Lesson From The Tax Court: The Measure Of Intent For Gift Exclusions Under §102(a)

When my church stopped in-person worship services in 2020, we kept paying our part-time child-care workers.  We first paid them with PPP loan money (which we treated as wages).  When that ran out, we decided to continue payments.  Why did we do that?  First, they were part of our church family and we knew that losing those amounts would be a hardship for them.  Second, we wanted to retain goodwill so they would come back when we resumed in-person worship.  So we had dual intent, mixed motives.  Which dominated would determine whether those continued payments were taxable compensation or non-taxable gifts.  How is a Court supposed to figure that out?

Juan Pesante, Jr., and Maria A. Moreno-Pesante v. Commissioner, (Bench Opinion, May 6, 2021) (Judge Copeland) teaches how the Tax Court measures the intent of a payor to determine whether a taxpayer may exclude a payment as a gift under §102(a).  There, the payor had sent mixed messages on whether a $25,000 payment to Mr. Pesante was a gift.  The Tax Court agreed with the IRS that the payment was not a gift.  Judge Copeland’s reasoning gives a great road map for how taxpayers and their tax advisors should approach this messy life-in-all-its-fullness issue.  Details below the fold. 

Law:  The Power of The Trial Court
Whether §102(a) excludes a payment as a gift depends upon the intent of the payor.  The classic case that most professors teach is Commissioner v. Duberstein, 363 U.S. 278 (1960).  But that opinion is actually the consolidation of two cases: the named one, and a second one, Stanton v. Commissioner.  I like to also teach Stanton because it emphasizes how this §102 issue is won or lost at the trial level.  So let’s take a look at both to understand the law.

Facts of Duberstein:  Mr. Duberstein ran a business in Ohio and was friendly with the owner of a similar business in NY to whom he regularly referred customers.  One day the NY business owner sent a big “thank you” in the form of a Cadillac.  Mr. Duberstein did not report the Caddy as income.  On audit, the IRS said he should have.  Mr. Duberstein decided to go to Tax Court.

The Tax Court held that Mr. Duberstein “failed to carry the burden of proving that the automobile was a gift.”  Instead, the Tax Court found, the NY owner intended to compensate Mr. Duberstein for the valuable business referrals.  The Sixth Circuit reversed by substituting its judgment for that the Tax Court on the facts presented.

Facts of Stanton: Mr. Stanton was the comptroller for Trinity Church in NY and president of Trinity Operating Company, the subsidiary the Church created to manage its considerable real estate holdings.  For that work he earned a salary of $22,000 per year.  Following some unpleasantness over the firing of another employee by the Operating Company’s Board of Directors, Mr. Stanton and his secretary tendered their resignations which were accepted.  At that time the Board also voted to pay Mr. Stanton $20,000 and a smaller sum to the secretary.  The amounts closely resembled the severance pay given to the fired employee but the resolution authorizing the payment used the word “gratuity.”  Mr. Stanton did not report the $20,000 as income.  On audit, the IRS said he should have.

Unlike Mr. Duberstein, Mr. Stanton paid the asserted deficiency and then sued for refund in federal district court in New York.  Smart move.  Judge Mortimer Byers found, without explanation, that the payment was a gift.  The Second Circuit reversed.  Like the Sixth Circuit in Duberstein, the Second Circuit substituted its judgment for that of Judge Myers.  The opinion by Judge Learned Hand explains how the Church had mixed motives for paying Stanton and decides that the payment was better viewed as severance pay than as a nontaxable gift.

The Supreme Court Opinion. The Supreme Court’s  opinion makes three important points about the exclusion for gifts.

First, intent of the payor determines whether a payment is an excludable gift.  If the payment “proceeds from a detached and disinterested generosity...out of affection, respect, admiration, charity or like impulses” then the payment is a gift.  Id. at 285.

Second, intent is inherently a question of fact.  It an objective inquiry into all the facts and circumstances surrounding the payment and not merely the subjective expression of intent by the payor at some point in time.  Wrote the Court: “the donor's characterization of his action is not determinative -- that there must be an objective inquiry as to whether what is called a gift amounts to it in reality.” Id. at 286.  And that objective inquiry “must be based ultimately on the application of the factfinding tribunal's experience with the mainsprings of human conduct to the totality of the facts of each case.” Id. at 289.

