Despite a contrary decision of the Sixth Circuit, the Tax Court held that economic benefits an S corporation shareholder received from a split-dollar life insurance arrangement were payments of compensation taxed as ordinary income, not distributions of property under Sec. 301.
Medical practice's employee welfare benefit plan
Rueben De Los Santos is a medical doctor and, during 2011 and 2012, he was the sole shareholder of Dr. Ruben De Los Santos MD, PA, an S corporation, which employed De Los Santos and his wife, as well as four other individuals. De Los Santos included in his income, as the sole shareholder of the S corporation, 100% of its items of income and expense.
In 2006, the S corporation adopted an employee welfare benefit plan that provided benefits to De Los Santos, his wife, and the four other employees, which they received in their capacity as employees. On audit of De Los Santos's 2011 and 2012 tax years, the IRS determined that the plan was a compensatory split-dollar life insurance arrangement and that the economic benefits De Los Santos realized for those years by participating in the plan were taxable ordinary income. In De Los Santos, T.C. Memo. 2018-155, the Tax Court, agreeing with the IRS's determination, granted the IRS's partial cross-motion for summary judgment on the issue. The court, however, left the computation of the exact amount the taxpayers were required to include in income for further proceedings.
De Los Santos was not satisifed with this decision and filed a second motion for partial summary judgment on the income issue. In the motion, he contended that the economic benefits received by a shareholder pursuant to a split-dollar life insurance arrangement are a distribution under Sec. 301, regardless of whether the taxpayer receives the benefits in his capacity as an employee or as a shareholder. He relied on a Sixth Circuit decision, Machacek, 906 F.3d 429 (6th Cir. 2018), rev'g and remanding T.C. Memo. 2016-55.
Taxation of split-dollar life insurance arrangements
Under regulations issued in 2003, split-dollar life insurance arrangements like the one employed by De Los Santos's S corporation are categorized as either "compensatory arrangements" or "shareholder arrangements." A compensatory arrangement is an arrangement entered into in connection with the performance of services by a service provider for a service recipient. A shareholder arrangement is an arrangement entered into between a corporation and another person in that person's capacity as a shareholder in the corporation.
In both types of arrangements, the owner of the life insurance contract (here the S corporation) pays the premiums, and the nonowner (here De Los Santos) has a current interest in the policy. The economic benefits of the arrangement are treated as being provided to the nonowner of the life insurance contract, and the nonowner must take into account the full value of all economic benefits, less any consideration paid for them.
Depending on the relationship between the owner and the nonowner, the economic benefits may constitute a payment of compensation, a distribution under Sec. 301, or a transfer having some other tax character. Under a compensatory arrangement, the economic benefits will generally constitute the payment of compensation to the service provider, and under a shareholder arrangement, the economic benefits will generally constitute a distribution to the shareholder.
The Tax Court's decision
The Tax Court held that because the compensatory split-dollar life insurance arrangement provided benefits to De Los Santos in his capacity as an employee of the S corporation, they were not a distribution by a corporation to a shareholder with respect to its stock. It further held that for purposes of taxing employee fringe benefits, De Los Santos is treated as a partner of a partnership and therefore the economic benefits he realized were Sec. 707(c) guaranteed payments taxable as ordinary income.
For purposes of the second partial motion for summary judgment, De Los Santos did not dispute that the life insurance arrangement at issue was a compensatory arrangement and conceded that the S corporation provided him with death benefits in exchange for the performance of services. He consistently characterized the benefits provided by the plan to all six employees of the S corporation as employee benefits. Thus, the Tax Court determined that the arrangement was necessarily a compensatory arrangement.
Although logically it seemed that this would mean that the benefits from the plan were in the nature of compensation, De Los Santos continued to argue that benefits from a split-dollar life insurance arrangement always must be treated as distributions of property and therefore the benefits he received were Sec. 301 corporate distributions even though the benefits were received in exchange for services he performed in his capacity as an employee.
De Los Santos based his argument in support of this proposition on Machacek, in which the Sixth Circuit considered the effect of Regs. Sec. 1.301-1(q)(1)(i), captioned "Split-Dollar and Other Life Insurance Arrangements," on the treatment of benefits received from a split-dollar life insurance arrangement. Paragraph (q)(1)(i) provides: "The provision by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement, as defined in [Regs. Sec.] 1.61-22(b)(1) or (2), of economic benefits described in [Regs. Sec.] 1.61- 22(d) . . . is treated as a distribution of property."
