Modification of leave donation plan could bring unintended tax consequences
Issue:

Your organization currently has a policy that allows employees to donate accrued paid leave to other employees in need of additional time off. Eligible employees may request surrendered leave for a qualified "medical emergency," the care of a spouse or child in the event of a medical emergency, or extended time off following the death of a parent, spouse or child.

You would like to expand the policy to allow donations to benefit employees who experience "catastrophic casualty losses" due to terrorist attacks, fires or natural disasters. A catastrophic casualty loss would include severe damage to (or destruction of) an employee's primary residence, requiring immediate action to secure the premises. Donated leave would be available only for a limited period following the catastrophic casualty loss.

Can you make this change without triggering taxes for donor employees?

Answer:    

Generally, a taxpayer's assignment of the right to receive compensation for services does not relieve the taxpayer of tax liability for the assigned income. This rule does not apply to bona-fide employer-sponsored (medical) leave-sharing plans or qualified major disaster leave-sharing programs. Under IRS guidance set forth in Rev. Rul. 90-29, amounts paid to an employee under a medical leave-sharing plan are includible in the recipient's gross income as compensation for services, and are "wages" subject to withholding taxes. The donor employee is not subject to income or withholding taxes, but may not claim an expense, loss deduction or charitable contribution for the surrendered leave.

Existing plan. According to a recent IRS ruling, the current policy qualifies as a bona-fide employer-sponsored (medical) leave-sharing plan under Rev. Rul 90-29. As such, payments under the plan are includible in the recipient’s gross income and subject to withholding. The donor employee has no income or withholding tax liability.

Proposed plan. However, according to the IRS, the new provision would disqualify the policy as a medical leave-sharing plan under Rev. Rul 90-29 because it provides recipients with leave for occasions when the employee is facing a "catastrophic casualty loss," which may or may not involve a personal or family medical emergency (and, therefore, is not limited to a qualified medical emergency).

The new policy also fails to meet the requirements of a qualified major disaster leave-sharing plan (as set forth in IRS Notice 2006-59) because it does not limit leave to victims of declared major disasters under Sec. 401 of the Stafford Act or pursuant to 5 U.S.C. 6391.

Despite the altruistic intent, adding the proposed "catastrophic casualty losses" provision into the current medical leave-sharing plan would result in taxation to donor employees. Payments made under the modified policy would be considered “wages” to donor employees and would be subject to withholding taxes.

Cite: IRS Letter Ruling 200720017, May 18, 2007.
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