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By Wendy M. Greenberg, Esq., Morrison & Foerster LLP
It is not at all uncommon for our clients to make provisions for long-time
employees in their wills or trusts. Most
of the time, we don't think twice about these bequests, because we know that
our clients think of the beneficiaries as friends, or even family members,
first, and as employees second. But,
there are a few traps for the unwary here, including possibly unintended tax
Internal Revenue Code Section 102(a) states generally that
gross income does not include the value of property acquired by gift, bequest,
devise, or inheritance. However, subsection
(c) of that same Section 102 provides that amounts transferred by an employer
to or for the benefit of an employee shall nevertheless be includable in the
employee's gross income. There is some
indication in the case law that this rule may not be as absolute as it appears
(see, e.g., T.C. Memos 2003-97 [enhanced version available to lexis.com subscribers] and
2008-73 [enhanced version]), and that where a transfer
between an employer and employee is completely unrelated to the employment
relationship, it could be deemed a gratuitous transfer not subject to income
tax (but subject to gift, estate, and/or generation-skipping tax instead).
The seminal case on this issue
is Commissioner v. Duberstein,2
a Supreme Court case from 1960. Duberstein actually considered two
cases, one (Duberstein) in which a business owner gifted a frequent referrer of
clients with a Cadillac, and one (Stanton) in which a comptroller of a church
was given $20,000 upon his resignation, "in appreciation of the services
rendered" by him. The principles that
resulted from these cases are not exactly black-and-white, but the factors used
to determine whether a payment may be treated as compensation, rather than as a
gift, may be summarized as follows:
1. Could the
payment be seen as recompense for past services?
2. Could the
payment be seen as an inducement for future services?
3. Could the
payment be seen as satisfaction of an obligation of the employer?
Seen from the other side, to be
truly gratuitous, a transfer must be made out of "detached and disinterested
rather than in a business context.
Given the lack of clarity
regarding the application of Section 102(a), it seems most prudent to attempt
to firmly cast a transfer to an employee as either completely compensatory,
tied to services provided or to be provided, or completely gratuitous, having
nothing to do with the employee/employer relationship. As specifically one or the other, the tax
consequences will be limited to either the income tax realm or the gift and
estate tax realm, without concern for imposition of both types of taxes.
employment agreement whereby the client is required to transfer certain
property to the employee at the client's death (if the employment relationship
is then intact) renders the amount to be transferred a debt that will be deductible
for estate tax purposes. The transfer
could be grossed up to ensure that the beneficiary has enough cash to pay the
Generally, as long as the top
income and gift/estate tax rates are both applicable and fairly equal, the tax
consequences of treating a transfer to an employee as either pure compensation
or pure bequest would also be fairly equal.
But, keep in mind that a transfer structured as pure compensation would
never have any generation-skipping tax implications, so, where an employee is
more than one generation younger than the client, the employment agreement
approach is preferable. Of course, the
agreement could provide for at-will termination, so that the client continues
to have the same flexibility as he or she would if the transfer were
The most salient concern
regarding the described employment agreement is that it requires the client to
inform the employee of the proposed transfer.
If the client would rather keep the transfer testamentary, you should
ensure that the relevant provisions in the client's will or trust do not
condition the transfer on the employee's continued employment in order to more
firmly characterize the transfer as a gratuitous bequest. There will still be a risk that the transfer will
also be treated as taxable compensation to the employee.
There probably is no
one-size-fits-all solution for tax efficiency in transfers to employees, but
with some consideration, the possibility of double taxation, at least, might be
 There are particularly broad requirements and
ramifications where the employee-beneficiary is a caregiver under California
State law, discussion of which is outside the scope of this article.
363 US 278 (1960) [enhanced version / unenhanced version available from lexisONE Free Case Law].
 Commissioner v. LoBue, 351 US 243 [enhanced version / unenhanced version].
Morrison & Foerster's
Trusts and Estates group provides sophisticated planning and administration
services to a broad variety of clients.
If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or
© Copyright 2011 Morrison &
Foerster LLP. This article is published
with permission of Morrison & Foerster LLP.
Further duplication without the permission of Morrison & Foerster
LLP is prohibited. All rights
reserved. The views expressed in this
article are those of the authors only, are intended to be general in nature,
and are not attributable to Morrison & Foerster LLP or any of its
clients. The information provided herein
may not be applicable in all situations and should not be acted upon without
specific legal advice based on particular situations.
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