Revenue Ruling 71-37: Gift or Compensation?
A payment from a corporation to a deceased employee's spouse has complex tax considerations. The final treatment depends on the company's established motive.
When a corporation makes a payment to the surviving spouse of a deceased employee, the tax implications hinge on whether it is a gift or compensation. This classification directly impacts the tax treatment for both the company and the spouse. The framework for this determination stems from the Supreme Court’s decision in Commissioner v. Duberstein and subsequent tax law changes.
Determining the Nature of the Payment
The Internal Revenue Service (IRS) evaluates several factors to ascertain the true nature of a payment to a deceased employee’s spouse, as no single factor is decisive. The conclusion rests on a comprehensive review of the facts and circumstances surrounding the payment to uncover the corporation’s primary motivation.
A primary consideration is whether the payments were made directly to the surviving spouse and not to the deceased employee’s estate. A payment to the estate is more likely to be viewed as a settlement of obligations, such as for unpaid salary. The analysis also examines if the corporation had a legal obligation to make the payment, as a pre-existing contractual duty points toward compensation. Similarly, the absence of an established company policy for making such payments can support the argument for a gift.
The financial condition of the surviving spouse is another element. Payments made in light of a spouse’s financial need are more indicative of generosity. The IRS also looks at whether the spouse performed any services for the corporation, as payments for services are inherently compensatory. Furthermore, if the corporation does not derive any direct economic benefit from the payment, it strengthens the case for a gift. Finally, the method for calculating the payment is scrutinized; if the amount is tied to the deceased employee’s salary, it suggests a compensatory motive.
Tax Consequences for the Recipient
The classification of the payment has significant tax consequences for the surviving spouse. While Internal Revenue Code (IRC) Section 102 excludes gifts from gross income, this exclusion does not apply to amounts transferred by an employer to an employee’s beneficiaries. This creates a strong presumption that such payments are taxable compensation, making it difficult to classify them as excludable gifts.
If the payment is classified as compensation for the past services of the deceased employee, the amount is considered taxable income to the recipient. This income is reported in Box 3 (“Other income”) of Form 1099-MISC. This amount is subject to ordinary income tax rates.
Tax Consequences for the Corporation
The corporation’s tax treatment of the payment also diverges based on its classification. If the payment is deemed compensation for past services, the corporation can deduct the full amount as an ordinary and necessary business expense.
Should the payment be classified as a gift, the corporation’s ability to take a deduction is restricted. The deduction for business gifts is limited to a maximum of $25 per recipient for the entire taxable year. The significant difference between a full deduction and a nominal $25 deduction often influences how a corporation might prefer to classify the payment.
Establishing Corporate Intent
A corporation can proactively shape the interpretation of a payment by carefully documenting its intent at the time the payment is authorized. The most effective tool for this is a formal resolution from the Board of Directors. This document should be created contemporaneously with the decision to make the payment, not retroactively, to serve as credible evidence of the company’s motives.
The language of the resolution is paramount. To support a gift classification, the resolution should explicitly state that the payment is being made out of motives such as sympathy, generosity, and concern for the spouse’s financial well-being. It should avoid any language that connects the payment to the deceased employee’s service, refers to it as a bonus, or suggests it is a form of deferred compensation. However, even with a carefully worded resolution, overcoming the strong legal presumption that the payment is compensation remains a significant challenge.