"In a crisis, be aware of the danger — but recognize the opportunity." — John F. Kennedy
While 2020 thus far has been challenging to say the least, it contains opportunities that employers should recognize. On March 13, 2020, President Donald Trump made an emergency declaration for the entire United States in response to the COVID-19 pandemic. This declaration was followed by the Coronavirus Aid, Relief, and Economic Security Act (CARES) Act, P.L. 116-136, which was enacted on March 27, 2020. This article focuses on two specific opportunities available during 2020 that are beneficial to both employers and employees: (1) Sec. 139 disaster relief payments and (2) Sec. 127 educational assistance payments.
Disaster relief payments
Generally, Sec. 61 provides that "gross income means all income from whatever source derived." Sec. 102 provides an exception to inclusion in gross income for bona fide gifts, but this exception does not generally apply to gifts from employers. Before 2001, even if an employer wanted to make a "gift" to assist an employee or his or her family in need, it would be taxed as wages (i.e., included as gross income) and be subject to employment tax. Sec. 139 was added in 2001 in response to the 9/11 terrorist attack and designed to allow employers to provide tax-advantaged assistance to employees (or technically any individuals) who were suffering from a qualified disaster. Specifically, Sec. 139 carves out another exception for qualified disaster relief payments providing that employer payments are not included in gross income nor are those payments subject to employment tax.
A qualified disaster relief payment is a payment made to or for the benefit of an individual "to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of the qualified disaster" and includes reimbursements to pay for repairs to a personal residence and any government-funded aid (Sec. 139(b)). A "qualified disaster" is defined as a disaster resulting from terroristic or military action, a federally declared disaster, a disaster determined by the IRS to be of catastrophic nature, or a disaster determined by federal, state, or local government or agency (Sec. 139(c)).
As mentioned above, any qualified disaster relief payment is not included in gross income and is not "treated as net earnings from self-employment, wages, or compensation subject to tax." (Secs. 139(a) and (d)). Any such payment shall be deductible by the employer to the same extent it would be if the payments were includible in income (Joint Committee on Taxation, Technical Explanation of the "Victims of Terrorism Tax Relief Act of 2001" (JCX-93-01) (Dec. 21, 2001)). However, any payment that is excluded from gross income is not deductible to the extent the deduction would benefit the individual who received the payment. (Sec. 139(h)). This limitation is designed to prevent a double benefit to owner-employees who are receiving a qualified disaster relief payment.
How the Sec. 139 benefit affects employers and employees
ABC Inc. has 10 employees, all of whom are located in a qualified disaster area and have been negatively affected by it. ABC Inc. would like to assist its employees in their time of need by providing each with $1,000, costing ABC Inc. $10,000 for the bonus payments to the employees. ABC Inc. will also pay $765 to cover its one-half share of the payroll taxes, while the employees collectively will pay $765 to cover their one-half share. The total cost and corresponding business deduction to ABC Inc. is $10,765.
Assuming the employees are all in a 22% income tax bracket, then the employees will pay $2,200 for income taxes. The net amount after taxes to the employees is $7,035 (or $703.50 per employee). In this example, the employer is spending $1,076.50 per employee for bonus payments and the employees are only each netting $703.50.
Modifying the example, assume ABC Inc. instead offers an employee qualified disaster relief payment program, and each of the 10 employees qualifies and participates in the program. ABC Inc. desires to provide a grant of $750 per employee for a grant total of $7,500. ABC Inc. would not have to pay any employment tax despite remaining eligible to deduct the full amount of the grants as a business expense of the company. The employees would not incur any employment tax or income tax on the grant from ABC Inc., resulting in each employee's netting the entire $750.
In comparing the two above examples, ABC Inc.'s using the employee qualified disaster relief payment program in lieu of bonus payments results in a total net savings to the company of $3,265 (or $326.50 per employee). Each employee nets $750 through the grant program instead of only $703.50 after employment and income taxes on the bonus payments, resulting in a per-employee increase of $46.50. Remember this assumed a 22% income tax bracket for all employees, but for employees in higher income tax brackets the savings would be even greater. Therefore, by using the employee qualified disaster relief payment program instead of giving assistance bonus payments, the employer spends less and the employees receive more — a proverbial "win-win."
The employee qualified disaster relief payment program
The language of Sec. 139 is very succinct and there are no regulations interpreting it to provide any additional guidance. Interestingly, no formal written plan is required to provide an employee qualified disaster relief program. However, it is still highly recommended to have a written program along with an employee acknowledgment and certification. As a preliminary step, the employer should determine who will be eligible to participate in the program and how it will determine the "reasonable assistance" to be granted to each employee. Sec. 139 does not limit the amount of a grant under the program, but the grant must be reasonable based on the circumstances (which includes taking into account the duration of the disaster).
Additionally, the program should specify the qualifying disaster and applicable time period, as well as explain the kind of expenses that are included and excluded from the program. The employee acknowledgment and certification should provide: (1) the amount being requested, (2) a representation of eligibility to participate in the program, (3) a statement that the grant request consists only of necessary and qualifying expenses under the program, and (4) an agreement by the employee to be bound by the terms of the program. Employers need not require any actual proof or documentation from employees aside from the aforementioned recommended signed employee acknowledgment and certification (Joint Committee on Taxation, Technical Explanation of the "Victims of Terrorism Tax Relief Act of 2001" (JCX-93-01) (Dec. 21, 2001)). Employers would be wise to consult with their legal advisers before attempting to implement a program qualifying under Sec. 139.
