Tax Considerations in Implementing Donated Leave Policies

In light of recent natural disasters, employers may be looking for additional low-cost programs to assist employees affected by such events. “Donated leave,” “leave-sharing,” or “voluntary shared leave” programs or policies are employee benefits that employers may offer. Generally, a donated leave program allows an employee to donate accrued hours of paid vacation, personal, or sick leave to benefit other employees who need more leave than they have available. However, an employee’s good intentions may have negative unintended consequences.  

The Internal Revenue Service has issued little guidance concerning the implementation and operation of donated leave programs. Employers interested in establishing such a program should be aware that unless their donated leave program meets certain requirements, the tax implications of such a program could be confusing and unexpected for employees.  

General Tax Rules for Leave-Sharing Plans 

Federal tax law provides that income for services is taxed to the person who earned it. For example, if Employee A earns $500 for their work during a specific week, they will be taxed on that $500. Alternatively, suppose Employee A requests that their employer pay the $500 directly to a co-worker instead. In that case, tax law dictates that even though Employee A never received the $500 that they earned, the $500 is still taxable to Employee A. 

The same rule applies if, instead of transferring the $500 directly to the co-worker, Employee A donates their earned paid time off to a co-worker. Consequently, if the co-worker is sick for an extended period and has exhausted their PTO, and Employee A tells them, “I have extra PTO, just use mine,” under general tax principles, any pay that the co-worker receives from using Employee A’s PTO will be taxable to Employee A and not to the co-worker who received the extra PTO.  

Exceptions to the General Tax Rules 

The IRS offers exceptions for employer-sponsored leave-donation programs. The first exception allows for “bona fide leave-sharing arrangements” for medical emergencies, while the second exception covers leave banks for natural disasters. Leave donated under circumstances that do not meet the requirements of either of these two exceptions will ordinarily be taxed to the employee donating the leave and will also be considered the donor employee’s wages for employment tax purposes.  

Medical Emergencies Exception 

An employer-sponsored leave-sharing program may permit an employee to donate unused paid leave to another employee in the event of a medical emergency. Under IRS Revenue Ruling 90-29, a medical emergency is defined as “a medical condition of the employee or a family member that will require the prolonged absence of the employee from duty and will result in a substantial loss of income to the employee because the employee will have exhausted all paid leave available apart from the leave-sharing plan.” 

Under this exception, the amounts received are not taxable to the employee donating the leave 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 employee donating the leave may not claim an expense, charitable contribution, or loss deduction for any leave donated.  

The IRS has provided guidance on what constitutes a bona fide employer-sponsored leave-sharing arrangement under the medical emergency exception. To be valid, a leave-sharing program should:  

• Be in writing and be administered by the employer. 

• Be created as a “leave bank” into which employees may deposit their donated leave and from which the leave will be distributed to the employees who request it. 

• 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. The IRS has also approved plans that include extended time off following the death of a parent, child, or spouse. 

• Have a procedure for employees to make a written application for leave, which describes the medical emergency or condition. The employee should be eligible to receive leave from the bank only after the application has been approved and the applicant has exhausted all available paid leave. Any leave received by the employee through the program should be paid at the employee’s normal rate of compensation. 

• Specify limits, if any, on the amount of paid leave time that may be surrendered annually by a given donor. 

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

Major Disaster Exception 

Employees may also draw from an employer-sponsored leave bank if the employee experiences a “major disaster.” A “major disaster” is defined by the IRS as:  

1. A disaster declared by the President under §401 of the Stafford Act that warrants individual assistance or individual and public assistance from the federal government;
2. or  major disaster or emergency, as declared by the President, pursuant to §501 of the Stafford Act.  

Disasters declared by state or local authorities do not meet the definition of a “major disaster” for purposes of this exception. As with medical emergency programs, the employee donating under the major disaster program may not claim an expense, charitable contribution, or loss deduction for any leave donated. Also, the payments to the recipient under the program are treated as the recipient’s wages for purposes of FICA, FUTA, and tax withholding unless otherwise excluded under the Internal Revenue Code.  

To shift the tax liability from the donor to the recipient, a major disaster leave-sharing program must be in writing and meet the following requirements:  

• The program allows a donor to deposit accrued leave into 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 program does not allow the employee donating leave to specify the leave recipient. A leave recipient may receive paid leave at the recipient’s standard pay rate from leave deposited in the bank. The leave must be used for purposes related to the specified natural disaster. 

• The maximum annual amount of leave a donating employee may donate cannot exceed the maximum amount of leave they normally accrue during the year. 

• The program places a reasonable limit on the period of time after the disaster occurs during which leave can be donated and used, based on the severity of the disaster.   

• A recipient may not receive cash instead of using the paid leave received.  

• The employer must reasonably determine the amount of leave a recipient may receive. 

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

State-Specific Considerations 

The types of leave that an employee may donate generally vary from state to state, as states have different rules regarding an employee’s right to various kinds of leave, whether it is accrued, earned, or unearned, or whether it is vacation pay, sick pay, or the catch-all paid time off. Thus, an employer must be aware of what leave may be donated in each state in which it operates in order not to run afoul of state law. 

Avoiding Adverse Tax Consequences  

Employers must understand and avoid adverse tax consequences to a donor employee under a leave-sharing program and know which employees receive taxable wages in such events. If the program properly fits within one of the two exceptions, the tax liability will be effectively shifted from the donor to the recipient.