SPLIT-DOLLAR LIFE INSURANCE IS A CONFERRED BENEFIT TO EMPLOYEES, BUT UNLIKELY TO CHANGE CHARACTER OF INCOME WHEN CONFERRED ON AN EMPLOYEE-OWNER

August 9, 2022Articles, Life Insurance, Sixth Circuit, US Tax Court off
ABSTRACT

Split-Dollar life Insurance is a reportable transaction but it has not manifest the tax benefits that promoters had hoped: deductions in the year of expense and indefinitely deferred gain. In 2018, in Machacek, the Sixth Circuit held that an employee-owner of an S-corporation receives the benefit of the increased value of the plan as capital gain rather than ordinary income because Treas. Reg. § 1.301-1(m)(1)(i) assumes that a shareholder receives a property distribution for the economic benefits conferred by engaging in a split-dollar life insurance arrangement. Subsequently, in De Los Santos, the tax court refuted the assumptions of the Sixth Circuit because Congress already distinguished that for a shareholder to receive a distribution with respect to its stock requires that the distribution is “in their capacity as such” shareholder. Because the taxpayer’s were clearly receiving compensation for services, this was not in their capacity as a shareholder. This note describes this transaction in depth and analyzes the reasoning of the Sixth Circuit and tax court in Machackek and De Los Santos. It concludes that Machacek is unlikely to propagate to other jurisdictions because its reasoning overlooks Congress’s legislative intent, causes a change in realization that would not occur until the property is “unqualifiedly made subject to the demands” of the shareholder, and incorrectly determines that subchapter S should not apply apply which otherwise would require that a 2% shareholder receiving fringe benefits receive ordinary income rather than capital gain.

Table of Contents

I. INTRODUCTION

Abusive tax shelters are ripe for fraud, but fraud is not inherent. Rather, fraud arises from the intent of the transaction, which is usually a multifaceted approach to cause any and all of the following: create a deduction, defer gain, and change the character of income. Often transactions of this type are crafted for marketing to and use by a wide audience. Hence, as a type of transaction becomes known to the Internal Revenue Service, it may be deemed a “reportable transaction” and require more disclosure than simply reporting it on the appropriate individual or entity schedule. This article explores one such reportable transaction, split-dollar life insurance, because recently a split of judicial authority affected the character of income from such transactions for owner-employees of S-corporations. I consider these judicial opinions and the underlying administrative guidance, legislation and legislative intent to conclude that the Sixth Circuit authority that allows taxpayers to treat these transactions as a capital gain shareholder distribution is an aberration unlikely to proliferate to other jurisdictions.

II. SPLIT-DOLLAR LIFE INSURANCE PURPORTS TO OFFER INVESTORS ALL THE UPSIDES OF AN ABUSIVE TAX SHELTER

Employee compensation must be reasonable and is deductible by a corporation in the year it is earned or paid to the employee. Yet, many S-corporations are operated (in part) by its owner and the owner is also an employee. Therefore, when an S-corporation profits, the additional income passes through to the owner who must add the business income to his personal taxable income. On the other hand, if S-corporation profits are used to repay the owner’s capital investment or to give a loan to the owner, they are not treated as additional taxable income. This tax advantageous result may be attractive where the owner –employee does not need immediate access to the additional profits and can defer paying tax to a future year when his gross income will be lower, such as after retirement.

Most split-dollar life insurance arrangements are part of an employee benefit plan. The owner-operator of an S-corporation works with a trust company that forms a trust for the benefit of the S-corporation. The trust then contracts with a life insurance provider to purchase life insurance on the life of employees, including on the life of the owner of the S-corporation. Each life insurance contract may be assigned to a beneficiary (e.g. wife or daughter) and if the employee dies, the plan will first compensate the S-corporation for its premium payments to date and provide the remainder of the proceeds to the beneficiary. Alternatively, if the employee survives to the age of retirement, the plan vests and the employee may borrow against the vested value, which is not taxable income, or cash out, in which case they owe tax.

However, on the life of the owner-employee a special life insurance contract is purchased that is many times more expensive than a whole life insurance policy. The insurance contract has a special vesting schedule for the expense that is in excess of the cost of normal, whole life insurance. The S-corporation contributes funds to the trust to pay for this very costly life insurance, and then deducts that excessive cost, often reducing its passthrough income to zero. By contrast, if the owner of the S-corporation took a loan directly from the S-corporation to purchase the life insurance, there would be no deduction by the corporation but rather a credit to the accounts receivable. Moreover, whereas a 401(k) retirement plan has a low ceiling for before-tax annual contributions, the amount of the split-dollar life insurance investment is unlimited allowing the S-corporation to offset all or most of its profits with large deductions for life insurance.  

An additional benefit of a split-dollar life insurance plan is that the trust invests the excess premiums (those not need to fund the actual cost of life insurance), so that after several years the funds grow to provide  extra profits to compensate the investors, trustees, and the beneficiary whose cash out value vests according to a predetermined schedule. Once the policy vests, rather than cash out the policy, the beneficiary may simply borrow against the policy. Voila…no taxable event occurs during the beneficiary’s life.     

Is this scheme too good to be true? Indeed, but courts are split on exactly how to characterize the income. 


