Monday, November 21, 2022
Lesson From The Tax Court: The Employer/Employee Gift Rule
Relationships can be messy. That is true whether they are work relationships or romantic relationships. But it is especially true for romantic relationships with co-workers. Throw in a power disparity (in either direction) and the relationship becomes even trickier. That is why I suspect most readers subscribe to the standard advice to avoid romantic relationships with co-workers—even if they honor that advice in the breach. After all, the standard advice is often easier said than done. Humans are not little neat boxes where you can separate relationships into “work” and “personal.” It’s messy.
That messiness invades tax law. The Supreme Court has said as much in how it tells us to apply the §102(a) exclusion from income for gifts. Congress has tried to lessen the §102(a) mess with a bright line rule in §102(c) that prohibits the exclusion when a gift is from employer to employee. Call that the employer/employee gift rule. In Jennifer Joy Fields and Walter T. Fields v. Commissioner, T.C. Sum. Op. 2022-22 (Nov. 10, 2022) (Judge Panuthos), we see the employer/employee gift rule applied to a CEO’s decision to help an employee buy a home with company money. Despite their personal relationship, the employer/employee relationship meant there was no exclusion.
Today’s lesson seems especially timely in light of the approaching holiday season with all its messy relationship and gift-giving complexities. Details below the fold.
Backstory of §102(c)
Generally, gross income includes any accession to wealth, clearly realized, over which the taxpayer has dominion and control. Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).
Equally generally, §102(a) provides: “Gross income does not include the value of property acquired by gift.” However, §102(c) specifically nukes that exclusion as to “any amount transferred by or for an employer to, or for the benefit of, an employee.” Thus, employer/employee gifts are not excluded from gross income under §102(a).
Congress enacted §102(c) as part of the Tax Reform Act of 1986, 100 Stat. 2085, at 2110. It was in reaction to decades of litigation over the scope of §102(a), especially in recurring fact patterns involving severance pay. Resolving those cases required a fact-intensive study of the relationship between the giver and receiver. It was messy. The Supreme Court explained why in Commissioner v. Duberstein, 363 U.S. 278 (1960): what makes a gift a gift is the intent of the giver. And figuring out the intent of the giver is “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. It’s what my colleague Bill Casto calls a Wobbly Table of Factors test. You can work out the acronym. Justice Frankfurter’s partial dissent in Duberstein explains that acronym in more measured terms. He wrote:
“What the Court now does sets factfinding bodies to sail on an illimitable ocean of individual beliefs and experiences. This can hardly fail to invite, if indeed not encourage, too individualized diversities in the administration of the income tax law. I am afraid that, by these new phrasings, the practicalities of tax administration, which should be as uniform as is possible in so vast a country as ours, will be embarrassed.” Id. at 297.
You can see how the nice bright-line rule in 102(c) partially ameliorates Justice Frankfurter’s objections.
The very messiness—excuse me, I mean individualized diversities—of the Duberstein test is why the Duberstein Court also punted responsibility for sorting through the messiness on the trial court: “One consequence of this is that appellate review of determinations in this field must be quite restricted.” Id. at 289.
You see that punt most clearly in comparing Duberstein to the companion case that the Court decided at the same time and in the same opinion, Stanton v. United States (same cite).
In Duberstein, Mr. Duberstein ran a business in Ohio and over the years got to know Mr. Berman, who ran a similar business in in New York. Over those years Ms. Duberstein threw business to Mr. Berman. Eventually, a grateful Mr. Berman sent Mr. Duberstein a Cadillac. The Tax Court, as fact-finder, sorted through the facts, and decided the Caddy was no gift. The Supreme Court, using it’s very restricted standard of review, affirmed.
The companion case is more interesting for today’s lesson. There, Mr. Stanton was an employee (the Comptroller) for a holding corporation that managed the various quite valuable properties of Trinity Church in Manhattan. Yes, for all you Federalist fans, that’s where Hamilton is buried. Upon Mr. Stanton’s separation, the corporation Board of Directors approved a resolution to pay Mr. Stanton $20,000. Pretty good money in 1943. Mr. Stanton said it was a gift because part of the resolution said so. The IRS said it was severance pay because another part of the resolution said so, reciting that Mr. Stanton had to release all claims for any other compensation. There were other messy facts that created ambiguity about the intent behind the $20,000 payment.
Mr. Stanton paid the assessed tax and sued for a refund in federal district court. So that got him before District Court Judge Mortimer J. Byers, who became the fact-finder. Judge Byers resolved the ambiguities in favor of Mr. Stanton and gave short shrift to the IRS’s determination. On appeal, however, the 2nd Circuit reversed in an opinion written by Judge Learned Hand. The Circuit thought the ambiguities should be resolved in favor of the IRS because of the presumption of correctness. Stanton v. United States, 268 F.2d 727, 729 (2d Cir. 1959) (“Certainly the taxpayer in the case at bar did not prove that to any substantial degree the "honorarium" was more than an expression of gratitude for exceptional services rendered.”)
