Taxation of Employee Donated Sick Leave

Even simple acts of kindness, such as donating paid sick leave to co-workers in need, can trigger complex tax requirements.

The IRS recently released Private Letter Ruling 200720017 that sheds light on the federal tax consequences of such donations, highlighting the importance of following specific requirements such as employer-sponsored medical leave-sharing arrangements or qualified employer-sponsored major disaster leave-sharing plans. Absent these arrangements, donating employees could incur income and employment taxes as well as potential gift tax liabilities.

The PLR provides an opportunity to consider these rules.

What is a Private Letter Ruling

We first have to explain what an IRS Private Letter Ruling or PLR is. An IRS private letter ruling is a written statement issued by the IRS that interprets and applies tax laws to a specific set of facts provided by a taxpayer or their representative. This ruling is only binding on the taxpayer who requested it and cannot be relied upon by anyone else.

A private letter ruling can be requested by a taxpayer who needs clarification on a specific tax issue or transaction, and wants to ensure that their proposed tax treatment will be accepted by the IRS. The ruling provides the taxpayer with a clear understanding of how the IRS will apply tax laws to their situation, and can help them avoid potential tax liabilities or penalties.

It is important to note that private letter rulings are not available for all types of tax issues, and there is a fee associated with requesting a ruling. Additionally, a private letter ruling may not be necessary in all cases, and taxpayers should consider consulting with a tax professional to determine if a ruling is appropriate for their situation.

Sick Leave Donation Programs

The requirements for an employee donation for sick leave program can vary depending on the policies of the employer and the specific program. However, some common requirements for such programs may include:

1. Eligibility criteria: Employers may establish eligibility criteria for employees who wish to participate in the program. For example, an employee may be required to have a certain number of hours of accrued sick leave before being eligible to donate or receive donated sick leave.
2. Donation limits: Employers may set limits on the amount of sick leave that can be donated or received by an employee. These limits may be based on the total number of sick leave hours an employee can accrue, or a maximum amount that can be donated or received within a specific period of time.
3. Approval process: Employers may require an approval process for employees who wish to donate or receive sick leave. This may involve submitting a request to a supervisor or HR representative, or following a specific process outlined in the program guidelines.
4. Use restrictions: Employers may establish restrictions on how donated sick leave can be used. For example, donated sick leave may only be used for a specific medical condition or for a specific period of time.
5. Confidentiality: Employers may establish confidentiality requirements to protect the privacy of employees who donate or receive sick leave. This may involve keeping the names of donors and recipients confidential, or requiring employees to sign a confidentiality agreement.

These are some common requirements for employee donation for sick leave programs, but it’s important to check with the specific employer to understand the requirements of their program.

Income Tax on Donations of Sick Leave

The federal tax consequences of donating paid sick leave depends on whether the donation is made through the employer or directly from the employee. It also depends on whether the recipient employee or a third party actually receives the payment.

As the recent IRS ruling explains, where employees forfeit paid sick leave to the employer and the employer credits the recipient employee with the donated sick leave, the payments will only be considered taxable income to the recipient employee (for both federal income and employment taxes). This tax treatment only applies where the transfer is made pursuant to an “employer-sponsored medical leave-sharing arrangement” or a “qualified employer-sponsored major disaster leave-sharing plan.”

These plans have a few specific requirements. For example, as the recent IRS ruling notes, the latter type of plan only covers transfers of paid sick leave that are made pursuant to a Presidential-declared disaster. Payments associated with a major disaster that is not made pursuant to a Presidential-declared disaster do not qualify.

Gift Tax Liability on Donation of Sick Leave

While not addressed in the IRS rulings, presumably donations made pursuant to these plans will not trigger a gift tax liability for the donating employee.

Absent one of these arrangements or plans, the “assignment of income” doctrine specifies that the donating taxpayer is subject to both federal income and employment taxes on sick leave that is donated to recipient employees. The donating employee could also incur a gift tax liability for the transfer.

This would be similar to the scenario where the donating employee simply wrote a check to the recipient employee; however, the donating employee may be able to avoid a gift tax on a direct transfer if they make the payment directly to a hospital or medical provider (and the payment is applied to qualified medical expenses).

The Non-Profit Entity Option

A better option might be to create a separate non-profit entity to handle these types of donations.

With the non-profit, employees might be able to offset their income tax obligation with a charitable tax deduction (assuming that they do not run into an alternative minimum tax situation and/or their itemized deductions are not phased out due to the amount of their adjusted gross income) and there would probably be no gift tax consequences.

This option could have the added benefit of avoiding the restrictions imposed by the “medical leave-sharing arrangement” and “major disaster leave-sharing plan” and the qualified medical expense limitation for the gift tax exclusion.

Non-Tax Considerations

There are non-tax implications that have to be considered as well. For example, in McGinnis v. Allianz Life Ins. Co. of North America, 77 F. Supp. 2d 1297 (N.D. Ga. 1999), the taxpayer was disabled and out of work but was still receiving pay as she received donated sick time from her co-workers. She contended that she could take advantage of the exception to the pre-existing condition exclusion as she was still working. She argued that her work did not end when she actually stopped working given the continued pay. The court did not agree, but it came down to an interpretation of state law.

The Ramos-Borges v. Commonwealth of Puerto Rico, 740 F. Supp. 2d 262 (D.P.R. 2010), case provides another example of a non-tax issue. The plaintiff in that case was donated leave from co-workers, but the employer denied the request. The plaintiff argued that the employer did this to prevent her from getting a salary to encourage her to resign from her position.

These cases highlight the type of non-tax issues that have to be considered with these arrangements.

The Takeaway

This PLR sheds light on the federal tax consequences of donating sick leave, highlighting that it only applies when done through employer-sponsored medical leave-sharing arrangements or qualified employer-sponsored major disaster leave-sharing plans. Additionally, it is important to note that employees could incur a gift tax liability if they donate sick leave outside of these arrangements or plans, unless they create a separate non-profit entity to handle the donations. As with any tax-related matter, it is always best to consult with a tax professional to determine the best course of action for your specific situation.