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Jun 2007
13
June 13, 2007

The Tax Consequences of Employee Leave Donation Programs

Employee leave donation programs are popular among public sector employers, and increasingly private companies are creating systems for employees to donate their paid leave for the benefit of other employees. The tax consequences of such programs, however, are a key consideration for employers.

The basic principle of tax law dictates that income for services is taxed to the person who earned it. Say, for example, employee Joe is entitled to a $500 paycheck at the end of the month, but tells his employer, "instead of paying me that $500, send the check directly to my coworker, Sally." While Joe never saw a penny of that $500, in the world of tax law it is considered Joe's income and taxable to Joe.

The same rule generally applies if, instead of transferring $500 directly, Joe decides to donate his paid time off to Sally. If Sally is ill for an extended period of time and has exhausted her sick days, and Joe tells Sally, "I have a couple of extra paid sick days, just use mine," under general tax rules, any pay that Sally receives from using Joe's sick days will be taxable to Joe.

Can this be avoided? Yes, but you have to follow some IRS rules.

The IRS offers exceptions for employer-sponsored, leave-donation programs. The first allows for "bona fide leave-sharing arrangements" for medical emergencies, while the second covers leave banks for natural disasters.

Leave donated under circumstances that do not meet the requirements of either of the two exceptions will ordinarily be taxed to the donor employee, and will also be considered the donor employee's wages for employment tax purposes.

Medical Emergencies

Under the medical emergencies exception, the amounts received are not taxable to the donor, and are considered "wages" of the recipient for purposes of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and income tax withholding, unless excluded by a specific provision of the Internal Revenue Code. The leave donor may not claim an expense, charitable contribution, or loss deduction for any leave donated.

This raises the question of what exactly is a "bona fide employer-sponsored leave-sharing arrangement?" The IRS has not explicitly defined such an arrangement, but has provided some guidance by way of example.

Based on IRS recommendations, the leave-sharing arrangement for medical emergencies should:

  • Be in writing, established and administered by the employer.

     
  • Create a leave bank for employees to deposit their donated leave to, from which the leave will be distributed to the employees who request it. A "one-on-one" plan, where one employee directs donated leave to a particular employee, is more likely to be viewed as income to the donor employee, followed by a gift to the recipient. The safest route is to create rules regarding the manner in which surrendered or deposited leave will be granted to eligible recipients.

     
  • Specify that leave is to be used only for medical emergencies, which should be restricted to a major illness or medical condition of the employee, or family member of the employee, that requires a prolonged absence. This may include intermittent absences related to the same illness or condition. The IRS also has approved plans that include extended time off following the death of a parent, child, or spouse.

     
  • Have a procedure in place for employees to apply for leave, in writing, describing the medical emergency or condition. The employee should be eligible to receive leave from the bank only after the application is approved and the applicant has exhausted all paid leave. Any leave received by the employee should be paid at the employee's normal rate of compensation. Donated leave may be converted to reflect differences in pay rates. For example, if the donor employee is regularly paid $15 per hour and donates eight hours to the leave bank, and the recipient is ordinarily paid $10 per hour, the recipient will receive 12 hours of leave at $10 per hour.

     
  • Restrict eligibility under the plan to employees requesting leave for "medical emergencies." In a recent private ruling the IRS found a plan that allowed employees suffering "catastrophic casualty losses" due to terrorist attack, fire, or other natural disaster to be outside the scope of a qualified medical emergency leave program.

     
  • Specify any limits on the amount of paid leave time that may be surrendered by a given donor per year. The employer will want employees to have a certain amount of leave available for their own illnesses or uses before donating to a leave bank.

     
  • Make sure the leave transferred under the donation plan is actually used as medical leave by the recipient. If the program simply liquidates the donated leave and pays cash to the recipient, it will not be viewed as a qualified medical emergency leave program.

Disaster Plan

To shift the tax liability from the donor to the recipient, the "major disaster leave-sharing plan" must be in writing and meet these requirements:

  • The plan allows a donor to deposit accrued leave in an employer-sponsored leave bank for the use of other employees who have been "adversely affected by a major disaster," which means the disaster has caused severe hardship to the employee or family members of the employee, and requires the employee to miss work.

     
  • The plan does not allow a leave donor to specify a leave recipient.

     
  • The amount of leave a donor may donate in any given year may not exceed the maximum amount of leave that he or she normally accrues during the year.

     
  • A leave recipient may receive paid leave (at the recipient's normal rate of pay) from leave deposited in the bank. The leave must be used for purposes related to the natural disaster.

     
  • Based on the severity of the disaster, the plan places a reasonable limit on the period of time after the disaster occurs when time can be donated and used.

     
  • A recipient may not convert leave received under the plan directly into cash instead of using the leave. However, a recipient can use leave received under the plan to eliminate a negative leave balance that exists because of the natural disaster. A recipient may also substitute leave received under the plan for leave without pay used because of the disaster.

     
  • The employer must make a need-based reasonable determination as to how much leave each recipient may receive under the leave-sharing plan.

     
  • Leave deposited for one major disaster may be used by only employees affected by that disaster. Leave deposited in the bank that is not used by the end of the specified period must be returned to the donors.

This tax-shifting exception applies only to leave-sharing plans that are established for major disasters as declared by the President of the United States.

Like medical emergency plans, the leave donor under the major disaster plan may not claim an expense, charitable contribution, or loss deduction for any leave donated. Also, the payments to the recipient under the plan are treated as the recipient's "wages" for purposes of FICA, FUTA, and tax withholding, unless otherwise excluded under the Internal Revenue Code.

It is important to avoid adverse tax consequences for a donor employee under a leave-sharing program, and for an employer to know which employee receives taxable wages. If the program properly fits within one of the two exceptions, the tax liability will be effectively shifted from the donor to the recipient. While the "medical emergencies" exception seems to cover most employer-sponsored plans for medical leave donation, following the guidelines set forth above should help ensure that the plan does not face IRS scrutiny.

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