When it got to the Supreme Court, the government pressed for a strong presumption that gifts made in the course of business were not excludable. Under that approach, Mr. Stanton would have to overcome the presumption that the $20,000 was not a gift.
The Court rejected the government’s test in favor of the vague “mainsprings of human conduct” test, punting to the fact-finder. However, the Court did not think Judge Byers had done a good enough job and so remanded the case for more facts. Judge Byers obliged and wrote a really detailed and interesting opinion that takes a deep dive into the history Trinity Church and explains why he resolves the ambiguities in favor of finding the $20,000 to be a gift. Stanton v. United States, 186 F. Supp. 393 (E.D.N.Y. 1960). A grumpy 2nd Circuit affirmed. 287 F.2d 876 (2d Cir. 1961) (noting that “Chief Judge Lumbard concurs in this result because of the directive of the Supreme Court that appellate review be "quite restricted," ... although he is of the opinion that the contrary inference should have been drawn from the undisputed basic facts for the reasons set forth in the majority opinion of Judge Hand ....”). Id. at 877.
So you can see that when Congress eventually enacted §102(c) in 1986, it adopted a narrower but stronger test that what the government had proposed. It would apply to gifts between employers and employees but the messy Duberstein test would still apply to other business relationships. Thus, §102(c) would apply to Mr. Stanton and would mean that the $20,000 could not be a gift. But it would not apply to Mr. Duberstein because his relationship with the giver was not an employer/employee relationship.
From 2009 to 2017 Ms. Field was employed by a company called Paragon Gaming, a casino management company out of Nevada, whose founder was a man named Mr. Scott Menke. While Ms. Field was an employee of the company, she also had a personal relationship with Mr. Menke. “Text messages and emails between petitioner and Mr. Menke reflect a relationship between the two outside the workplace.” Op. at 2. The nature of that personal relationship is not detailed in the opinion.
In 2012 Paragon wired $35,000 Canadian dollars to Ms. Field’s bank account for no apparent reason. In 2014, when Ms. Field bought a home in Washington state, Paragon sent the $53,020 down payment directly to the title company on her behalf. Ms. Field apparently did not report either amount as income in the years the payments were made. Nor were there any contemporaneous records of why the payments were made.
In January 2017, Ms. Field separated from Paragon and the company gave her a severance package. The Severance Agreement treats those prior payments as “employee advances that are currently outstanding ... and owed by you.” The Agreement then says the company will write off the advances and she has no obligation to repay. Hmmm, that sounds like the payments were loans and Paragon was discharging the debt. And Ms. Field’s attorney drafted a different provision that would have explicitly labeled the payments as loans the repayment of which would be withheld from the severance payments provided for in the Agreement. But Paragon did not file a 1099-C with the IRS. It filed a 1099-MISC for 2017, reporting the payments (which amounted to $79,500 in U.S. dollars) as “other income.” She did not report those amounts.
Thanks to the unblinking vigilance of the IRS Information Return Program computers, the IRS spotted the omitted income and dinged Ms. Fields for it, along with an accuracy-related penalty.
Lesson: The Bright Line Employer/Employee Gift Rule
In Tax Court Ms. Fields wanted the Court to dive into the messy facts of her relationship with Mr. Menke. She tried to argue—using texts, emails, and the draft severance provision—that her personal relationship meant the 2012 and 2014 payments had been gifts or, if they had started out as loans, their discharge was intended to be a gift. Either argument would work for §102(a) purposes.
But this was not a messy case. Both the 2012 and 2014 payments themselves, as well as their discharge in the Severance Agreement, were payments from an employer (Paragon) to an employee (Fields). That runs smack into the employer/employee gift rule in §102(c). Judge Panuthos generously suggests that there may be an exception “when the relationship between the employer and the employee is personal and unrelated to work.” Op. at 5. He even cites some cases. But do not be misled by his kindness. There is no such exception. All of those cases he cites dealt with tax years prior to 1986 when there was no §102(c) prohibition. It was all still messy. It is true that back in 1989 the IRS proposed an amendment to Treas. Reg. 1.102-1 that would have carved out a limited exception from the employer/employee rule “if the purpose of the transfer can be substantially attributed to the familial relationship of the parties.” But even that limited exception would not apply in today’s case, and it’s still only a proposed regulation. I apologize but I cannot find a link to the Federal Register where the regulations amendment was proposed. I invite any enterprising reader to provide that for the rest of us!
Bottom Line: Section 102(c) gives us a nice bright-line rule that payments from employers to employees are not excludable under §102(a) as gifts. A straightforward application of that rule means Ms. Fields has no chance of deducting the payments her employer made to her, regardless of her employer’s actual intent and regardless of the nature of their personal relationship. Remember that this holiday season.
Coda: After January 2017 Ms. Field continued having a business relationship with Paragon, but now as an independent contractor and not as an employee. The opinion does not say whether she continued to have a personal relationship with Mr. Menke, who died in 2020. But if there were indeed any more such payments, the test would no longer be the employer/employee rule in §102(c). It would then be the “mainsprings of human conduct” test of Duberstein. And those texts, emails, etc. would become relevant.
