfies the requirement in Section 139 of a federally declared disaster.As a result, beginning immediately, employers may provide tax-free payments to employees — while still claiming a full deduction for the payments — provided the payment is to reimburse or pay the employee for “reasonable and necessary personal, family, living, or funeral expenses” incurred as a result of COVID-19.Payments are NOT covered by Section 139 if they compensate employees for expenses that are otherwise compensated for by insurance or that are intended to replace lost income. Thus, payments of sick pay or family medical leave remain fully taxable to the employee.
Applying Section 139 for COVID-19 related expenses
If we apply the guidance above, a common example of how this might play out is as follows:
As a result of the COVID-19 pandemic, one of your employees is forced to hire a babysitter or nanny to watch his or her children during the work day. They have to pay the caretaker $100 per day for each work day, which is a cost you would not have otherwise incurred if not for the school shut down resulting from COVID-19. That employee normally gets about $500 a week in commissions that are part of their paycheck. However, they won’t get the $500 for the foreseeable future due to the slowdown caused by COVID-19.
Normal wages per paycheck: $2,000
Qualified expenses under Section 139: $500
Total gross wages (Taxed): $1,500
Qualified expenses (Tax free): $500
Total Payments to Employee: $2,000 (unchanged)
Total Payroll Tax Savings: $38.25
Total Federal Income Tax Savings (Assuming 22% tax rate): $110.00
Total Tax Savings (Federal): $148.25
In the example above, the employee saves a total of $148.25 in taxes and has that money in their pocket as soon as their payroll check clears. There will also be a smaller, but helpful benefit at the state level as well that is dependent upon the state in which you work in. As you can see, the example above would provide a net cash benefit to your employee of at least $150 to help them with additional unforeseen costs that were incurred because of COVID-19 if their employer chooses to offer this their employees.
The mechanics of how to make this happen aren’t super simple but also aren’t insurmountable. You will need to work closely with your payroll provider and/or CPA to make sure you’re doing this correctly. It isn’t quite as simple as writing someone a check for a set dollar amount. You will also want to make sure you have adequately documented everything as an employer should you be required at a later point in time to substantiate the payments you made to your employees. If you run your own payroll, you will want to make sure this payment is reported in the right field in your software. Some helpful templates are below: