Revenue Ruling 63-27: Gift or Compensation?

When an employer makes a voluntary payment to the surviving spouse of a deceased employee, it creates a complex tax situation. The central question is whether the money constitutes a nontaxable gift or taxable compensation. This determination dictates how the payment is reported, whether taxes are owed, and depends on the specific facts surrounding the payment.

Determining the Nature of the Payment

The Internal Revenue Service (IRS) and the courts rely on a set of factors to determine the payment made to a deceased employee’s survivor. These standards are largely derived from the principles established in the Supreme Court case Commissioner v. Duberstein, which focused on the payor’s intent. The core of the inquiry is whether the payment was made out of “detached and disinterested generosity” or for business-related reasons. A payment is more likely to be considered a gift if it is made directly to the surviving spouse rather than to the deceased employee’s estate.

A consideration is whether the employer had any legal or contractual obligation to make the payment. If the company was not required to pay the amount under an employment contract, corporate policy, or other agreement, the payment leans toward being classified as a gift. The analysis also examines whether the employer gained any economic benefit from making the payment. If the primary motive was to address the financial needs of the surviving spouse, it supports the characterization of the payment as a gift.

Conversely, certain factors point toward the payment being compensation. If the amount is calculated based on the deceased employee’s past services or is tied directly to their former salary, it suggests a compensatory nature. The IRS will also look at whether the surviving spouse performed any services for the employer, as payments for services are inherently income. No single factor is decisive, as the classification depends on the employer’s intent based on all the facts.

Tax Consequences for the Recipient

If the payment is determined to be a gift, it is excludable from the recipient’s gross income under Internal Revenue Code (IRC) Section 102. However, the tax code explicitly states that this gift exclusion does not apply to amounts transferred by an employer to an employee.

While the payment here is to a surviving spouse, this rule creates a strong presumption that payments made in an employment context are compensatory. To overcome this, the payment must be shown to stem from the employer’s “detached and disinterested generosity” rather than from any business motive. If this standard is met, the surviving spouse receives the entire amount tax-free and does not need to report it as income.

If the payment is classified as compensation, the full amount is considered taxable income to the recipient under IRC Section 61. The employer will report this payment to the IRS and the recipient on Form 1099-MISC in Box 3 as “Other Income.” The surviving spouse must then include this amount in their gross income and pay the corresponding income taxes.

Tax Consequences for the Employer

The employer’s ability to deduct the payment is governed by a separate set of rules under IRC Section 162, which allows deductions for “ordinary and necessary” business expenses. The tax treatment for the employer does not have to align with the tax treatment for the recipient. An employer can, in some circumstances, deduct a payment that the recipient receives as a tax-free gift.

If the payment is classified as compensation, the employer can deduct the full amount, provided it is considered a reasonable expense.

For payments that are excludable from the recipient’s income as a gift, the employer’s deduction is limited by IRC Section 274. This section caps the business gift deduction at $25 per recipient for the entire taxable year. If an employer makes a $10,000 payment that is successfully treated as a gift by the surviving spouse, the company can only deduct $25 of that amount. This limitation often influences an employer’s willingness to characterize such payments as gifts, as the financial benefit of a full compensation deduction is substantial.