FAQs About COVID-19 Tax-Free Disaster Relief Payments

Kirsch CPA Group

Dec 17, 2020

Many people are struggling to make ends meet during the COVID-19 pandemic. Fortunately, some individuals qualify for federal-income-tax-free disaster relief and disaster mitigation payments paid by some employers under Internal Revenue Code Section 139. Here are some FAQs and answers about how the rules work.

Is COVID-19 Pandemic a Qualified Disaster?

The Internal Revenue Code defines the term “qualified disaster” to include any federally declared disaster, which means any disaster determined by the President of the United States to warrant federal assistance under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. On March 13, 2020, President Trump declared the COVID-19 crisis a national emergency, effective as of March 1.

Any amount received by an individual as a Sec. 139 qualified disaster relief payment is federal-income-tax-free. Such payments are also exempt from federal payroll taxes and the federal self-employment tax because they don’t count as wages, compensation or self-employment income. For purposes of this article, we’ll call these qualified disaster relief payments “Sec. 139 payments.”

In the context of the COVID-19 crisis, a Sec. 139 payment is any amount paid to or for the benefit of an individual:

1. To reimburse or pay reasonable and necessary personal, family, living or funeral expenses incurred as a result of the COVID-19 crisis,

2. To reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or the repair or replacement of its contents — to the extent the need for the repair, rehabilitation or replacement is attributable to the COVID-19 crisis. For example, such expenditures might be necessary to detoxify a residence after COVID-19 contamination due to quarantined individuals staying there.

3. By a federal, state, or local government, or agency or instrumentality thereof, in connection with the COVID-19 crisis in order to promote the general welfare.

The following limitations apply to the tax-free treatment of disaster relief payments:

Tax-free Sec. 139 payments don’t include payments for expenses that are compensated by insurance or otherwise.
No federal income tax deduction or credit is allowed to the person for whose benefit a tax-free Sec. 139 payment is made for an expenditure covered by such payment.
Presumably, tax-free Sec. 139 payments don’t include payments by a governmental agency for income replacement, such as state unemployment compensation benefits, because those would be considered payments covered by insurance.

Can Payments to Employees Qualify for Tax-Free Treatment?

Payments to an employee that meet the definition of Sec. 139 qualified disaster relief payments aren’t subject to federal income tax or federal employment taxes. As such, they need not be reported on the recipient employee’s Form W-2. Employers can deduct Sec. 139 payments to employees as ordinary and necessary business expenses.

In guidance issued in 2003, the IRS concluded that payments under an employer’s program to pay or reimburse employees for reasonable and necessary unreimbursed medical, temporary housing and transportation expenses incurred as a result of a flood disaster met the definition of tax-free Sec. 139 payments. The same logic should apply in the context of the COVID-19 pandemic.

For payments to an employee to be tax-free Sec. 139 payments, they must be made:

1. To reimburse or pay for the employee’s reasonable and necessary personal, family, living or funeral expenses incurred as a result of the COVID-19 crisis, or

2. To pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or the repair or replacement of its contents — to the extent such expenses are attributable to the COVID-19 crisis.

Observation: It appears that employer payments to cover employee costs to set up and operate a home office should qualify as tax-free Sec. 139 payments.

Payments intended to simply replace the employee’s income or for expenses that are covered from insurance won’t qualify for tax-free treatment. Any nonqualified payments are treated as garden-variety taxable employee compensation unless some other tax-law provision dictates otherwise.

Therefore, employers that want to make tax-free Sec. 139 payments to employees should consider adopting a written plan outlining when an employee is eligible for the payments and limiting them to reasonable, necessary unreimbursed expenses incurred as a result of the COVID-19 crisis.

Do Disaster Mitigation Payments Qualify for Tax-Free Treatment?

Sec. 139 qualified disaster mitigation payments are eligible for the same tax-free treatment as Sec. 139 qualified disaster relief payments. A qualified disaster mitigation payment means any amount paid pursuant to the Robert T. Stafford Disaster Relief and Emergency Assistance Act to or for the benefit of a property owner for hazard mitigation with respect to the property.

The following rules and restrictions apply to Sec. 139 disaster mitigation payments:

Any amount for the sale or disposition of property doesn’t count as a qualified disaster mitigation payment.
No increase in the tax basis of any property is allowed for any amount that’s treated as a tax-free Sec. 139 qualified mitigation payment.
No federal income tax deduction or credit is allowed to the person for whose benefit a tax-free Sec. 139 qualified mitigation payment is made for an expenditure covered by such payment.

Can Payments from Charitable Organizations Qualify for Tax-Free Treatment?

Payments from charitable organizations to individuals affected by the COVID-19 pandemic may not qualify as Sec. 139 payments. However, IRS guidance issued in 2003 indicates that a charitable organization’s payments to cover an individual’s unreimbursed medical, temporary housing or transportation expenses incurred as a result of the COVID-19 crisis should be eligible for the federal-income-tax-free treatment that applies to gifts.

Under the same logic, charitable organization payments to cover other reasonable and necessary unreimbursed expenses incurred by individuals affected by the COVID-19 crisis would also apparently qualify for tax-free treatment.

Need Help?

Any kind of financial relief, including tax relief, is valuable during the COVID-19 emergency. The tax-free treatment of Sec. 139 qualified disaster relief and disaster mitigation payments can help individuals stay afloat during these difficult times. Kirsch CPA Group can help you to identify relief that is eligible for tax-free treatment under Sec. 139 and assist you in applying for such relief. Contact Kirsch CPA Group at 513.858.6040.