S CORPORATION'S PAYMENT OF INSURANCE PREMIUM WAS PROPERTY DISTRIBUTION TO SHAREHOLDER

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S CORPORATION’S PAYMENT OF INSURANCE PREMIUM WAS PROPERTY DISTRIBUTION TO SHAREHOLDER

Posted by Kim Chen on October 31st, 2018

Machacek, Jr. v. Comm., (CA6 10/12/2018) 122 AFTR 2d 2018-6269
In a case of first impression, the Court of Appeals for the Sixth Circuit, reversing the Tax Court, has held that the economic benefits flowing to the taxpayers, husband and wife, from the payment of a $100,000 premium on the husband’s insurance policy had to be treated as distributions of property by a corporation to its shareholder under Reg § 1.301-1(q)(1)(i). The Tax Court had held that in addition to the pass-through amount of the premium payment, the taxpayers were required to report as taxable income the economic benefits flowing from the increase in value of the life insurance policy caused by the payment of the premium.
Background. Under Reg. §1.61-22(b)(1), a split-dollar life insurance arrangement is any arrangement between an owner and a non-owner of a life insurance contract that satisfies the following criteria:
1. Either party to the arrangement pays, directly or indirectly, all or any portion of the premiums on the life insurance contract, including a payment by means of a loan to the other party that is secured by the life insurance contract;
2. At least one of the parties to the arrangement paying premiums is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the life insurance contract; and
3. The arrangement is not part of a group-term life insurance plan unless the group-term life insurance plan provides permanent benefits to employees
Arrangements satisfying the criteria set out by Reg. § 1.61-22(b)(1) are generally referred to as “traditional” split-dollar arrangements. However, the split-dollar regs also apply to any arrangement qualifying either as a “compensatory” arrangement or a “shareholder” arrangement, regardless of whether those arrangements satisfy the criteria for a traditional arrangement. (Reg § 1.61-22(b)(2))
An arrangement qualifies as a “compensatory” arrangement if:
a. The arrangement is entered into in connection with the performance of services and is not part of a group-term life insurance plan;
b. The employer or service recipient pays, directly or indirectly, all or any portion of the premiums; and
c. Either
A. The beneficiary of all or any portion of the death benefit 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
B. The employee or service provider has any interest in the policy cash value of the life insurance contract. (Reg. § 1.61-22(b)(2)(ii))
An arrangement qualifies as a “shareholder” arrangement if:
i. The arrangement is entered into between a corporation and another person in that person’s capacity as a shareholder in the corporation;
ii. The corporation pays, directly or indirectly, all or any portion of the premiums; and
iii. Either
A. The beneficiary of all or any portion of the death benefit is designated by the shareholder or is any person whom the shareholder would reasonably be expected to designate as the beneficiary; or
B. The shareholder has any interest in the policy cash value of the life insurance contract. (Reg § 1.61-22(b)(2)(iii))
The split-dollar regulations make no reference to Subchapter S.
Facts. Machacek, Inc., which was wholly owned by the married taxpayers John Machacek, Jr. and Marianne Machacek (the Machaceks) adopted a Sterling Benefit Plan (Sterling Plan) in order to provide certain benefits to its employees. Pursuant to the plan, Machacek, Inc. provided John Machacek with a life insurance policy and paid the $100,000 annual premium in the 2005 tax year.
Both Machacek, Inc. and the Machaceks filed timely tax returns the 2005 tax year. Because Machacek, Inc. was an S corporation, its income, losses, deductions, and credits were “passed through” to shareholders for tax purposes. Machacek Inc. deducted the $100,000 premium, and that amount was thus not included in the Machaceks’ individual income. The Machaceks also did not include as individual income the economic benefits flowing from the increase in value of the life insurance policy.
Tax Court decision. The Tax Court concluded that purported welfare benefit plan in which the taxpayers’ company participated was a nonqualified deferred compensation arrangement, and the taxpayers had to include in their gross income any vested accrued benefits in the plan under Code Sec. 402(b)(4), because the plan failed to cover eligible non-highly compensated employees.