III. THE IRS DENIED THE BENEFITS TOUTED BY MARKETERS OF SPLIT-DOLLAR LIFE INSURANCE

Beginning in 1999, the Internal Revenue Service began disallowing employer deductions for contributions to split-dollar life insurance arrangements, and began including in employee taxable income the cash value accumulated in the plans, which employees tended not to claim. Generally, the IRS was successful and taxpayers were assessed large additions to tax as well as a 20% negligence penalty.

The earliest litigation focused largely on taxpayer’s attempts to escape the implications of split-dollar life insurance. Taxpayers first claimed that the plans were group life insurance, which are outside the scope of treasury regulation for split-dollar life insurance.1 However, group life insurance plans require that individual factors such as age or findings by a medical professional in a required screening not affect the cost of the policy. Next, taxpayers argued that the regulation governing split-dollar life insurance was unconstitutional under the Chevron-deference standard. They contended that the regulation was arbitrary and capricious or contrary to I.R.C. § 61 because it required the employee to pay tax on the accumulated value of the policy when no death or cash out occurred within the year.2 This argument was to no avail.3 Although I.R.C. § 61 concerns “ascension to wealth” but does not mention the controlling language in the regulation, “economic benefit,” the court analogized to prior jurisprudence about an employer’s irrevocable set-aside to compensate an employee in the future for services already rendered. There, because the employer’s creditors could not reach the set aside the employee must report income despite that he was yet to control the funds.4

In 2016, in Machacek v. Commissioner, the tax court continued this line of authority and disallowed an S-corporation’s deduction of the annual premiums on the excessive costs of its sole shareholder-employee’s split-dollar life insurance policy.5 As in the prior cases, the shareholder individually in his capacity as an employee also was required to pay tax on his annual accession to wealth from the benefits he received from the S-corporation’s contribution to his split-dollar life insurance policy.6 The tax court held that Machacek’s split-dollar life insurance arrangement was made in his capacity as an employee and not as a shareholder.7 Machacek was required to pay additional tax on both the actual cost of life insurance, approximately $6,000 annually, which he misreported on his W-2, and more significantly, the vested accrued benefit of the insurance plan in each year less any amount thereof which was taxed in a prior year.8 Essentially, the terms of the plan required ten years of employment with the corporation and at least fifty-five years of age. Because Machacek reached both the employment duration and age requirements by the years in question, his plan was already vested despite that it was not cashed out.

However, these long-standing and consistent rulings changed in 2018 when the Sixth Circuit Court of Appeals overruled the tax court’s decision in Machacek, holding that the increase in value of Machacek’s split-dollar life insurance policy was taxable as long term capital gain rather than taxed as ordinary gain9 because the increase in the vested value of the policy was a shareholder distribution, not employee compensation.10

In 2021, in De Los Santos, the tax court refuted the Sixth Circuit’s decision that overruled Machacek and held that the owner-operator’s gain on a split-dollar life insurance policy was taxable as ordinary income.11 The Internal Revenue Service, which preferred the result in the tax court, subsequently issued a notice on decision, non-acquiescing to the Sixth Circuit’s opinion in Machacek in all cases appealable to circuits other than the Sixth Circuit.12 To summarize this background, in all jurisdictions except the Sixth Circuit, the vested accrued value of a split-dollar life insurance plan, in addition to the annual cost of the employee’s life insurance, is taxable to an owner-employee as ordinary income. 

A. SPLIT-DOLLAR LIFE INSURANCE MAY BE OFFERED IN EXCHANGE FOR SERVICES OR TO A SHAREHOLDER

The treasury regulation that governs split-dollar life insurance is effective for any split-dollar life insurance arrangement entered into after September 17, 2003, including that any arrangements that are “materially” modified are treated as new arrangements, so also fall under the regulation if materially modified after the effective date.13

“Any arrangement between an owner and a non-owner of a life insurance contract is treated as a split-dollar life insurance arrangement if the arrangement is . . . [a compensatory arrangement or a shareholder arrangement].”14 Generally, the owner of a life insurance contract is the person named as the policy owner of the contract.15 In contrast, a non-owner is “any person (other than the owner) who has any direct or indirect interest in such a policy.”16

Terminology is important to understand. The S-corporation creates a trust for its own benefit, and the trust purchases life insurance – thus the S-corporation thereby becomes the “owner” of the life insurance contract. The insurance is purchased on the life of the corporation’s employees, most notably, on the employee-owner’s life (i.e., the  individual who works for and owns the S-corporation). The S-corporation “owns” the split-dollar life insurance policy because it pays the premiums for the policy and is reimbursed for those premiums once the policy is cashed out. The “non-owner” of the split-dollar life insurance policy is the employee-owner who may assign the accrued value, that which exceeds what will be reimbursed to the S-corporation, to a beneficiary of their choice. Thus, the employee-owner owns the S-corporation, but with regard to the split dollar-life insurance policy, under the regulation the employee-owner is the “non-owner” and the S-corporation is the “owner.”

The regulation states that “[d]epending on the relationship between the owner and the non-owner, the economic benefits may constitute a payment of compensation, a dividend distribution under section 301, a contribution to capital, a gift, or a transfer having a different tax character.”17 The compensatory arrangement and the shareholder arrangement are the most common.