In making this second point, the Supreme Court rejected the government’s proposed bright-line test that if the payment was in any way connected with the business of the payor, it could not be a gift as a matter of law.  While the government had gotten Congress to enact §102(c) which creates a bright-line rule that payments from an employer to an employee cannot be a gift, it was unable to convince the Supreme Court to create an even more far-reaching rule of law.  Justice Benjamin Cardozo emphasized that “the multiplicity of relevant factual elements, with their various combinations, creat[es] the necessity of ascribing the proper force to each...” Id.

Third, and perhaps most important, it’s up to the trier of fact to evaluate all the facts and circumstances and to “ascribe the proper force” to each.  Whether the tier of fact is a jury or judge, the Supreme Court instructed reviewing courts not to disturb the trial court's conclusion unless clearly erroneous.  That is, a reviewing court should not simply substitute its own experience with the mainsprings of human conduct for that of the trier of fact, as the Second and Sixth Circuits did in both Duberstein and Stanton.  A reviewing court should instead defer to the trier of fact’s judgment unless “the reviewing court on the entire evidence is left with the definite and firm conviction that a mistake has been committed.”  Id. at 291.

After making these three points, the Supreme Court reversed the Sixth Circuit and reinstated the Tax Court’s judgment.  The Caddy was taxable non-employee compensation.  However, it remanded the Stanton case back to the New York trial court because Judge Byers’s opinion had not explained how he had resolved the mixed motives for the $20,000 payment to Mr. Stanton.  On remand, Judge Byers examined the mixed motives and explained that the most important fact for him was that the payment was made by a Church and not a profit-seeking corporation.  Stanton v. United States, 186 F. Supp. 393 (E.D.N.Y. 1960).  This was not a “disposition of funds of a corporation conducted purely for the financial profit of stockholders.”  Instead, it was a decision made by fiduciaries of a Church, and was "more than a mere whim or transitory emotion, but was rather a deep sense of appreciation for the way in which Mr. Stanton had enabled the members of the Vestry to rise to the requirements of their high office.”  Id. at 397.

On appeal a second time, the Second Circuit affirmed.  “We cannot say that Judge Byers' careful and detailed findings and conclusions are clearly erroneous, and accordingly we affirm the judgment of the district court.”  United States v. Stanton, 287 F.2d 876 (2d Cir. 1961).

Thus, in situations where a payment is made from mixed motives, it is up to the trier of fact to figure out whether the dominant motive was disinterested generosity or whether the dominant motive was to compensate for past, present, or future services.  Judge Copeland shows us how that is done.

Facts
Like Mr. Duberstein, our taxpayers here are from Ohio, part of the Sixth Circuit.  Mr. Pesante was an employee of a successful wholesale eyewear laboratory called Nexus Vision Group, LLC ("Company 1"). On January 1, 2016 Company 1 was acquired by Hoya Vision.  The opinion does not explain whether the purchase was an asset sale or stock sale.  However, the ownership of Company 1 overlapped with that of an affiliated company, Nexus Vision Illinois, LLC (Company 2).  The opinion does not explain the degree of overlap.  At a meeting, Company 2's members decided Company 2 would pay Mr. Pesante $25,000.  The decision was reached only after some debate.

Why did they do that?  The record is unclear.  Mr. Pesante testified that the managing member of Company 2--- Gerry Shaw, who appears to also have been the managing member of Company 1---told Mr. Pesante that the $25,000 “was a gift, a reward for his services.”  Oh, like that’s helpful!  It’s the very embodiment of mixed motives.

Company 2 treated the payment as non-employee compensation and filed a 1099-MISC.  Mr. and Ms. Pesante, however, treated the payment as a gift and did not report it.  Naturally, the ever vigilant IRS computers caught the discrepancy and it triggered an exam.  The IRS decided the payment was taxable and sent the Pesantes an NOD to that effect.  They timely petitioned the Tax Court.

