Revenue Ruling 65-31: Corporate Payment Tax Rules
Learn how corporate intent shapes the tax treatment of payments to a deceased employee's family, defining the consequences for both the business and recipient.
Revenue Ruling 65-31 provides a framework for the tax implications of payments made by a corporation to the widow or estate of a deceased employee-shareholder. This guidance from the Internal Revenue Service (IRS) is used to determine the correct tax treatment for both the company making the payment and the individual receiving it. The ruling’s purpose is to establish whether such a payment is a gift, a form of deferred compensation, or a dividend distribution. This classification dictates the subsequent tax obligations and potential deductions.
Determining the Nature of the Payment
The core of Revenue Ruling 65-31 lies in determining the corporation’s primary motivation for making the payment, as the payer’s intent is the controlling element. The IRS scrutinizes several factors to classify the payment as deferred compensation for past services, a dividend to a shareholder, or a gift. This analysis focuses on the economic substance of the transaction rather than the labels used by the corporation.
A primary consideration is whether the payment was made according to an established plan or policy. If a corporation has a history of making such payments or a formal, written plan is in place, the IRS is more likely to view the payment as deferred compensation. This suggests the payment is not a spontaneous act of generosity but rather an expected benefit connected to employment.
Another factor is the connection between the payment and the deceased’s stock ownership. If the payment amount is proportional to the number of shares held by the deceased’s estate, it points toward a disguised dividend. The IRS will examine whether non-shareholder employees’ surviving spouses receive similar benefits to distinguish between shareholder distributions and other types of payments.
The deliberations of the corporation’s board of directors are also subject to review. The minutes of the board meeting where the payment was approved can provide direct evidence of intent. If the discussion centered on the financial needs of the widow or was framed as an act of sympathy and respect, it supports the classification of the payment as a gift.
Corporate Tax Implications
The tax outcome for the paying corporation hinges on the payment’s classification. If the payment is determined to be additional compensation for the past services of the deceased employee, it is generally considered an ordinary and necessary business expense. As such, the corporation can typically deduct the full amount on its federal income tax return under Internal Revenue Code Section 162, provided the total compensation is reasonable.
If the payment is classified as a dividend, it is not deductible for the corporation because it is a distribution of after-tax profits. Similarly, if the payment is characterized as a gift, the corporation cannot deduct it as a business expense. While businesses can deduct certain gifts, the low annual limit per recipient under Section 274 makes the deduction for a substantial payment negligible.
Recipient Tax Implications
For the widow or estate receiving the funds, the tax consequences depend entirely on the payment’s classification. If the payment is deemed to be compensation for the decedent’s past services, it is fully taxable to the recipient as ordinary income. A small death benefit exclusion was repealed for deaths after August 20, 1996, so such payments are now treated like wages and must be reported.
A payment classified as a dividend is also considered taxable income for the recipient. The widow or estate would report this as dividend income. Depending on whether the dividends are qualified or non-qualified, they may be taxed at preferential long-term capital gains rates or at ordinary income rates.
The most favorable outcome for the recipient occurs if the payment is classified as a gift. Under Internal Revenue Code Section 102, a true gift is excludable from the recipient’s gross income, meaning no federal income tax is owed on the amount received. The recipient does not need to report the value of the gift as income.
Essential Documentation and Formalities
To support the intended tax treatment of a payment to a deceased employee’s survivor, a corporation must maintain meticulous records. The most important piece of documentation is the official minutes from the board of directors’ meeting where the payment was authorized. These minutes should explicitly state the board’s intent and the basis for the payment.
This contemporaneous documentation is the strongest evidence a corporation can present to the IRS. Phrases like “in recognition of past services” or “as consideration for loyal service” strongly imply the payment is compensation. To support a gift classification, the resolution should avoid any language that suggests the payment is for services rendered.
Establishing a formal, written plan before any payment becomes necessary can also provide clarity, though it often points toward compensation. The absence of a pre-existing plan can strengthen the argument that a specific payment was a spontaneous act of generosity. Clear and consistent documentation is indispensable for defending the chosen tax treatment.