A compensatory arrangement has three elements. First, “the arrangement is entered into in connection with the performance of services and is not part of a group term life insurance plan.”18 Second, “the employer or service recipient pays, directly or indirectly, all or any portion of the premiums.”19 Third, “[e]ither (1) the beneficiary . . . is designated by the employee or service provider or is any person whom the employee or service provider would reasonably be expected to designate as the beneficiary; or (2) [t]he employee or service provider has any interest in the policy cash value of the life insurance contract.”20 

In a compensatory arrangement the life insurance is intended to compensate the employee for services performed, whereas in a shareholder arrangement “the arrangement is entered into between a corporation and another person in that person’s capacity as a shareholder in the corporation.”21 Practically speaking, the compensatory arrangement is distinguished because the plan is adopted to compensate employees other than the employee-owner with life insurance. That the plan vests after a number of years of service also indicates a compensatory plan. Hence, on the face of the plan one sees the intent to compensate the owner-employee in his capacity as an employee, rather than as a shareholder.

Next, to determine that amount of tax, one must consider the value of the economic benefits conferred on the non-owner and value to which the non-owner has current access. These are: “[t]he cost of current life insurance provided to the non-owner . . . , [t]he amount of policy cash value to which the non-owner has current access . . . ,  and [t]he value of any other economic benefits.”22 “[T]he amount of the current life insurance protection provided to the non-owner for a taxable year . . . equals the excess of the death benefit over the total amount payable to the owner under the split-dollar life insurance arrangement, less the portion of the policy cash value” either paid for by the non-owner or paid by the non-owner to the owner for the benefits.23 Finally, “a non-owner has current access to that portion of the policy cash value to which, under the arrangement, the non-owner has a current or future right, and that currently is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s general creditors.”24 To reiterate, the employee is taxed when the owner pays for a life insurance policy that is not a group policy; the cost of the policy is taxable to the employee. Where the owner contracts to pay for accumulated value, that value is taxable to the employee as long as the value is accrued, meaning vested as part of the plan, and either available for borrowing or reimbursement of other expenses or will not be paid back to the owner or otherwise set aside from the owner’s creditors.

B. SPLIT-DOLLAR LIFE INSURANCE PURCHASED BY AN S-CORPORATION ON THE LIFE OF THE EMPLOYEE-OWNER IN CONJUNCTION WITH AN EMPLOYEE BENEFIT PLAN IS EMPLOYEE COMPENSATION

In Our Country Home Enterprises, Inc., three closely held corporate entities and their shareholders adopted the “Sterling Benefit Plan,” which combined individual welfare benefit funds of employers with the plans to be held in trust by the plan administrators.25 Essentially, where a singular employer adopts a welfare benefit plan to purchase life insurance policies for its employees, trust administrators combine the funds of many employers. The employers could set the age of retirement and the number of years of employment required for full vesting.26 In addition, the employer could change the terms of the adoption agreement, as Our Country did when it changed its retirement age from 59 to 57, then the age of its sole shareholder.26 Furthermore, the employer’s account would retain any non-vested funds of an employee who left before retirement and redistribute the funds to the remaining participating employees.27

The companies (petitioners) purchased permanent life insurance plans and employees other than employee-owners participated in each.28 Both plans compensated employees with death benefits in amounts ranging from five to twenty times their salary.29 30 The companies deducted the amounts they contributed to the plans in each tax year and the shareholder-employees reported no income resulting from the vesting of their life insurance policies.31 

i. THE PLANS ADOPTED BY OUR COUNTRY HOME AND CODE ENVIRONMENTAL SERVICES WERE COMPENSATORY SPLIT-DOLLAR LIFE INSURANCE BECAUSE THE PLANS PROVIDED INDIVIDUAL DETERMINATION OF BENEFITS

Petitioners argued that their plans were group term life-insurance and that the premiums they paid were fully deductible as employee compensation.32 If correct, the companies were entitled to deduct up to $50,000 in each tax year.33 Since “the amount of insurance provided to each employee . . . [must be] computed under a formula that precludes individual selection,”34 the companies contended that the coverage their plans offered each employee was based on the employee’s prior year’s salary, and so did preclude individual selection.35 The tax court disagreed that the plans qualified as group plans because the plans often provided coverage additional to the compensation ratio stated in the adoption agreement and individual risk factors accounted for the individual plans later grouped for one combined premium price.36 37 In short, though a single premium was contracted for, that amount was determined by first calculating the cost of insuring each individual who was to be insured.

On this basis, the court concluded that the shareholder-employee arrangement was a compensatory split-dollar life insurance plan, not a group plan, and that the companies must treat the premiums as investments in the contract, which are only deductible if the contract has been transferred to the non-owner.38 Here, no property was transferred to the non-owner because the trust retained the property. Therefore, the employers could not deduct the cost of premiums.

ii. PETITIONERS ARGUED THAT THE TREASURY REGULATION WAS INCONSISTENT WITH A “REALIZATION EVENT”, BUT THIS ARGUMENT FAILED

Recall, the economic benefits of split-dollar life insurance are taxable to the non-owner when the non-owner has a current or future right to the funds, and direct or indirect access while simultaneously the owner and their creditor’s must have no access.24 Petitioners argued that this was unconstitutional because the interpretation of the I.R.S. was inapposite with a realization event.39 The substance of this claim is below but derives from case law governing administrative regulation referred to as “Chevron” deference. The principle is that administrative regulation must not be against any express intention of Congress and otherwise must reasonably construe Congress’ statutory charge, which means the regulation must not be “arbitrary or capricious, or manifestly contrary to the statute.40

In turn, first the court determined that I.R.C. § 61 (that income is from “whatever source derived”) is the controlling statutory enactment, but does not define the term “economic benefit.”41 Second, the court concluded that the treasury regulation fit within the jurisprudence interpreting I.R.C. § 61 because they have held that “the benefit derived from an employer’s set-aside of money or property as compensation for services rendered is includible in the service provider’s gross income at the time of set-aside, where the money or property is beyond the reach of the employer’s creditors.”42 Therefore, the treasury regulation is not arbitrary and capricious, so petitioners could not avoid that economic benefit is taxable in the year in which the benefit is conferred despite that both owner-employee and employees had only a future interest.

