Tax Treatment of Payments Under Revenue Ruling 79-38

Revenue Ruling 79-38 from the Internal Revenue Service (IRS) provides guidance on payments a corporation makes to the surviving spouse of a deceased employee. This ruling clarifies whether such a payment is a non-taxable gift or taxable compensation. The classification depends on the facts and circumstances, with the corporation’s intent being the primary factor.

Determining the Intent of the Payment

The analysis under Revenue Ruling 79-38 focuses on the corporation’s motive, guided by principles from the Supreme Court case Commissioner v. Duberstein. The Court defined a gift as proceeding from a “detached and disinterested generosity.” In contrast, a payment made for past services or from which the payer expects an economic benefit is considered compensation.

Several factors are examined to uncover the corporation’s intent. A consideration is whether the payment was made directly to the surviving spouse rather than the deceased’s estate. A payment to the spouse may suggest a gift, while a payment to the estate is more indicative of a compensation-related obligation. The existence of a corporate plan for such payments can also point away from a gift.

Another factor is whether the corporation had a legal obligation to make the payment. If the company was contractually bound, the payment is almost certainly compensation, while the absence of an obligation supports a gift. The IRS also considers if the corporation derived any business benefit, such as improved employee morale, from the payment.

The analysis also involves the recipient’s circumstances. Whether the surviving spouse performed any services for the corporation is relevant; if they did not, it strengthens the argument for a gift. A payment based on the deceased’s salary suggests deferred compensation, while a payment determined by the spouse’s financial needs points toward a gift.

Tax Consequences for the Corporation

The tax outcome for the corporation that makes the payment is directly tied to the payment’s classification as either a gift or compensation. This distinction dictates whether the corporation can deduct the amount from its own taxable income.

If the payment is determined to be compensation for the past services of the deceased employee, it is considered an ordinary and necessary business expense. Such expenses are generally deductible by the corporation. This allows the company to reduce its overall taxable income by the amount of the payment, thereby lowering its tax liability. The payment is treated similarly to salary or bonuses paid to active employees.

Conversely, if the payment is classified as a gift, the corporation’s ability to deduct the amount is limited. While businesses can deduct certain gifts, the rules are much more restrictive than those for business expenses. Generally, a payment classified as a gift to a surviving spouse under the Revenue Ruling 79-38 framework is not deductible by the corporation.

Tax Consequences for the Recipient

For the surviving spouse who receives the payment, the tax implications are a mirror image of the corporation’s treatment. The classification of the payment as either a gift or compensation determines whether the funds are included in the recipient’s gross income for the year. This directly impacts the individual’s personal income tax liability.

When a payment is classified as a gift, it is excluded from the recipient’s gross income. This means the surviving spouse receives the entire amount tax-free. The payment is not reported as income on their tax return and is not subject to federal income tax. This outcome aligns with the principle that gifts are transfers made out of generosity and not as a form of earned income.

If the payment is deemed to be compensation, it represents taxable income to the surviving spouse. The amount must be included in their gross income for the tax year in which it was received. This payment would be considered “income in respect of a decedent,” and the recipient would be responsible for paying income tax on the full amount. The corporation would typically report this payment to the IRS and the recipient on a Form 1099-MISC.