Corporate Payments to a Surviving Spouse: Gift or Income?

When a corporation makes a payment to the surviving spouse of a deceased employee, the central issue is whether the payment constitutes a non-taxable gift or taxable income. This determination hinges on the corporation’s intent, which has direct consequences for the company’s ability to deduct the payment and for the spouse’s tax liability. Guidance from the Internal Revenue Service and court cases provide a framework for this issue. For the corporation, the payment may be a deductible business expense, while for the spouse, it could be a tax-free gift or taxable income.

Corporate Deduction for Payments

A corporation may be able to deduct payments made to the surviving spouse of a deceased employee as an ordinary and necessary business expense under Internal Revenue Code (IRC) Section 162. An “ordinary” expense is common and accepted in the company’s trade or business, and a “necessary” expense is one that is helpful and appropriate for the business. The corporation must demonstrate that the payment serves a legitimate business purpose, such as boosting employee morale or as part of an informal policy to provide for the welfare of employees’ families.

The amount of the payment must also be reasonable. An unreasonably large payment may be reclassified by the IRS, potentially as a disguised dividend, especially in closely held corporations where the surviving spouse may also be a shareholder. Reasonableness is determined by considering the deceased employee’s role, salary, and length of service, as well as the company’s financial condition.

If the primary intent is determined to be “detached and disinterested generosity,” the payment will be classified as a gift. Under IRC Section 274, the deduction for business gifts is limited to $25 per recipient per year. This creates a conflict for the corporation; arguing the payment was a necessary business expense to secure a full deduction makes it more likely the payment will be taxable income to the spouse.

Determining Taxability for the Surviving Spouse

From the surviving spouse’s perspective, the question is whether the payment is a tax-free gift under IRC Section 102 or taxable income. The Supreme Court case Commissioner v. Duberstein established that the corporation’s intent is the deciding factor. A payment is a gift if it proceeds from “detached and disinterested generosity” or out of affection, respect, or charity. A payment made for a business purpose or in expectation of an economic benefit is not a gift.

The IRS and courts analyze several factors to ascertain the corporation’s true intent. Factors that support a payment being classified as a gift include:

• The payment was made directly to the surviving spouse rather than to the deceased employee’s estate.
• The corporation was not contractually bound to make the payment through an employment agreement or established plan.
• The corporation derived no economic benefit from the payment, such as improved employee morale.
• The surviving spouse performs no services for the corporation in connection with the payment.
• The corporation investigated the spouse’s financial situation and tailored the payment to meet those needs.
• The payment was not calculated based on the deceased’s salary or length of service.
• The deceased employee had been fully compensated for all past services.

Documentation and Board Resolution

The corporation’s intent is best established through contemporaneous documentation, with the formal resolution adopted by the board of directors being the most important evidence. This resolution, recorded in the corporate minutes when the payment is approved, serves as the primary record of the company’s motives. A resolution is fundamental to substantiating the tax treatment of the payment for both the corporation and the surviving spouse.

To support the position that a payment is a gift, the board resolution should contain specific language that reflects benevolent intent. For instance, it might state the board’s sympathy and concern for the surviving spouse and note that the board has considered their financial needs. This language directly addresses the factors that courts weigh in determining gift intent.

The resolution should explicitly state that the payment is a voluntary expression of generosity and not made pursuant to any contract, plan, or legal obligation. It is also beneficial to include a statement clarifying that the deceased employee had been fully compensated for all services rendered to the corporation. The concluding clause should formally approve the payment amount and direct it to be paid to the surviving spouse, describing it in terms that align with a gift, such as “a gratuity.”