Courts may impose a penalty for understatements of income that exceed 10% or $5,000, but a taxpayer may avoid the penalty if they demonstrate that they acted with reasonable care and in good faith by consulting a tax professional.43 Here, the court upheld the government’s claim that the taxpayer’s failed to establish that they reasonably relied on the independent advice of a qualified tax professional by supplying adequate tax information.44 Only the owner-employee of Our Country sought the advice of independent counsel, an estate planner, but he did so only after investing in the plan and could not substantiate what specific advice he relied on.26 Thus, all individual petitioners were liable for a 20% penalty in accord with I.R.C. § 6662(a).

Also, petitioners were liable for a 30% penalty assessed for failing to disclose a “reportable transaction”.45 This applies to either “any listed transaction” or “any reportable transaction . . . a significant purpose of such transaction is the avoidance or evasion of Federal income tax.”46

In 2007, the I.R.S. provided notice that certain trust arrangements that purported to be “welfare benefit programs and that utilize cash value insurance policies” were considered “listed transactions.”47 This notice specifically identified transactions for purchase of life insurance by a trust that is contributed to by an employer who is the owner of the contract. Therefore, according to the court, the owners were subject to an additional 30% tax for failure to disclose the sufficiently similar transactions to reportable transactions.

IV. IN MACHACEK THE TAX COURT FOLLOWED ITS REASONING IN OUR COUNTRY HOME ENTERPRISES, INC. TO DISALLOW DEDUCTIONS UNTIL THE INSURANCE PLAN IS TRANSFERRED, INCUR TAX IN THE YEAR ECONOMIC BENEFIT IS RECEIVED, AND IMPOSE PENALTIES

In Machacek Inc., v. Comm’r, T.C. Memo 2016-55, because the employee benefit plan was adopted prior to the effective date of Treasury Regulation § 1.61-22 but subsequently adopted healthcare reimbursement after the effective date, the tax court first decided whether the change was “material.” If affirmative, the plan would be governed by the split-dollar life insurance regulations. The new guiding rule is that “if it went beyond a mere ministerial change and created a different legal entitlement,” the change is material.48 Absent other change in terms, if a plan lapses but is reinstated within a short period of lapsing, though modified, it is immaterial.49 The tax court held that adding a health expense reimbursement to the life insurance plans was a material modification because it “unlocked” access by the non-owner of the split dollar life insurance to funds that prior were unavailable until retirement or upon death.50

The primary issue is whether the plan the Machacek’s alleged was an employee benefit plan was really compensatory split-dollar life insurance and, if so, the tax consequences thereof. First, because the plan adoption agreement required certification that John Machacek (personally) was insurable by way of supplying medical history information and vesting was based on years of employment, the court concluded the plan was not a group policy.51 Second, the contributions to the plan were from Machacek, Inc., the owner of the insurance policy by way of a trust.52 Third, John Machacek, in his personal capacity was able to name the beneficiary, who was himself.53 Therefore, the court determined that the arrangement was a compensatory split-dollar life insurance plan.

Furthermore, the court determined that John Machacek could affect a distribution of the property at any time because the plan was fully vested in both 2005 and 2006.52 As a result, in each tax year Machacek’s taxable income was increased by the accumulation value for that year as well as the cost of the life insurance, which was non-deductible because it was not a welfare benefit plan and there was no transfer of property.54 Lastly, Machacek was assigned a 20% penalty under § 6662(a).55 Despite that Machacek did not properly report the cost of life insurance on his W-2, he was not assigned a penalty for failure to report a reportable transaction, presumably because he reported on his W-2.

V. THE SIXTH CIRCUIT OVERRULED THE TAX COURT TO ALLOW AN EMPLOYEE-OWNER OF SPLIT-DOLLAR LIFE INSURANCE TO TAX GAIN AS A SHAREHOLDER DISTRIBUTION RATHER THAN COMPENSATION FOR SERVICES

Machacek appealed to the Sixth Circuit Court of Appeals, which overruled the tax court. The Sixth Circuit held that when the non-owner of a split-dollar life insurance policy is a shareholder of an S-corporation, the arrangement is necessarily entered into in the non-owner’s capacity as a shareholder, regardless of the services they may also perform. Consequently, under this bright line rule Machacek’s split-dollar life insurance accumulated value was taxed as a shareholder distribution rather than a compensatory arrangement. 

