Sterling Plan Yields Tarnished Tax Results

In consolidated test cases involving the Sterling Plan, a purported welfare benefit plan, the Tax Court held that life insurance policies issued on the lives of employees of C corporations and S corporations as part of the corporations’ participation in the Sterling Plan were part of a split-dollar life insurance arrangement; thus, the employees realized income for the benefits they received from the life insurance policies, and the corporations could not deduct the payments made to the welfare benefit plan.

Background

Almost 50 cases were filed in the Tax Court regarding deficiencies assessed by the IRS stemming from the various taxpayers’ participation in the Sterling Plan. The IRS and the taxpayers selected seven cases as test cases to resolve the issues related to the Plan and agreed to be bound by the results in the test cases. Five of these cases involved the purchase of insurance for employees of a C corporation or an S corporation by the Plan to fund the retirement benefits it offered. (Two of the cases, not discussed below, involved a corporation that participated in the Plan but did not purchase insurance for employees through it.)

The Sterling Plan was marketed as a welfare benefit plan consisting of the respective separate plans that each participating employer customized to apply to its employees alone. The Sterling Plan would pay death, medical, and disability benefits with respect to a participating employee to the extent that his or her participating employer selected. Each employer selected the general provisions, the participation requirements, and the vesting schedule applicable to its Plan. Each employee designated to whom the Plan would pay the benefits with respect to the employee.

The death benefit that the Sterling Plan agreed to pay to a participating employee was the face amount of an insurance policy that it purchased on the employee’s life. The employer effectively paid the premiums on the insurance policy through its payments to the Plan, and the insurance policy usually had a cash-value component that increased annually. The Plan’s payment of any nondeath benefit to an employee was generally limited to the cash value of the insurance policy related to that employee. An employer could terminate its participation in the Plan and cause each of its employees to be fully vested in his or her policy (including its cash value). A participating employee, upon retiring, could take his or her insurance policy in satisfaction of any post-retirement death benefit payable to the employee.

The life insurance purchased for the corporations’ employees was purchased by the Sterling Plan, but the employees were required to make formal applications for the insurance, answering standard questions about the employees’ health history and activities, and to undergo a medical examination. The owner of the policy issued was the trust for the Plan.

The corporations made contributions that were used by the Plan to pay premiums on the insurance policies of the employees, increasing the cash value of the policies. On their tax return for the years they made contributions, the corporations took a full deduction for the contribution payments to the Plan. The employees did not report any income related to their participation in the Plan.

The IRS disagreed with both the corporations’ and the employees’ treatment of their involvement with the Sterling Plan. With respect to the corporations, the IRS issued a deficiency notice for the years at issue that disallowed their claimed deductions for payments made to the Plan because the life insurance arrangement was a split-dollar life insurance arrangement subject to the economic benefit regime rules, under which the payments to the Plan were not deductible. The IRS also issued deficiency notices to the employees, stating that the benefits that they received from the insurance purchased for them was includible in their income for the years at issue.

The Tax Court’s Decision

The Tax Court held that each corporation’s participation in the Sterling Plan was part of a split-dollar life insurance arrangement, not a welfare benefit program, because the participation in the Plan met the three-prong definition of a compensatory arrangement in Regs. Sec. 1.61-22(b)(2)(ii). As such, the corporations’ employees covered by the insurance policies under the Plan were required to include in income all the economic benefits the Plan provided them through the insurance policies. Further, the court held that because the Plan was a split-dollar life insurance arrangement, under Regs. Sec. 1.83-6(a)(5), no deduction was allowed to the corporations for their payments to the Plan.

Plan participation was split–dollar life insurance arrangement: Under the special rules of Regs. Secs. 1.61-22(b)(2)(ii) and (iii), an arrangement between an owner and a nonowner of a life insurance contract is a split-dollar life insurance arrangement if it is either a compensatory arrangement or a shareholder arrangement. An arrangement is a compensatory arrangement if it meets each prong of a three-prong test. First, the arrangement must be entered into in connection with the performance of services and not as part of a group term life insurance plan under Sec. 79. Second, the employer or service recipient must pay, directly or indirectly, all or any portion of the premiums. Third, either (1) the beneficiary of all or any portion of the death benefit must be designated by the employee or service provider or must be any person whom the employee or service provider would reasonably be expected to designate as the beneficiary; or (2) the employee or service provider must have an interest in the policy cash value of the life insurance contract. The parties in the cases agreed that the corporations were the owners of the life insurance policies.

The corporations and the employees argued that the insurance purchased was group term insurance and the first requirement was met because the amount of the insurance was based on the employees’ compensation without regard to their health. The Tax Court found that under Sec. 79, the insurance did not qualify as group term insurance because the amount of insurance provided to each employee was not computed under a formula that precludes individual selection. The court observed that although the Sterling Plan purported to base death benefits on a compensation-based formula, the death benefits provided were often larger than the formula amount, and that the information required to be provided during the insurance application process suggested that issuance of the insurance took into account the personal risk characteristics of the employees. Thus, the court concluded that individual selection was involved and the insurance consequently was not group term life insurance.

