Rev. Rul. 63-38: Corporate Payments to a Surviving Spouse

When a corporation makes a payment to the surviving spouse of a deceased employee, the tax implications can be complex. The Internal Revenue Service (IRS) provides guidance through Revenue Ruling 63-38, which establishes a framework for determining the true nature of such payments.

The central question is whether the payment constitutes a non-taxable gift or taxable compensation. The analysis is guided by the Supreme Court’s decision in Commissioner v. Duberstein, which established that a gift must be made from “detached and disinterested generosity.” Determining the payor’s primary intent is a question of fact, and Revenue Ruling 63-38 applies these principles to analyze the circumstances of the payment.

Determining the Nature of the Payment

The classification of a payment to a surviving spouse as a gift or compensation hinges on the corporation’s intent. To ascertain this intent, the IRS and courts analyze several factors established in cases like Poyner v. Commissioner, with no single factor being decisive.

One area of focus is whether the corporation had a legal obligation to make the payment. If the company was contractually bound through an employment agreement or an established plan, the payment is almost always treated as compensation. Another factor is whether the deceased employee had been fully compensated for past services, as the payment may be seen as settling that obligation. If the payment amount is linked to the deceased’s salary, it also points toward compensation.

The analysis also considers whether the corporation derived an economic benefit, such as boosting employee morale, which points to compensation. Conversely, payments made directly to the surviving spouse, rather than the deceased’s estate, are more likely to be considered gifts. If the surviving spouse never performed services for the corporation, it strengthens the argument for a gift.

Courts also look at how the company characterized the payment in its records. A board of directors’ resolution that describes the payment as a “gift” to express sympathy carries more weight than one that frames it as “in recognition of past services.” Finally, if the corporation considered the financial needs of the surviving spouse, the payment is more indicative of a gift driven by generosity.

Tax Consequences for the Recipient

The tax outcome for the surviving spouse is a direct result of the gift-versus-compensation determination. If the payment is classified as a gift, it is not considered gross income for the recipient. This means the entire amount is received tax-free, providing direct financial support without an accompanying tax liability. When the facts and circumstances align with this definition, the surviving spouse is not required to report the payment on their income tax return.

On the other hand, if the payment is determined to be compensation, the tax consequences are different. The payment is treated as taxable ordinary income because it is considered a payment for the past services of the deceased employee. The surviving spouse, as the recipient, is responsible for the associated income tax and must report the amount on their tax return. This classification can reduce the net value of the payment, so the recipient must plan for the tax impact.

Tax Consequences for the Paying Corporation

The tax implications for the corporation making the payment are the inverse of those for the recipient. The classification of the payment as either compensation or a gift directly impacts its deductibility as a business expense. This can create a situation where the interests of the corporation and the surviving spouse do not align.

When a payment is classified as compensation, it is considered an ordinary and necessary business expense under Section 162 of the Internal Revenue Code. This allows the corporation to deduct the full amount from its taxable income, provided the total compensation paid for the deceased employee is reasonable. This deduction reduces the corporation’s overall tax liability, making it a financially advantageous treatment for the business.

Conversely, if the payment is determined to be a gift, the corporation’s ability to claim a deduction is severely limited. The Internal Revenue Code restricts the deduction for business gifts to $25 per recipient per year. For any payment of significant value, this means the vast majority would be non-deductible. This limitation makes the “gift” classification unfavorable from the corporation’s tax perspective, as the gesture comes at a higher after-tax cost.

The Importance of Corporate Documentation

Corporate documentation is important for navigating the complexities of these payments. The intent behind the payment, which is the focus of an IRS analysis, is best established through records created when the decision is made. A corporation’s ability to support its chosen tax treatment depends on the clarity of the documents created at the time.

The most important evidence is the minutes from the board of directors’ meeting where the payment was approved. These minutes should explicitly state the motives for the payment. If the corporation intends for the payment to be a gift, the resolution should contain language reflecting this intent. For example, the minutes could state the payment is made “in light of the surviving spouse’s financial needs” and as a “voluntary expression of sympathy.” The resolution should also declare that the payment is not for past services or to induce future services from other employees.

If the corporation intends the payment to be compensation, the documentation should reflect a business purpose. The board resolution might state that the payment is “in recognition of the valuable and loyal past services of the deceased employee” and is intended to be “part of a policy to ensure adequate compensation.” This language frames the payment as an earned benefit, aligning it with the criteria for a deductible business expense.

The board’s documented reasoning serves as the strongest evidence of its intent. This formal record provides a clear and defensible position in the event of an IRS audit, making it more difficult for the IRS to recharacterize the payment. Without such clear documentation, the determination is left to an interpretation of the various factors, creating uncertainty.