Split-Dollar Life Insurance Arrangements and the Tax Code
A recent Tax Court decision in De Los Santos v. Commissioner illustrates the complexity of split-dollar life insurance arrangements. Taxpayers who participate in these or other types of life insurance arrangements should consult knowledgeable tax counsel to ensure that arrangement is reported properly on all applicable tax returns.
In 2003, the Treasury Department issued final regulations addressing the taxation of split-dollar life insurance arrangements. Split-dollar life insurance arrangements of the sort involved in this case fall into one of two categories—“compensatory arrangements” or “shareholder arrangements.” Reg. § 1.61-22(b)(2)(ii), (iii). In both types, the “owner” of the life insurance contract pays the premiums, and the “non-owner” has a current interest in the policy.
In the case of any split-dollar arrangement, “economic benefits are treated as being provided to the non-owner of the life insurance contract,” and the non-owner “must take into account the full value of all economic benefits,” less any consideration paid therefor. Reg. § 1.61-22(d)(1). “Depending on the relationship between the owner and non-owner, the economic benefits may constitute a payment of compensation, a distribution under section 301,” or a transfer having some other tax character. Id. This means that economic benefits under a “compensatory arrangement” will generally constitute the payment of compensation to the service provider, and economic benefits under a “shareholder arrangement” will generally constitute a distribution to the shareholder. Our Country Home Enters., Inc. v. Comm’r, 145 T.C. 1, 51 (2015).
Indeed, the regulations provide that “[t]he provision by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . of economic benefits . . . is treated as a distribution of property.” Reg. § 1.301-1(q)(1)(i).
Readers will find the details and factual setting of the De Los Santos case below:
De Los Santos v. Comm’r, 156 T.C. No. 9| April 12, 2021 | Lauber, J. | Dkt. No. 5458-16
Short Summary: Taxpayer-husband is a medical doctor. During 2011 and 2012 (“Years at Issue”), he was the sole shareholder of Dr. Ruben De Los Santos MD, PA, an S corporation organized in Texas (“S Corp.”). The S Corp. employed taxpayer-husband and taxpayer-wife, the latter of whom served as office manager for the medical practice. Four other employees also worked for S Corp.
Prior to the Years at Issue, the S corp. had adopted an employee welfare benefit plan to provide its employees with life insurance and other benefits. Under the plan, taxpayers were entitled to a $12.5 million death benefit, and the four rank-and-file employees were entitled to a $10,000 death benefit and certain flexible benefits. To fund the promised death benefits, the S Corp. used the Legacy Employee Welfare Benefit Trust (“Trust”), which purchased a life insurance policy insuring the taxpayers’ lives. The policy was a “flexible premium variable universal life” policy with accumulation values based on the investment experience of a separate fund.
During 2006-2010, the S Corp. paid $1,862,349 to the Trust and treated these contributions as tax-deductible expenses of the medical practice. During 2007-2012, the Trust paid aggregate premiums of $884,534 on the policy. Because of these premium payments and the investment gains thereon, the “accumulation value” of the policy was $640,358 at the end of the year 2011 and $744,460 at the end of the year 2012.
The taxpayers timely filed joint federal income tax returns for 2011 and 2012. They did not report any income on these returns related to their participation in the plan. On December 4, 2015, the IRS issued taxpayers a notice of deficiency, determining that the economic benefits they received under the plan were currently taxable to them as ordinary income. The taxpayers filed a petition with the United States Tax Court challenging the determination.
After the parties filed cross-motions for partial summary judgment, the Tax Court held that the plan constituted a compensatory split-dollar life insurance arrangement and that the economic benefits flowing to the taxpayers generated current taxable income. See De Los Santos, T.C. Memo. 2018-155. Thereafter, the taxpayers filed a second motion for summary judgment contending that the characterization of the payments should be treated as a distribution under Section 301 of the Code.
Key Issues: Whether the compensatory split-dollar life insurance arrangement resulted in ordinary income to the taxpayers or distributions under Section 301 of the Code.
Primary Holdings: Because the compensatory split-dollar life insurance arrangement afforded benefits to taxpayer-husband in his capacity as an employee of the S corporation, such benefits may not be characterized as a distribution by a corporation to a shareholder with respect to its stock. In addition, for purposes of taxing employee fringe benefits, the taxpayer-husband is treated as a partner of a partnership and the economic benefits he realized are therefore taxable under Section 707(c) as guaranteed payments, i.e., ordinary income.
