A good friend called me recently with a question for one of his clients. The client, an elderly client with health problems, wanted to know if the payments she has been making to her caregivers could be treated as non-taxable gifts, or if she has to report the payments to the IRS as wages?
In many cases, the bonds of affection that have developed between a service provider and the person receiving the services make the distinction between a non-taxable gift and taxable compensation difficult to sort out.
Objective Context Matters More Than Intent
The Supreme Court’s decision in United States v. Duberstein is frequently cited for the proposition that a true gift is marked by “detached and disinterested generosity” of which the truest indicator is the transferor’s intent: “What controls is the intention with which payment, however voluntary, has been made.” But the facts in Duberstein (actually, two cases that were combined for argument and decision) show that context actually matters more than the donor’s intent.
One of the cases before the Supreme Court involved a Cadillac automobile that one businessman had given to another as a token of appreciation for having referred a number of clients. The second case involved a retirement package given to a retiring employee of a church in appreciation for his years of dedicated service.
In both cases, the donor had offered testimony that the property was to be intended to be considered a non-taxable gift. Despite direct testimony by the donors, the Supreme Court was swayed by the fact that in both situations the payments had been made “in a context with business overtones—an employer making a payment to a retiring employee; a businessman giving something of value to another businessman who has been of advantage to him in his business.” Thus, in the case involving the Cadillac, the Supreme Court held for the IRS because despite the donor’s testimony that a gift was intended, the donee admitted that he did not think he would have received the Cadillac if he had not furnished the donor with valuable customers. In the case involving the Church, the Supreme Court, apparently swayed by the similarity of the “gift” to a normal retirement package, remanded the case back to the trial court (which had held that the transfer was a gift) for “further findings.”
Love Can Complicate The Question
The distinction between gifts and income can be difficult to see. The more intimate the relationship between the parties, the more difficult that task becomes. United States v. Harris was a criminal tax case. This opinion will surely grab the reader’s attention!
David Kritzik, now deceased, was a wealthy widower partial to the company of young women. Two of these women were Leigh Ann Conley and Lynnette Harris, twin sisters. Directly or indirectly, Kritzik gave Conley and Harris each more than half a million dollars over the course of several years. For our purposes, either Kritzik had to pay gift tax on this money, or Harris and Conley had to pay income tax. The United States alleges that, beyond reasonable doubt, the obligation was Harris and Conley’s. In separate criminal trials, Harris and Conley were convicted of willfully evading their income tax obligations regarding the money and they now appeal.
As it turned out, the convictions of both women were reversed. First, the court noted that the government had not offered any proof in either case regarding Mr. Kritzik’s donative intent (which, although not necessarily determinative, is still highly relevant). Second, the convictions had to be set aside because
. . . current law on the tax treatment of payments to mistresses provided Harris no fair warning that her conduct was criminal. Indeed, current authorities favor Harris’ position that the money she received from Kritzik was a gift. We emphasize that we do not necessarily agree with these authorities, and that the government is free to urge departure from them in a noncriminal context. But new points of tax law may not be the basis of criminal convictions.
What About Tips?
Tips are discretionary (optional or extra) payments determined by a customer that employees receive from customers. Because they are optional, “tips” may seem like gifts; but by statute tips treated as taxable wages and are subject to income and withholding from the employee and FICA tax matching by the employer. Tips include:
- Cash tips received directly from customers.
- Tips from customers who leave a tip through a credit card any other electronic payment method.
- The value of any noncash tips, such as tickets or other items of value.
- Tip amounts received from other employees paid out through tip pools, tip splitting, or other formal/informal tip sharing arrangement.
All tips received by an employee must be reported to the employer and are subject to Federal income taxes. All cash tips received by an employee in any calendar month are subject to social security and Medicare taxes unless the tips are less than $20 per month, in which case tips are not required to be reported and taxes are not required to be withheld.
Because the tax burden falls on the shoulders of both the workers and the employer, there is a dual incentive to not report tips as income.
United States v. Conforte involved tips received by certain employees of Mustang Ranch, a legalized house of prostitution located in Nevada. Not everyone who worked at Mustang Ranch worked as a prostitute. There were also so-called “auxiliary personnel” such as maids, bartenders, security guards and cashiers. Income earned by the prostitutes was collected by a cashier who set aside a certain percentage as a “tip fund” for distribution to the auxiliary personnel. The government brought criminal tax evasion charges against the owners of the Mustang Ranch for willfully failing to file employment tax returns, to withhold income taxes, or to pay FICA taxes on the auxiliary personnel. The defendants’ convictions were affirmed.
Good Intentions Can Get You Into Trouble!
No matter how tempting it may be to “help” an employee by treating compensation as a gift, or by failing to properly report all taxable compensation to the IRS, the convictions in Conforte and the close calls suffered by the defendants in Harris should remind us that such a generous attitude can be very dangerous indeed.
If you feel tempted to classify a payment to someone who has been rendering any services as a gift, please first seek the advice of a qualified tax professional. Don’t take the risk!