Our gift tax rules impose a tax on certain transfers. This gift tax is required given our income tax rules. Absent a gift tax, taxpayers could simply sidestep income taxes by making non-taxable gifts to everyone rather than paying for goods and services.
So what happens when a business makes a gift? Does the recipient have to report the gift as income for income tax purposes? The court addresses this question in Pesante v. Commissioner, Docket No. 9107-19S.
Facts & Procedural History
The taxpayer worked as an employee for an optometry company. The company was sold in 2016.
The owners of the business also owned an affiliated entity. The affiliated entity decided to pay $25,000 to the taxpayer. The owner told the taxpayer that the money was a gift for his services as an employee. The taxpayer was not employed for the businesses at the time.
The company then issued a Form 1099-MISC to the IRS to report the $25,000 as non-employee compensation.
The taxpayer omitted the $25,000 from his income tax return. The IRS no sent the taxpayers a CP2000 notice or audited the taxpayer’s tax return. It included the $25,000 payment as income which led to this case in the U.S. Tax Court.
Gift vs. Compensation: From the Recipient’s Perspective
The question for the court was whether the $25,000 was a gift or compensation. Generally, for the recipient, gifts are not subject to income tax; whereas, compensation is subject to income tax.
The exclusion for gifts is found in Section 102:
Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.
This section also says that it does not exclude any amount transferred by or for an employer to, or for the benefit of, an employee.
This has to be compared to Section 74. Section 74 says that prizes and awards are taxable. There is a limited exception for employee achievement awards.
These employee rules did not apply to the taxpayer in this case as he was not an employee of the taxpayer at the time of the transfer.
This leaves us with just the general rules in Section 102. There have been a number of court cases that address these general rules. We previously covered one case involving gifts by church parishioners to a church pastor. The court, in that case, found the payments to be taxable compensation for services.
Gift vs. Compensation: From the Business’ Perspective
Generally, a business is not able to deduct gifts made to employees or other individuals. There is an exception for gifts of up to $25 to individuals.
Payments to third parties are generally deductible by a business. This includes payments for services, payments to refrain from acting in some way (such as a non-compete payment), etc.
There may be other options for deducting these costs. For example, prior to the Tax Cuts & Jobs Act (“TCJA”), taxpayers could classify these payments as entertainment expenses (Party Like its 2017: Deductible Entertainment Expenses). This deduction was eliminated by the TCJA. The costs may also be deducted as reimbursements in some cases. This can cover cash payments to employees if the employees incurred out-of-pocket expenses on behalf of the employer.
These rules are why most employers take the position that compensation is for services. It avoids arguments about whether the expenses are deductible or how they are classified.
The Evidence Presented
The court considered the evidence that was presented. It included a letter and testimony from the business owner. The business owner’s letter did not mention the transfer being a gift. Presumably it did not mention the transfer being a gift as the business likely deducted the payment.
The owner’s testimony did mention that the transfer was a gift. The court noted the inconsistency between the owner’s testimony and his prior letter.
The court considered the 1099-MISC that was issued by the business.
The court considered the taxpayer’s testimony. This included testimony that he was told the transfer was a gift.
Based on the facts, the court concluded that the transfer was compensation and was subject to tax. It reached this conclusion based on the services performed by the taxpayer for the affiliated business.
This is a close call. The taxpayer was never employed by the business that made the gift. The taxpayer was not even employed by the business at the time the transfer was made. The court found that the taxpayer was led to believe that this transfer was a gift.
It’s these smaller issues that are often overlooked when a business is sold. The tax planning often focuses on the larger items and issues. The parties may have been able to avoid this result with a little tax planning for this issue.
Since the court found the transfer to be compensation for services, the taxpayer may have raised affirmative issues as to whether the transfer qualifies him for the Sec. 199A deduction and whether he has other normal business expenses related to these services, such as home office deduction, car and truck expense deduction, etc. Depending on the facts, it may be that these deductions could significantly reduce the income tax on the $25,000 of income he received.