Before specifics are explained and analyzed, let us get a feel for the nature of Machacek’s argument. As discussed in Our Country Home Enterprises, Inc., the employer may only deduct ordinary and necessary business expenses, so extravagant expenses that far exceed the cost of a whole life policy are not deductible. Therefore, for an S-corporation, the non-deductible expense is income for the S-corporation and passes through to the owner, who also happens to be an employee. The owner is taxed as though this is ordinary income. Additionally, according to the tax court and discussed above, as the non-owner of the split-dollar life insurance policy, the individual, who is both an employee and shareholder, must pay tax at ordinary rates on the accrued value of the life insurance plan which is in excess of the employer contribution. In front of the Sixth Circuit Court of Appeals, Machacek likened this to double taxation, which S-corporations are supposed to avoid. Though, as you will see, the Sixth Circuit Court of Appeals does not agree with Machacek’s reasoning or follow his conclusion that the accrued value is not taxable. Yet, because Machacek is a S-corporation shareholder, the court favorably re-characterized the accrued value income from the life insurance plan as a shareholder distribution rather than ordinary gain.

A. IN THE SIXTH CIRCUIT, THE RELATIONSHIP BETWEEN AN EMPLOYEE-OWNER AND THE OWNER OF A SPLIT-DOLLAR LIFE INSURANCE POLICY IS A CONTROLLING CONSIDERATION DESPITE THAT ON THE FACE OF THE ARRANGEMENT IT APPEARS COMPENSATORY

Before the Sixth Circuit Court of Appeals, Machacek argued that Treasury Regulation § 1.301-(1)(m)(1)(i) controlled the character of income for a shareholder derived from accrued value of a split-dollar life insurance policy. In opposition, the government argued that an employee’s additional status as a shareholder (employee-owner) is not necessarily controlling of whether the arrangement for split-dollar life insurance with the policy owner is a shareholder policy. Rather, it argued, the controlling aspect is the capacity in which the split-dollar life insurance policy is contracted for.56 Essentially, the government said that if an employee-owner is always subject to distribution treatment rather than compensation, then, contrary to the treasury regulation, there is no distinction between a shareholder distribution and compensatory agreement. However, the government missed the distinction: not all non-owners of split-dollar life insurance are shareholders.26 The court of appeals sided with Machacek and resolved the question of income character as follows.

Essentially, Treasury Regulation § 1.301-1(m)(1)(i) controlled, because it states that “the provision by a shareholder of a split dollar life insurance arrangement . . . of economic benefits . . ., is treated as a distribution of property.” Thus, the court of appeals concluded that I.R.C. § 301 sufficiently demonstrates Congress’s intent that any split-dollar life insurance arrangement between a corporation and shareholder is a property distribution.10

The Sixth Circuit acknowledged that Treasury Regulation § 1.301-1(d) states that the shareholders’ “capacity as such” brings the inquiry of income character into that regulation as applied to I.R.C. § 301, whereas otherwise the regulation is entirely inapplicable.26 However, they reason that to suppose only if the arrangement is entered into in the shareholder’s capacity as such runs counter to explicit reference in paragraph (m) of the same regulation to paragraphs (b)(1) and (2) of Treasury Regulation 1.61-22, concerning split-dollar life insurance. The court asserted that by explicitly stating the paragraphs of Treasury Regulation § 1.61-22 that bring the arrangement under the guidance of Treasury Regulation § 1.301-1(a), the additional concern for “capacity as such [shareholder]” fails to recognize that it could have explicitly stated that compensatory arrangements are excluded.26 Therefore, the court determined to tax the economic benefit to the employee-shareholder as a dividend subject to capital gains. 

Machacek attempted to render a zero tax outcome. As his argument went, if I.R.C. § 301 saves the shareholder-employee from Treasury Regulation 1.61-22 even if the life insurance policy was purchased as employee compensation, the next iterative step, Machacek argued, is that subchapter S applies because Machacek, Inc. is an S-corporation, not a C-corporation.57 Though not explicit in the opinion of the Sixth Circuit’s opinion, if subchapter S applied, then the accumulated value was non-taxable, because under I.R.C. § 1368 it may adjust basis in stock, which is not taxable.26 The court rejected Machacek’s rationale and held that the controlling regulation was not usurped by subchapter S.58 Unfortunately, the Sixth Circuit neglects to elaborate why subchapter S does not apply, but it infers that the issue is so conclusive in Treasury Regulation § 1.301-1 that the accumulated value must be taxed as a distribution under I.R.C. § 301.

VI. IN DE LOS SANTOS, THE TAXPAYER URGED THAT ALL SPLIT-DOLLAR LIFE INSURANCE FOR THE BENEFIT OF AN EMPLOYEE-OWNER OF A CORPORATION IS A DISTRIBUTION OF STOCK UNDER I.R.C. § 301, BUT THE TAX COURT REJECTED THE ARGUMENT

In De Los Santos (appealable to the fifth circuit, but no appeal taken), the husband taxpayer was the sole shareholder of an S-Corporation who caused the business to fund a trust that purchased split-dollar life insurance for the benefit of their employees in exchange for the performance of services.59 The taxpayer and his wife were both employed by the S-corporation, along with four other employees.60 The taxpayers each received life insurance coverage of $12.5 million and the other employees $10,000 of coverage.26 The years in question were 2011 and 2012, and by the end of the latter the trust had contributed $884,534 to premiums and accumulated cash value of $744,460.26 Taxpayers caused the S-corporation to deduct the cost of the contributions to the trust and claimed no income from the accumulation value for the years in question nor any year prior.61 The taxpayers urged the court to follow the decision of the Sixth Circuit in Machacek that the accumulated value was not taxable at ordinary rates. 

