Companies considering setting up an employee emergency assistance fund should be aware of potential tax pitfalls and take steps to minimize any gap between how they operate their fund and the guidelines and regulations (imagine this as a regulatory gap). The IRS has very specific regulations which provide tax exemption for both the fund in question and employees receiving grants. However, failure to comply with these rules can result not only in the IRS denying tax exemption, but an additional excise tax for engaging in prohibited transactions. Conducting periodic audits of the fund, application and grant processes and regulatory compliance may help reduce a fund’s regulatory gap.
A 2009 IRS private letter ruling illustrates how poor planning can create tax problems for employee emergency assistance funds. The company in question, a defense contractor, attempted to set up a tax exempt private foundation to provide financial aid to the families of individual contractors who were injured or killed on the job. However, the IRS denied a 501(c)(3) exemption, for a number of reasons.
First, the company did not have the requisite exempt purpose, because it had no general beneficial effect on the public – the class of beneficiaries was essentially limited to employees and their families. Further, because the private foundation was funded and run by the company, it controlled both the source and dispensation of funds. This created a substantial private benefit to the company, because it was a “significant employment benefit.” As a result, the company exposed itself to potential excise taxes, because it used the foundation’s assets to benefit itself. This self-dealing is prohibited, except where there is a specific federally recognized “qualified disaster” where payments are considered to have a charitable purpose.
How can companies wanting to set up similar funds avoid these problems? First, companies should consider setting up a public charity instead of a private foundation. These charities must be independent from the company, and must receive funding from a variety of sources. However, the benefit of a public charity is that it may provide tax-free assistance to employees effected by a broad range of hardships, not just “qualified disasters.” If the company does decide on a self-funded private foundation for employee assistance, it should be sure only to impartially provide financial aid to employees demonstrably effected by “qualified disasters.”