The Sixth Circuit concluded that the cross-reference to Regs. Sec. 1.61-22(d) in Regs. Sec. 1.301-1(q)(1)(i), meant that the subsection applied to any split-dollar arrangement. Thus, it held that benefits from a split-dollar life insurance arrangement, whether it be a compensatory or a shareholder arrangement, are treated as distributions of property. The court acknowledged that the regulations generally provide under Regs. Sec. 1.301-1(c) that Sec. 301 is not applicable to an amount paid by a corporation to a shareholder unless the amount is paid to the shareholder in his capacity as such. Nonetheless, it concluded that this general rule must yield to Regs. Sec. 1.301-1(q)(1)(i), as a more specific provision that sets forth an "explicit inclusion . . . of all arrangements described in [Regs. Sec.] 1.61-22(b)(2)."
The Tax Court, which was not bound to follow the Sixth Circuit's opinion because De Los Santos's case was appealable to a different circuit, found that it was "unable to embrace the reasoning or result" of the opinion in Machacek. The Tax Court stated it could not do so because it could not ignore the plain language of Sec. 301(a) or interpret the regulation to thwart the statutory mandate the regulation was designed to implement.
The Tax Court observed that Sec. 301(a) unambiguously applies only to a distribution of property made by a corporation to a shareholder with respect to its stock. Thus, if a corporation makes a payment other than with respect to its stock — e.g., to a shareholder in his capacity as an employee or a lender — the payment is outside the scope of Sec. 301. Thus, by the plain language of the statute, the provision of benefits to De Los Santos in his capacity as an employee was not a Sec. 301 distribution.
Regarding the statutory mandate, the Tax Court noted that Regs. Sec. 1.301-1(a) describes the statute as setting forth "the general rule for treatment of distributions . . . by a corporation to a shareholder with respect to its stock." Regs. Sec. 1.301-1(c) further states that Sec. 301 "is not applicable to an amount paid by a corporation to a shareholder unless the amount is paid to the shareholder in his capacity as such."
According to the Tax Court, these general rules applied to the more detailed provisions in the Sec. 301 regulations, such that the phrases "distributions to shareholders" or "property transferred to a corporation by a shareholder" referred to a distribution made to a shareholder "in his capacity as such." Thus, in Regs. Sec. 1.301-1(q)(1)(i), the phrase a "distribution of property" was not a reference to all distributions of property to a shareholder, but was a reference only to distributions of property to a shareholder in the shareholder's capacity as a shareholder. Consequently, because the provision of benefits from a compensatory split-dollar life insurance arrangement is not a distribution to a shareholder in the capacity as a shareholder, Regs. Sec. 1.301-1(q)(1)(i) did not apply to the provision of benefits and it was not a Sec. 301 property.
The Tax Court then addressed why, since the split-dollar life insurance arrangement benefits were not a distribution of property under Sec. 301, they would be taxable as ordinary income. De Los Santos had explicitly conceded that the benefits he received from the split-dollar life insurance arrangement were employee benefits. The court explained Sec. 1372(a) states that for purposes of applying the income tax provisions of this Subtitle A, relating to employee fringe benefits, an S corporation shall be treated as a partnership, and any 2% shareholder of the S corporation shall be treated as a partner of that partnership.
In Our Country Home Enterprises, 145 T.C. 1 (2015), the Tax Court found in the case of an S corporation the 2% shareholder is treated as a partner for purposes of applying the employee fringe benefit rules, under Sec. 1372, and the economic benefits of a compensatory split-dollar life insurance arrangement are categorized as guaranteed payments under Sec. 707(c), which must be included in gross income as ordinary income under Sec. 61(a). Following its reasoning in Our Country Home Enterprises, because De Los Santos was the 100% shareholder in the S corporation at all relevant times and the benefits he received were employee fringe benefits, the Tax Court concluded that the benefits from the arrangement were treated as guaranteed payments that were ordinary income to the taxpayer.
On this point, De Los Santos argued that split-dollar life insurance benefits are not fringe benefits for purposes of Sec. 1372. The Tax Court stated: "Although the term 'fringe benefit' is not defined in the Code, all available evidence suggests that Congress intended to adopt the common understanding of this term, i.e., that a 'fringe benefit' includes any employer-provided benefit that supplements an employee's salary, specifically including life insurance benefits." It further noted that the Supreme Court had held in Smith, 324 U.S. 177, 181 (1945), that any fringe benefit is taxable unless excluded by Sec. 132 or some other explicit exclusionary rule.
Reflections
In a parting shot, the Tax Court provides another reason why the Sixth Circuit was mistaken about Regs. Sec. 1.301-1(q). The court observed that Sec. 1372 requires that an S corporation be treated as a partnership for employee benefit purposes, and partnerships cannot make distributions under Sec. 301. Thus, the Tax Court reasoned that Regs. Sec. 1.301-1(q) could not apply in De Los Santos's case because Sec. 1372 requires his S corporation to be treated as a partnership with respect to split-dollar life insurance benefits.
De Los Santos, 156 T.C. No. 9 (2021)