The tax court declined to follow the Sixth Circuit and reiterated its long-standing holding that an S-corporation could not deduct the contributions to the split-dollar life insurance plan, thus income passed-through to the taxpayer, and that taxpayers had ordinary income from the accrued value of the policy because the policy was compensatory split-dollar life insurance that constituted a fringe benefit to an S-corporation shareholder.62

The tax court denied the taxpayer’s motion for summary judgment for two reasons. First, the weight of authority did not show Treasury Regulation § 1.301-1(q)(1)(i) supersedes Congress’s intent that I.R.C. § 301 pertain to “distributions of stock.”  Second, Subchapter S controls with regard to 2% shareholders, so the taxpayer’s reliance on I.R.C. § 301 was unfounded.

A. I.R.C. § 301 GOVERNS SHAREHOLDER DISTRIBUTIONS “WITH RESPECT TO ITS STOCK” AND CONGRESSIONAL COMMITTEE REPORTS CLARIFY THAT THIS MEANS IN THE SHAREHOLDER’S “CAPACITY AS SUCH”

The characterization of income as applied under I.R.C. § 301(c) relates only to “a distribution of property . . . made by a corporation to a shareholder with respect to its stock.”63 The tax court asserted that the “plain meaning” of a statute must be “enforced . . . according to its terms” if Congress has already spoken as to the meaning.64 Congress has directly spoken to the meaning of “with respect to its stock”: “to shareholders in their capacity as such.”65 To provide context, when might property be distributed to a shareholder but not “in their capacity as such?” Some examples are if the shareholder is receiving property in their capacity as a creditor or debtor, or if they are simply an employee being paid a salary.26

Also, Treasury Regulation § 1.301-1(a) and (c) states that I.R.C. § 301 only applies if the “distributions to shareholders with respect to its stock” involve transactions between the corporation and shareholder in their “capacity as such.”66 Because Treasury Regulation § 1.301-1(m)(1)(i) is limited by only those distributions of stock to shareholders in their capacity as such, the sections application to Treasury Regulation § 1.61-22(b)(1) or (2) pertains to economic benefits bestowed by a corporation on a shareholder in their capacity as such.67 Additionally, Treasury Regulation §1.61-22 states that the “relationship” between the owner (of the split-dollar life insurance policy) and the non-owner receiving the benefits is controlling. Thus, the benefit may constitute “a payment of compensation, a distribution under § 301, . . . or a transfer having a different tax character.”68

Therefore, in De Los Santos, the tax court concluded that invariable application of I.R.C. § 301 to all circumstances between a shareholder and a corporation is irreconcilable with Congress’ clear intent that distributions of property by a corporation to a shareholder are only taxed as property distribution if provided to the shareholder in their capacity as a shareholder. “Capacity as such” not only excludes transactions where a taxpayer receives compensation despite that they are an employee-owner and not just an employee, but also distinguishes between distributions to shareholders that constitute profits from those that are returns of basis. The effect of the later distinction is not only with regard to the character of income to the employee-owner, but precludes the S-corporation from deducting when they are distributing profits. 

B. I.R.C. §§ 1372 AND 702(c) REQUIRE THAT A 2% SHAREHOLDER REPORT FRINGE BENEFITS AS ORDINARY INCOME, WHICH FORECLOSED THE TAXPAYER’S RELIANCE ON I.R.C. § 301

S-corporations are governed by Subchapter S. Partnership rules apply to S-corporations with regard to employee fringe benefits and a 2% owner is treated as a partner.69 However, if payments to the partner are for services and are not with regard to the income of the partnership, then under § 61(a) the person is not considered a member of the partnership.70 The court’s primary point is that this result prevents an S-corporation from providing fringe benefits to any shareholder while avoiding payroll taxes. Hence, not only does the employee-owner have ordinary income, but the S-corporation must pay payroll tax. 

            The court’s argument overrides any notion that I.R.C. § 301 permits owners of S-corporations to be taxed at capital gains rates on fringe benefits offered in return for services rendered. The court speculated that if § 301 were controlling, S-corporations may as well make their employees small shareholders, in which case they would avoid payroll taxes with negligible effect on the distribution of profits.71 Therefore, the fringe benefits conferred on De Los Santos were taxed as ordinary income.

VII. DISCUSSION

Following De Los Santos, the I.R.S. issued an Action on Decision, non-acquiescing to Machacek in cases appealable to jurisdictions other than the Sixth Circuit.72 Regarding those cases appealable to the Sixth Circuit, the I.R.S.’s position is that taxpayer’s must adopt consistent reporting. For example, if the taxpayer is to take advantage of the result in Machacek which treats split-dollar life insurance as a corporate distribution, the S-corporation, as the owner of the split-dollar life insurance policy, will not be able to claim a deduction upon transferring the accrued value of the life insurance account to the employee post-retirement.73 Also, for S-corporations with more than one shareholder, the distribution to the owner-employee would create a second class of stock with superior rights to another class.74 This is because any instance where an owner-employee receives an alleged distribution in his capacity as a shareholder but really due to a compensatory split-dollar life insurance arrangement, other shareholders who are not employees will have no split-dollar life insurance agreement. The problem of creating a second class of stock by virtue of the split-dollar life insurance benefit would have severe consequences because the S-corporation could no longer pass-through taxable income. 