Lesson 1:  Intent is Measured by Payor’s Actions, Not Words
After hearing testimony from Mr. Pesante and Mr. Shaw (the managing member), and after reviewing all the relevant documents, Judge Copeland found that Company 2 led Mr. Pesante “was led to believe that the $25,000 payment was a non-taxable gift”---likely through Mr. Shaw but the opinion's passive voice hides the actor.

But words are not enough.  Judge Copeland concludes that three “objective facts” show the dominant intent was to compensate Mr. Pesante for his past service to Company 1: (1) the disagreement over whether to make the payment in the first place; (2) the payor’s decision to issue a 1099-MISC; and (3) the timing of the payment close to the sale, which acknowledged, in Judge Copeland’s judgement, “his past services in building up the value of [Company 1].”

I think the most important of these three objective facts was the reporting of the payment on a 1099-MISC.  Judge Copeland writes “Unfortunately, here, Mr. Pesante has not presented sufficient evidence to overcome the payor’s treatment of the gift/reward as taxable....”   In other words, by reporting the payment as compensation, the payor’s action created a presumption for the taxpayer to overcome.  In addition, note that the IRS determination here was consistent with the payor’s action, meaning the taxpayer must also overcome the presumption of correctness that attaches to NODs.  Query what would happen if the payor acted as if the payment were a gift yet the IRS determined it was taxable.  Which presumption should beat the other?

Comment: It Is What It Is---Whatever the Tax Court Says It Is!
Another trial judge, looking at the same evidence, might come to different conclusion.  Each of the three objective facts Judge Copeland relies upon might tell a different story to a different judge with a different understanding of those famous "mainsprings of human conduct."  For example, the First and Third facts together may tell a story of disinterested generosity.  Perhaps the reason members of Company 2 debated whether to pay anything to Mr. Pesante was because the overlap between Company 1 and Company 2 was not total.  Mr. Pesante had provided no services to Company 2.  He had been employed by Company 1.  Sure, maybe he added value to Company 1 that was reflected in the sales price (for some reason, Mr. Pesante emphasized this fact at trial---not a choice I would have made but I note he was proceeding pro se).  But even if true that only benefited the members of Company 2 to the extent they were also owners of Company 1.  I do not think it would have benefited members of Company 2 who were not also members of Company 1.

So if they received no past, present or future benefit from Mr. Pesante, why should they agree to use Company 2’s money to pay Mr. Pesante?  Well, that might go to the timing of the payment.  Notice it was not just close in time to the sale but also close in time to when Mr. Pesante lost his job.  Maybe they felt bad he lost his job.  Perhaps, like Mr. Stanton's case, they viewed him like family and wanted to do something to help him tide over his transition to new employment, whatever that may be.  They wanted to wish him well.

As for the 1099-MISC, it means only that someone running the payroll software made that choice.  Perhaps one of the LLC members directed that choice so that Company 2 could deduct the payment?  But that individual decision would not reflect the corporate decision. 

That is all speculation about what a different judge might find.  It is not what Judge Copeland found. And the Supreme Court has told us that this was Judge Copeland’s call.  No way would a reviewing court find clear error here.  Similarly, if Judge Copeland had gone the other way---if her experience with the mainsprings of human conduct had led her to conclude this was a gift---that, too, would most likely survive appeal.

Bottom line: Whether a payment is a gift depends on the intent of the payor.  Intent, in turn, is measured by the objective actions of the payor.  The most important of those objective actions may well be how the payor reports the payment to the IRS.  Objective actions is the best measure of intent.

Coda:  Our church did not report the post-PPP payments to our child-care workers on their W-2’s.   We thus treated them as gifts.  We were also careful to document our dominant intent in the relevant minutes.  I am confident these actions are adequate measures of intent should the issue ever arise.  However, undermining my confidence is a discovery we made during our annual internal audit (in April): our administrative assistant had put in the confusing notation “non-taxable compensation” for the payments in Quickbooks and on each check!  Sigh.  Thank goodness only relatively small amounts are involved, so the chance of this becoming an issue for anyone is, blessedly, remote. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return to TaxProf Blog each and every Monday for a new Lesson From The Tax Court