The corporations and the employees also argued that the third requirement of Regs. Sec. 1.61-22(b)(2)(ii) was not met because the employees did not designate beneficiaries and did not have a direct or indirect interest in the life insurance policies. The Tax Court found both these contentions to be untrue.

The corporations and the employees maintained that since the Sterling Plan was the actual designated beneficiary of death benefits on the policies, despite the fact that the Plan was required to pay over those death benefits to the beneficiaries designated by the employees, the employees did not designate beneficiaries. The court did not agree with this reasoning, stating that “[t]he fact that the death proceeds from the life insurance policies are funneled through the Sterling Plan to each of the ultimate recipients does not blur our view (or our conclusion) that each of those recipients is the beneficiary of the death benefit for purposes of section 1.61-22(b)(2)(ii)(C).”

The Tax Court further concluded that the corporations’ employees had interests in their life insurance policies and the cash values thereof based on five facts. First, each life insurance policy and any funds related to it were intended to be received by the corresponding employee or his or her designee(s) and no one else, and those employees were the only ones who had the right to receive or otherwise to redirect to someone else the cash value of the life insurance policies related to them. Second, the employees could elect to receive their policies upon retiring from employment with the employer. Third, the funds in the Plan could not be accessed by either the corporations or their creditors, and upon retirement or cessation of participation in the Plan, the employees were certain to get those funds in the form of the policies that then passed to them. Fourth, a participating employee, before actually receiving the funds in his or her account, could be allowed to direct the investment of those funds and thus enjoy the benefit of any investment gain or suffer the detriment of any investment loss. Fifth, if the participating employee were to die while his or her insurance policy was in force, then the death benefit under that policy would ultimately be paid to his or her beneficiary in accordance with the terms of the policy.

Income to employees from participation in the Plan: The IRS argued that the employees of the corporations must include in income all of the economic benefits that the Sterling Plan provided to them through the life insurance policies. The employees countered that they did not receive economic benefits during the years at issue in excess of the consideration that they paid for the benefits, asserting that the employees did not have a current or future right to the cash value of the life insurance policies related to them, either by direct receipt of the cash or by causing the cash to be used to pay other benefits provided under the Plan and that they could not cause any of the life insurance policies to be distributed to them.

The Tax Court again sided with the IRS. It explained that the tax consequences of a split-dollar life insurance arrangement are determined under the economic benefit provisions of Regs. Secs. 1.61-22(d) through (g) unless a split-dollar loan is involved, or one is not involved and the nonowner of the insurance contract makes premium payments on the insurance contract. The parties had agreed that there were no split-dollar loans involved, and the court found that the employees, who were the nonowners of the insurance contracts, did not make premium payments, so it determined that the economic benefit provisions did apply. Under these provisions, employees must recognize the full value of the economic benefits, net of any consideration that the employees paid to their employers for the benefits. Here, because the Sterling Plan was a compensatory arrangement, the income would be compensation or a guaranteed payment to the employee, if the corporation was an S corporation and the employee was also a 2% shareholder.

Deduction to the corporations for contributions to the Plan: With respect to the deduction for the contributions, the Tax Court first noted that, like any other expense, to be deductible, the expenses must be ordinary and necessary business expenses under the general rule of Sec. 162(a). However, as the court further explained, the general rule for determining the deductibility of expenses related to split-dollar life insurance arrangements has been supplemented with special rules in the regulations.

Under Regs. Sec. 1.61-22(f)(2)(ii), expenses related to such arrangements are deductible only if the requirements of Regs. Sec. 1.83-6(a)(5) are met. Under the latter regulation section, the deduction is limited to the amount the employee must include in income under Regs. Sec. 1.61-22(g)(1), which specifies that the employee generally must recognize income on the transfer to him or her of ownership of the life insurance policy. Thus, the court held, because the corporations did not transfer any life insurance policies to their participating employees during the subject years, and the employees did not recognize any income from their participation in the Plan, the corporations could not deduct their contribution payments to the Plan.

Reflections

The Tax Court affirmed in its decision that the Sterling Plan was substantially similar to the transactions identified as listed transactions in Notice 2007-83, and therefore the 30% accuracy-related penalty in Sec. 6662A for reportable transaction understatements applied to the employees (other than one to whom the IRS, for unstated reasons, conceded it did not). Based on the decision in these consolidated cases, Notice 2007-83, and the decisions in Neonatology Assocs., P.A., 115 T.C. 43 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002), and its progeny, practitioners should be aware that participating in plans like the Sterling Plan will not yield the tax benefits claimed by their promoters and will likely lead to disastrous tax results for those involved.

Our Country Home Enters., Inc., 145 T.C. No. 1 (2015)