The reasoning in De Los Santos is thorough and sound. The most important aspect is that it maintains the principle of non-delegable congressional duties and weight of authority.75 Congress has the sole authority to legislate and may not delegate that duty to administrative agencies. Here, Congress enacted I.R.C. § 301 which applied only to distributions to shareholders with respect to their stock. The legislative committee report confirms Congress’s intent that “with respect to its stock” means “in the shareholders capacity as [a shareholder].” 

In Machacek, the Sixth Circuit was wrong to conclude that Treasury Regulation § 1.301-1(a), which echoes I.R.C. § 301 that the code governs distributions to shareholders with respect to its stock, is subservient to a narrow paragraph at the end of the regulation regarding split-dollar life insurance. Treasury Regulation § 1.301-1(m)(1)(i) should be amended to explicate that split-dollar life insurance arrangements described by Treasury Regulation § “1.61-22(b)(1) or (b)(2)(iii)” may not be treated as a property distribution under I.R.C. § 301 if the arrangement is compensatory. This avoids any ambiguity as to whether an arrangement between a shareholder and a corporation is necessarily entered into in the capacity as such.

Another example where the Sixth Circuit’s interpretation could lead to an unresolvable, regulatory law-making exercise concerns the timing of tax. According to Treasury Regulation §1.301-1(c), the timing of inclusion in gross income for a distribution by a corporation to a shareholder is “when the cash or other property is unqualifiedly made subject to their demands.” According to case law, a dividend was “unqualifiedly made subject to the . . . demands” of a shareholder not in the year the dividend was declared, but in the month it became payable.76 This result suggests that the taxpayer could avoid tax until the property (i.e. the accrued value of life insurance policy) is transferred.

By comparison, according to Treasury Regulation § 1.61-22(d)(ii), for purposes of computing the tax on the benefit incurred, the value of “current access” is that to which a non-owner has a “current or future right, and that currently is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s creditors.” In Machacek the taxpayer “unlocked” funds otherwise unavailable until death or upon retirement when the S-corporation adopted an amendment such that accrued value could be used for healthcare reimbursement. That constituted a material change (one that goes “beyond a mere ministerial change and created a different legal entitlement”77) after § 1.61-22 took effect, so despite that Machacek, in his capacity as employee-shareholder, did not unqualifiedly make the property subject to his demands, he did have a future right that was accessible by the non-owner. The funds were accessible by the non-owner because they could cover healthcare expenses. Hence, it seems that the Sixth Circuit may have to reconcile the conflict between §§ 1.61-22 and 1.301-1(c) if and when an employee-owner and S-corporation have contracted for a split-dollar life insurance arrangement and the employee-owner argues that no taxable event has occurred because the accrued value is not “unqualifiedly made subject to his . . . demands as a shareholder.” Even within the Sixth Circuit, this argument could lead the Court of Appeals to recognize the likely error in Machacek and reverse the holding in a future case. 

However, the most striking example of failure to acknowledge the hierarchy of authority concerned the Sixth Circuit’s avoidance of subchapter S. Clearly Machacek’s contention that subchapter S necessitated that his distribution was not subject to tax was erroneous, but the court was wrong to rely on a treasury regulation over the code itself. Subchapter S necessitates that for the purposes of fringe benefits, 2% shareholders be treated as third parties who receive gross income under I.R.C. § 61.

VIII. CONCLUSION

In conclusion, taxpayers in the Sixth Circuit should be wary of relying on the conclusions in Machacek because the downside risk that the S-corporation cannot deduct any of the transaction and that the S-corporation loses its pass-through status means that it would be subject to double taxation. Taxpayers in other circuits are currently required to treat as ordinary income distributions when an employer purchases split-dollar life insurance for them, and if these taxpayers fail to report that income or characterize it as capital gain, they risk further penalties to tax given that they are on notice by the tax court’s decision in De Los Santos and the IRS Action on Decision non-acquiescing to the Sixth Circuit’s decision in Machacek.

