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Why Sharing the Wealth Isn’t Always Taxable

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Sep 19th 2016
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Usually, the Internal Revenue Code spells things out precisely; it’s those real-life situations that refuse to fall conveniently into place. For example, a wide-ranging definition of income entitles Uncle Sam to collect taxes on “all income from whatever source derived,” including payments that are “compensation for services.”

But no taxes are due on money or other assets received as gifts. So, the courts are often tossed the troublesome question of whether a payment is compensation that should be listed on Form 1040 or a gift that escapes taxes.

Consider the unusual case of Rosa Runyon, who received $10,000 from her former bosses, Franklin Burford and Edsel Lucas, and was told by them that the money was a gift. Franklin and Edsel decided to be generous because they made windfall profits of more than $4 million apiece from the sale of their coal-mining company.

Several weeks after the sale, they each gave a personal check for $5,000 to Rosa; she had been their company’s bookkeeper and receptionist for seven years, but had left her job six years before the sale. The checks were accompanied by a handwritten note from Edsel. The note advised her of the company’s sale by him and Franklin and of their awareness of the important role she had played in its formation, especially during the hard, lean years. So, they wanted to show their appreciation for her contribution to its success by saying “Thanks, Rosa” and by enclosing a check from each of them for $5,000.

A cautious Rosa asked her two benefactors whether she had to list the unexpected $10,000 on her Form 1040. Edsel told her it was a gift and not taxable to her, as did Franklin, an attorney who had practiced tax law for 10 years and taught the subject at a law school for three years.

Yet, her ex-bosses subsequently filed gift tax returns that didn’t include the payments to Rosa and similar payments by them to several other company employees and former employees. Moreover, both Franklin and Edsel wrote off the payments to Rosa and the other employees as business expenses on their own Form 1040s. The IRS went after Rosa for income taxes on the $10,000, but the Tax Court sided with her.

The court held that the money was a nontaxable gift. The owners were in no way obligated to pay Rosa; she had been adequately compensated by the company for her services, had never been an employee of Edsel or Franklin, and didn’t expect to work for them in the future.

A related investigation revealed that Franklin and Edsel also took business-expense deductions for payments of $30,000 to Jamie Abdella, another of the company’s employees. Here, too, the Tax Court decided that Jamie had received a gift.

Said the court of the deductions claimed by Franklin and Edsel and their testimony that the payments were compensation: “Their generous impulse to make a gift was transformed by the time of the trial into a new economic impulse to save on their personal taxes. Regrettably, what was conceived and born in generosity was later debauched and disowned in avarice.”

Additionalarticles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 130 and counting).

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