Economic benefits of life insurance premium payments are not includible in income

By James A. Beavers, CPA, CGMA, J.D., LL.M.

The Sixth Circuit, reversing the Tax Court, held that the economic benefits an S corporation shareholder/employee received from the S corporation's payment of a premium on the shareholder/employee's life insurance policy was a shareholder distribution that was not includible in income.

Background

John Machacek and his wife, Marianne, were the sole shareholders in the S corporation John J. Machacek Jr. Inc. (Machacek Inc.). John Machacek was an employee of the company. In 2002, the company adopted a welfare benefit plan that provided him a life insurance policy under a split-dollar life insurance arrangement. Machacek Inc. owned the policy and paid the premiums under the arrangement. In 2005, the company paid a $100,000 annual premium on the policy and deducted the $100,000 premium, thereby reducing the amount included in the Machaceks' individual passthrough income from the company. The Machaceks did not include in income the economic benefits they received from the increase in the value of the life insurance policy caused by the premium payment.

The IRS determined that the premium payment was not deductible, resulting in an increase in net income for Machacek Inc., which was passed through to the Machaceks and includible in their income. It also determined that the economic benefit resulting from the company's payment of the premium on the policy was includible in the couple's income. The Machaceks disagreed, believing that the premium payments were a nontaxable distribution from an S corporation, and they challenged the IRS's determination in Tax Court.

The Tax Court sided with the IRS. The court found that including the economic benefit of the premium payment on the policy in the Machaceks' income was not mandated by the S corporation tax rules in the Code and regulations, but by the split-dollar life insurance rules in Regs. Sec. 1.61-22.

The Machaceks appealed the Tax Court's decision to the Sixth Circuit. In the Sixth Circuit, the Machaceks dropped their objection to the denial of the deduction to Machacek Inc., and the inclusion in their income of the increased income of the company passed through to them. The couple continued to argue, though, that the economic benefit resulting from the premium payment on the life insurance policy was a shareholder distribution from Machacek Inc. to John Machacek that was not includible in their income.

The legal and regulatory framework

Under Sec. 1366(a)(1), an S corporation's income, losses, deductions, and credits are passed through to its shareholders. The tax treatment of distributions of property by a corporation to its shareholders is generally governed by Sec. 301(c), but special rules in Sec. 1368 apply to S corporation distributions.

The rules governing the tax treatment of split-dollar life insurance arrangements in which an employer owns a life insurance policy on an employee and pays the premium are set out in Regs. Sec. 1.61-22. Under the regulations, a split-dollar life insurance arrangement can be a traditional, shareholder, or compensatory arrangement, but all of these types of arrangements are subject to the same rules in Regs. Sec. 1.61-22. The regulations provide an economic benefit regime for split-dollar arrangements, under which the nonowner of the policy must take into account the full value of all economic benefits from the policy and, depending on the relationship between the owner and the nonowner of the policy, the economic benefits may be treated as a payment of compensation, a Sec. 301 distribution, a contribution to capital, a gift, or a transfer having a different tax character. The split-dollar regulations do not refer to Subchapter S.

However, regulations under Sec. 301, which purport to govern the distribution of property by any corporation to its shareholders with respect to stock, also address the economic benefits that flow from split-dollar life insurance arrangements. Regs. Sec. 1.301-1(q)(1)(i) states that the provision of the economic benefits to a shareholder through a split-dollar life insurance arrangement is treated as a distribution of property.

The Sixth Circuit's decision

The Sixth Circuit overturned the Tax Court's decision and held that the premium payment on the life insurance policy was a distribution of property. The Sixth Circuit based its determination on Regs. Sec. 1.301-1(q)(1)(i).

In the Sixth Circuit, the Machaceks argued that the rules applying to distributions to S corporation shareholders took precedence over the split-dollar regulations. The couple contended that Regs. Sec. 1.301-1(q)(1)(i) applied to the premium payment and that under the regulation, the premium payment was an economic benefit treated as a distribution of property. Thus, Sec. 1368, which overrides the rules that generally apply to distributions to shareholders from corporations when the corporation is an S corporation, governed the treatment of the economic benefits from the premium payments.

The IRS countered that the split-dollar life insurance rules in Regs. Sec. 1.61-22 applied because John Machacek's split-dollar life insurance arrangement was a compensatory split-dollar arrangement. Under the split-dollar rules, the economic benefits arising from the premium payments were taxable income to the Machaceks. According to the IRS, although Regs. Sec. 1.301-1(q)(1(i) applies to compensatory split-dollar arrangements, this did not mean that in all cases involving a compensatory split-dollar arrangement that the taxpayer's status as a shareholder trumps the taxpayer's status as an employee. If it did, the IRS contended, it would defeat the reason for distinguishing in the regulations between compensatory and shareholder split-dollar arrangements. The court disagreed, finding that treating all economic benefits to shareholders as distributions would not undermine the purpose of the split-dollar regulations, stating that "the split-dollar regulations apply to all situations, not just situations where the non-owner of the policy is a shareholder, and thus there are obvious reasons for distinguishing between shareholder and compensatory arrangements" (slip op. at 9).

The Sixth Circuit found that Regs. Sec. 1.301-1(q)(1)(i) was dispositive, so the economic benefits the Machaceks received must be treated as distributions of property by a corporation to a shareholder, and it was irrelevant whether John Machacek's arrangement was a compensatory or shareholder split-dollar arrangement. The court explained that the explicit inclusion in Regs. Sec. 1.301-1(q)(1)(i) of all split-dollar arrangements described in Regs. Sec. 1.61-22, including compensatory arrangements, made it "clear that when a shareholder-employee receives economic benefits pursuant to a compensatory split-dollar arrangement, those benefits are treated as a distribution of property and are thus deemed to have been paid to the shareholder in his capacity as a shareholder" (slip op. at 10).

The court further observed that this interpretation was supported by Regs. Sec. 1.61-22(d), which provides that the economic benefits' tax treatment depends on the relationship between the owner of the life insurance policy and the nonowner. The IRS contended this meant that the tax treatment of a split-dollar arrangement depended on whether the arrangement was a shareholder arrangement or a compensatory arrangement, but the Sixth Circuit found that if this were the case, the regulations could have said so, and they did not.

Reflections

The Sixth Circuit's decision represents a fallback win for the Machaceks. Machacek Inc. had set up split-dollar arrangements for John Machacek and other employees as part of a plan called the "Sterling Benefit Plan," which had been promoted to the company as a welfare benefits plan. The promoters of the Sterling Benefit Plan had claimed that the payments of the premiums on the life insurance policies on John Machacek and other employees would be deductible by the company. However, the Tax Court found that the plan was actually a deferred compensation plan and, as alluded to in the Sixth Circuit's opinion, held that the payments were not deductible.

Machacek, No. 17-1131 (6th Cir. 10/12/18)

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