  1. Treas. Reg. 1.61-22(b)(iii).
  2. Our Country Home Enterprises, Inc. v. Comm’r, 145 T.C. at 51-52.
  3. Id. at 53.
  4. Id., citing, Brodie v. Comm’r, 1 T.C. 275; Sproull v. Comm’r, 16 T.C. 244.
  5. Machacek v. Comm’r, T.C. Memo 2016-55, 14.
  6. Id. at 9.
  7. Id. at 12-13.
  8. Id. at 14.
  9. Machacek v. Comm’r, 906 F.3d 429, 433, 436.
  10. Id. at 436.
  11. De Los Santos v. Comm’r, 156 T.C. 9, 124.
  12. AOD 2021-02 (IRS AOD).
  13. I.R.C. § 1.61-22(j)(1), (2)(i).  But see I.R.C. § 1.61-22(j)(2)(ii) (enumerating a non-exclusive list of immaterial modifications). 
  14. I.R.C. § 1.61-22(b)(2)(i).
  15. I.R.C. § 1.61-22(c)(1)(i).
  16. I.R.C. § 1.61-22(c)(2)(i).
  17. I.R.C. § 1.61-22(d)(1).
  18. I.R.C. § 1.61-22(b)(2)(ii)(A).
  19. I.R.C. § 1.61-22(b)(2)(ii)(B).
  20. I.R.C. § 1.61-22(b)(2)(ii)(C).
  21. I.R.C. § 1.61-22(b)(2)(iii)(A).
  22. I.R.C. § 1.61-22(d)(2).
  23. I.R.C. § 161-22(d)(3).
  24. I.R.C. § 1.61-22(d)(4)(ii).
  25. Our Country Home Enterprises, Inc. v. Comm’r, 145 T.C. 51-52, 9.
  26. Id.
  27. Id. at 14-15.
  28. Id. at 10.
  29. Id. at 15-18, 25-30.
  30. Regarding Environmental, however, valuation of the owner-employee plans sometimes exceeded the compensation provided for in the adoption agreement and on another year was limited by the face value of the plan, thus falling short of the prescribed regimen. Our Country Home Enterprises, Inc., 145 T.C. at 28-29. Also, Our Country was required to attest to risk factors for each employee, resulting in ranking the employees for purposes of shopping for acceptable plans.  Our Country Home Enterprises, Inc., 145 T.C. at 15-16.
  31. Id. at 18-20, 31-35.
  32. Id. at 41-43.
  33. I.R.C. § 79.
  34. Treas. Reg. § 1.79-(1)(a)(4).
  35. Our country Home Enterprises, Inc., 145 T.C. at 41.
  36. Id. at 42-43, citing, Towne v. Comm’r, 78 T.C. 791 (explaining that group insurance usually excludes “individual selection” because underwriters of those policies are at less liberty to request a medical examination or proof of insurability). 
  37. As a final attempt to avoid the determination that the policies were split-dollar life insurance plans, petitioner’s asserted that the trusts in which the plans were held were the beneficiaries of the plans, rather than the beneficiaries designated by the employees. Simply, the court disagreed because petitioner’s formalism does not have to be indulged by the Internal Revenue Service or the courts.  Id. at 44-45.
  38. Treas. Reg. 1.61-22(f)(2)(ii); I.R.C. § 72(e)(6); Treas. Reg. 1.83-6(a)(5) (overruled on other grounds).
  39. Our Country Home Enterprises, Inc., 145 T.C. at 51.
  40. Chevron, U.S.A, Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 842-844; Mayo Found. for Med. Educ. & Research v. U.S. 562 U.S. 44, 53.
  41. Our Country Home Enterprises, Inc. v. Comm’r, 145 T.C. at 52.
  42. Id. at 53, citing Brodie v. Comm’r, 1. T.C. 275 and Sproul v. Comm’r, 16 T.C. 244.
  43. I.R.C. § 6662(a).
  44. Our Country Home Enterprises, Inc., 145 T.C. at 65-66.
  45. I.R.C. § 6662(A).
  46. A “‘reportable transaction’ means any transaction with respect to which information is required to be included with a return or statement because . . . such transaction is of a type which the Secretary determines as having a potential for tax avoidance or evasion.”  I.R.C. § 6707(A); see also I.R.C. § 6011.  A “‘listed transaction’ means a transaction which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction.”  Id.  However, where “the relevant facts affecting the tax treatment of . . . [an] item are [not] adequately disclosed” no reasonable cause abatement may be afforded. I.R.C. § 6664(d)(3)(A).  Furthermore, failure to disclose relevant facts increases the applicable penalty from 20% to 30% of the understatement. I.R.C. § 6662(A)(c).
  47. I.R.S. Notice 07-83, 2007-2 C.B. 960.
  48. Machacek, T.C. memo 2016-55, 11, 12.
  49. Id. at 11.
  50. Id. at 12.
  51. Id. at 3-4, 12.
  52. Id. at 13.
  53. Id. at 8-9, 13.
  54. Id. at 14.  See also Treas. Reg. §§ 1.162-10, 1.83-6(a)(5).
  55. Id. at 15.
  56. Machacek, 906 F.3d at 435.
  57. Id. at 434.
  58. Id. at 435.
  59. De Los Santos, 156 T.C. 9, 122-23.
  60. Id. at 123.
  61. Id. at 123-124.
  62. Id. at 124.
  63. I.R.C. § 301(a); see also I.R.C. § 317 (defining the term “property” to mean “money, securities, and any other property; except . . . stock in the corporation making the distribution (or rights to acquire such stock)”).
  64. De los Santos, 156 T.C. at 130.
  65. S. Rep. No. 83-1622, at 1869 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 4868.
  66. Id. at 131.
  67. Id. at 131-32.
  68. Treas. Reg. § 1.61-22(d)(1).
  69. De Los Santos, 156 T.C. at 134, citing, Our Country Home Enterprises, Inc., 145 T.C. at 51 (relying onI.R.C. 1372(a) with regard to 2% shareholders of s-corporations who receive fringe benefits).
  70. I.R.C. § 707(c).
  71. De los Santos, 156 T.C. at 133.
  72. A.O.D., supra n. 12.
  73. Id., see also Treas. Reg. 1.83-6(a)(5).
  74. Id., see also  I.R.C. § 1361(b)(1)(D).
  75. U.S. Constitution, Article 1.
  76. Comm’r v. American Light & Traction Co., 156 F.2d 398 (7th Cir. 1946).
  77. Machacek, T.C. memo 2016-55, 11-12.

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Aaron worked as a case assistant for plaintiffs alleging failure to warn claims stemmed from pharmaceutical use and as a weight lifting trainer prior to attending law school. He recently interned at Andersen in their private client services tax accounting practice. When he's not reading and writing, he loves to spend time outside with his wife and son, their french bulldogs and chocolate labrador, and many chickens.