Comment 1: Loans? I confess I’m confused on why Paragon did not issue a 1099-C if it was treating the 2012 and 2014 payments as loans. I appreciate any reader insights on this. And if these were loans, then notice they carried no interest! That seems to me to make them classic compensation loans subject to §7872. So both Paragon and Ms. Fields would have income on the foregone interest in each of those years, although at least Paragon could deduct the same amount as employee compensation.
Comment 2: The Bad Scotch Rule. I can just hear some readers thinking “does this mean employers can never give ANY gifts to employees?” It does not. It just means there is no exclusion under §102(a). However, §132(e) allows employees to exclude from income de minimis gifts they receive from their employers. Treas. Reg. 1.132-6(e)(1) explains that “Examples of de minimis fringe benefits are ... occasional cocktail parties, group meals, or picnics for employees and their guests; traditional birthday or holiday gifts of property (not cash) with a low fair market value ....” The way I explain the emphasized language to my class is that if the employer gives a bottle of Scotch Whiskey to an employee as a holiday gift, then the employee can exclude it as a de minimis fringe benefit ... if it’s cheap. But if it’s expensive, then it not so excludable. So what is “low fair market value”? Well ... it’s messy.
Bryan Camp is the very neat George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.
@Ed: great question! I think that would be the right question, and those would be relevant facts, under the Duberstein test (intent of donor). But 102(c) (as I read it) CHANGES the test from intent of the donor to relationship of the parties at time of payment. If that relationship was ER to EE, then intent (and supporting facts such as those you suggest) does not matter. Kind of like how section 267 really focuses on relationships rather than intent. Remember, however, my views are influenced by 8 years working in Chief Counsel . If I was representing the donee taxpayer on those facts I might (a) advise them ex-ante to report the payments as income, but also (b) defend them ex-post on a decision to exclude, hoping for the court to create a judicial exception to the bright line rule. It would help even more if the donee was part of donor's family. Then I would throw the proposed reg. against the wall and hope it would stick!
Posted by: bryan | Nov 21, 2022 11:12:20 AM
What if the gift was made by the employer from their personal bank account with personal funds to an individual that is an employee in the company.
Posted by: Ed | Nov 21, 2022 10:52:03 AM
Your post today tweaked my interest because of a case I handled while with DOJ Tax Appellate. Grinstead v. United States, 447 F. 2d 937 (75th Cir. 1971). This was a classic widow bonus case where the company got the deduction for employee-related compensation and jury held, affirmed by CA7, that the widow did not have to include the income because it was a gift (which, if true, meant that corporation should not have gotten the deduction). Classic whipsaw for the IRS. The Court of Appeals and the trial judge said that they would have decided differently than the jury, but allowed the jury verdict to stand. Not a particularly important case. My key memory is that the trial judge, Judge Parsons of N.D. Ill. refused to give an instruction straight out of Duberstein (detached and disinterested generosity as I recall), and stated his reason on the record: He knew (without citing sources) that no Justice on the Supreme Court agreed with the holding in Duberstein and that the opinion was written by a clerk with no Justice agreeing. He therefore refused the Duberstein instruction. My bosses at DOJ would not let me put that in the brief, but one judge on the panel asked at appellate oral argument why the trial judge (Judge Parsons) did not give the Duberstein instruction. When I advised the panel, with appropriate record citations, they all just laughed. (Judge Parsons was a notorious wild card in the Seventh Circuit.)
Posted by: Jack Townsend | Nov 21, 2022 9:05:48 AM
And I would be remiss not to direct readers to Prof. Mark Cochran's article Cadillacs, Gold Watches, and the Tax Reform Act of 1986: The Continuing Evolution of the Tax Treatment of Gifts to Employees, 5 Akron Tax J. 27 (1988), available at https://commons.stmarytx.edu/cgi/viewcontent.cgi?article=1006&context=facarticles
Posted by: bryan | Nov 21, 2022 7:42:30 AM
@James: perhaps you are thinking of the limitation on the deductibility of business gifts? On the income side, was that ever a rule related to the exclusion for de minimis fringe benefits (the holiday turkey, etc.). I would love to hear from others.
Posted by: bryan | Nov 21, 2022 7:38:59 AM
Don't I recall a $25 per year exception for employer/employee gifts? Or am I just making that up? Is that a bright-line under 132(e)?
Posted by: James L Bradley | Nov 21, 2022 7:26:04 AM
A grateful shout-out to Prof. Will Foster (U. Ark.) for pointing out to me in an email how readers can indeed freely access the 1989 Notice of Proposed Rulemaking that would have added a small exception to the §102(c) employer/employee gift rule. Here's the link:
Posted by: bryan | Nov 21, 2022 7:02:58 AM
Prof. Linda Galler (Hofstra) is also on the case. She reports that one can also find the proposed reg ant preamble at this link: https://www.govinfo.gov/content/pkg/FR-1989-01-09/pdf/FR-1989-01-09.pdf . Page 627. Many thanks Prof. Galler!
Posted by: bryan | Nov 21, 2022 1:34:01 PM