Key Points of Law:
- The purpose of summary judgment is to expedite litigation and avoid costly, unnecessary, and time-consuming trials. See FPL Grp., Inc. & Subs. v. Comm’r, 116 T.C. 73, 74 (2001). The Tax Court may grant summary judgment regarding an issue as to which there is no genuine dispute of material fact and a decision may be rendered as a matter of law. Rule 121(b); Arts, Inc. & Subs. v. Comm’r, 118 T.C. 226, 238 (2002).
- In 2003, the Treasury Department issued final regulations addressing the taxation of split-dollar life insurance arrangements. Split-dollar life insurance arrangements of the sort involved in this case fall into one of two categories—“compensatory arrangements” or “shareholder arrangements.” Reg. § 1.61-22(b)(2)(ii), (iii). In both types, the “owner” of the life insurance contract pays the premiums, and the “non-owner” has a current interest in the policy.
- In a “compensatory arrangement,” the arrangement “is entered into in connection with the performance of services” by a service provider for a service recipient. Reg. § 1.61-22(b)(2)(ii)(A). 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.” Treas. Reg. § 1.61-22(b)(2)(iii)(A).
- In the case of any split-dollar arrangement, “economic benefits are treated as being provided to the non-owner of the life insurance contract,” and the non-owner “must take into account the full value of all economic benefits,” less any consideration paid therefor. Reg. § 1.61-22(d)(1). “Depending on the relationship between the owner and non-owner, the economic benefits may constitute a payment of compensation, a distribution under section 301,” or a transfer having some other tax character. Id. This means that economic benefits under a “compensatory arrangement” will generally constitute the payment of compensation to the service provider, and economic benefits under a “shareholder arrangement” will generally constitute a distribution to the shareholder. Our Country Home Enters., Inc. v. Comm’r, 145 T.C. 1, 51 (2015).
- Section 301 governs distributions of property by a corporation to its shareholders. Not all payments from a corporation to a shareholder, however, constitute “distributions” within the ambit of section 301. Rather, section 301(a) requires that the transfer be made “by a corporation to a shareholder with respect to its stock.” The phrase “with respect to its stock” means that the distributee must receive the payment in his capacity as a shareholder.” “Section 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.” Reg. § 1.301-1(c).
- Accordingly, a payment is not a “distribution” if the shareholder receives it in his capacity as a creditor of the corporation. Loftin & Woodard, Inc. v. U.S., 577 F.2d 1206, 1242 (5th 1978). Nor is a payment of a “distribution” if the shareholder receives it in his capacity as an employee of the corporation. Haber v. Comm’r, 52 T.C. 255, 268 (1969), aff’d per curiam, 422 F.2d 198 (5th Cir. 1970). “These transfers are not made with respect to stock because, if not for the obvious reason that the shareholder’s standing as a shareholder is incidental, the corporation receives equal value in return . . .”
- “The provision by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . of economic benefits . . . is treated as a distribution of property.” Reg. § 1.301-1(q)(1)(i).
- The split-dollar regulations govern the taxation of such arrangements, not only for income and gift tax purposes but also for employment taxes purposes. Reg. § 1.61-22(a)(1). And it is well established that an S corporation “cannot avoid federal employment taxes by characterizing compensation . . . as distributions of the corporation’s net income.” Veterinary Surgical Consultants, P.C. v. Comm’r, 117 T.C. 141, 145-46 (2001).
- Subchapter S governs the tax treatment of S corporations and their shareholders. Section 1372 provides that “for purposes of applying the provisions of this subtitle . . . which relate to employee fringe benefits—(1) the S corporation shall be treated as a partnership, and (2) any 2-percent shareholder of the S corporation shall be treated as a partner of such partnership.” A “2-percent shareholder” is defined to include “any person who owns . . . more than 2 percent of the outstanding stock of such corporation.” 1372(b).
- The term “fringe benefit” is commonly understood to mean “any form of employee compensation provided in addition to wages or base salary, as a pension, insurance coverage, vacation time, etc.” Webster’s New World Collegiate Dictionary 568 (4th 2010). Although the term “fringe benefit” is not defined in the Code, all available evidence suggests that Congress intended to adopt the common understanding of the term, i.e., that a “fringe benefit” includes any employer-provided benefit that supplements an employee’s salary, specifically including life insurance benefits.
Insight: The De Los Santos decision shows the complexity that arises when taxpayers engage in split-dollar life insurance arrangements. Taxpayers who participate in these or other types of life insurance arrangements should consult knowledgeable tax counsel to ensure that these arrangements are reported properly on all applicable tax returns.