Educational assistance payments
Sec. 127 — Educational assistance CARES Act change
Under Sec. 127, an employee may generally exclude from gross income any amounts paid or expenses incurred, up to $5,250, by an employer for educational assistance to the employee, subject to a number of requirements for eligibility (Sec. 127(a)). "Educational assistance" historically included the employer's payment of expenses incurred by or on behalf of an employee for education (such as tuition, fees, books, supplies, and equipment), or the employer's provision of education to an employee (including books, supplies, and equipment) (Sec. 127(c)(1)).
However, "educational assistance" does not include tools or supplies (other than textbooks) that the employee may retain after completing a course; meals, lodging, or transportation; or education involving sports, games, or hobbies, unless required as part of a degree program (Regs. Sec. 1.127-2(c)(3)).
Section 2206 of the CARES Act expanded the definition of "educational assistance" to include payments made after March 27, 2020, by an employer to an employee or lender for principal or interest on an employee's qualified education loan during the year 2020.
The inclusion of qualified education loans in an educational assistance program provides a tax benefit to both the employee and the employer. If the employer makes any payments under an employee educational assistance program, then the employee may claim an exclusion of up to $5,250. The $5,250 would not be included in gross income, so the employee would save money on income tax. Additionally, this amount would not be considered wages subject to employment tax, which would provide savings for the employer and employee.
How the educational assistance program benefit works
XYZ Inc. would like to give an extra $6,000 to an employee. The cost to XYZ Inc. would be $6,000 for the bonus payment to the employee. XYZ Inc. will also pay $459 to cover its one-half share of the employment taxes, while the employee will pay $459 to cover his or her one-half share. The total cost and corresponding business deduction to XYZ Inc. is $6,459. Assuming the employee is in a 22% income tax bracket, then the employee will pay $1,320 for income taxes. The net amount after taxes to the employee is $4,221.
Modifying the above example, assume XYZ Inc. instead offers an employee educational assistance program. XYZ Inc. pays $5,250 to or for an employee for purposes of tuition reimbursement or toward principal or interest on an existing student loan. XYZ Inc. would not have to pay any employment tax despite remaining eligible to deduct the payment as a business expense of the company. The employee would not incur any employment tax or income tax on the payment from XYZ Inc., resulting in the employee's netting the entire $5,250.
In comparing the two above examples, XYZ's using the employee educational assistance program in lieu of bonus payments results in a total net savings to the company of $1,209. The employee nets $5,250 through the education program instead of only $4,221 after employment and income taxes on the bonus payments, resulting in the employee receiving an extra $1,029. Therefore, by using the employee educational assistance program instead of giving bonuses, the employee receives more while the employer spends less.
Employee educational assistance program requirements
To qualify for the exclusion, the employer must have an educational assistance program in a separate written plan for the exclusive benefit of its employees. The plan must benefit employees who qualify under a classification the employer sets up. Reasonable classifications for the program could include job categories, type of compensation, length of service, or geographic location of employees. Unlike Sec. 139, an employer educational assistance program must contain a nondiscrimination requirement, meaning the program cannot be discriminatory in favor of officers, shareholders, highly compensated employees, or their dependents who are also employees (Regs. Sec. 1.127-2).
Sec. 127(b)(2) excepts employees not in the program who are included in a collective bargaining agreement where educational assistance was part of the bargaining between employee representatives and the employer.
Sec. 127(b)(3) contains a concentration test, stating that not more than 5% of amounts paid or incurred by the employer for educational assistance during the year may be provided for principal shareholders or owners. Additionally, under Sec. 127(b)(4), the program cannot offer the employees a choice between educational assistance and other benefits that would be includible in gross income.
Under Sec. 127(b)(6), the employer must provide reasonable notice of the terms of the program and its availability to employees. The written plan should also include the following terms: eligibility requirements for employees; specific benefits provided under the program (e.g., tuition, fees, costs of books, qualified loan payments, etc.); limitations on benefits such as course completion or grade requirements; terms regarding commencement and cessation of participation in the program; and a procedure for denial and appeal of reimbursement requests.
For employers that already have an educational assistance program in place, the employers can simply add qualified student loan payments to the list of educational expenses that the employers will reimburse for the employees' benefit. Since the qualified loan payments need to be made before Jan. 1, 2021, this opportunity would be most easily implemented for an employer that already has a qualified educational assistance program in place.
Act as soon as possible
Time is of the essence. Employers that have successfully weathered the 2020 storm and are in a position to assist their employees need to act now. With the president's disaster declaration for the COVID-19 pandemic, Sec. 139 has become available to employers across the entire country.
However, the expanded definition of "educational assistance" will sunset (in the absence of new legislation) at midnight on Dec. 31, 2020, thus reverting to only allowing tuition payment or reimbursement and not student loan repayment. Employers looking to avoid squandering these opportunities must be sure to have their programs established, implemented, and grants paid all before Jan. 1, 2021. Interested employers should consult with their legal and tax advisers now about the written programs, the implementation, and the timing for payments.
— Joseph M. Percopo, Esq., LL.M., is a partner and Kathleen M. Hugo, Esq., is an associate, both at Mateer Harbert in Orlando, Fla. To comment on this article or to suggest an idea for another article, please contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.