The Tax Court determined that Machacek, Inc. was not entitled to deduct the $100,000 premium payment; because the $100,000 premium payment was not deductible, Machacek, Inc. underreported its income for that year and, due to the pass-through nature of S corporations, the increased income was passed through to the Machaceks, who were then required to pay income tax on that amount. Further, the life insurance policy funding the plan was found to be a part of a compensatory split-dollar life insurance arrangement, and the insured taxpayer, Mr. Machacek, also had to include in gross income the economic benefit under it. (Machacek, Jr., TC Memo 2016-55, see Purported welfare benefit plans were nonqualified deferred compensation arrangements (04/07/2016))
The issue. On appeal, the dispute concerned the tax treatment of the economic benefits flowing to John Machacek as a result of Machacek, Inc.’s payment of the premium. The parties disputed whether the Machaceks were required to report as taxable income — in addition to the pass-through amount of the premium — the economic benefits flowing from the increase in value of the life insurance policy caused by the payment of the premium. On appeal, the non-deductibility of the premium payment was not disputed by the Machaceks, and they conceded that they must report the amount of the premium payment as pass-through income.
Parties’ positions. The Machaceks relied on the statutory provisions governing the tax treatment of S corporations, arguing that such prevented double taxation otherwise imposed pursuant to an interpretative reg on split dollar life insurance premiums that have been paid by S corporations. Under Code Sec. 1361 et seq., S corporations are generally exempt from corporate income tax, and instead an S corporation’s income, losses, deductions, and credits are passed through to its shareholders.
On the other hand, IRS argued (and the Tax Court agreed) that the economic benefits should be treated as individual income, rather than as a shareholder distribution, because John Machacek received life insurance as part of a compensatory split-dollar arrangement. IRS noted that such treatment would be uncontroversial if the recipient of the economic benefits were an ordinary employee, rather than an S corporation’s shareholder-employee. While IRS recognizes that Reg. § 1.301-1(q)(1)(i) applies to both compensatory and shareholder arrangements, it concluded that it “does not mean that in any situation where a compensatory arrangement covers a shareholder, the taxpayer’s status as a shareholder trumps his status as an employee, causing the economic benefit to be treated as a distribution to a shareholder”. IRS contended that such an interpretation of the reg would make no sense, as it would defeat the reason for distinguishing between a compensatory arrangement and a shareholder arrangement.
Appellate decision. The Sixth Circuit concluded that under Reg. § 1.301-1(q)(1)(i) the economic benefits flowing to the Machaceks from Machacek, Inc.’s payment of the $100,000 premium on John Machacek’s life insurance policy had to be treated as distributions of property by a corporation to its shareholder. The Court reversed the Tax Court and remanded for further proceedings consistent with its opinion.
The Sixth Circuit noted that in finding for IRS the Tax Court did not address Reg. § 1.301-1(q)(1)(i). Neither party cited or relied on this reg, and the Sixth Circuit was aware of no case discussing the reg in any context.
The Court noted that the Tax Court had found that John Machacek’s life insurance policy qualified as a compensatory split-dollar arrangement. It was undisputed that John Machacek’s life insurance policy did not qualify as a traditional split-dollar arrangement and that the parties appeared to concede that John Machacek’s life insurance policy was not a shareholder arrangement. However, Reg. § 1.301-1 — the reg purporting to govern the distribution of property by any corporation to its shareholders with respect to their stock — addressed the treatment of economic benefits flowing from split-dollar life insurance arrangements.Reg. § 1.301-1(q)(1)(i) states that “the provision by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement, as defined in Reg. § 1.61-22(b)(1) or (2), of economic benefits described in Reg § 1.61-22(d) … is treated as a distribution of property”. (Reg. § 1.301-1(q)(1)(i)) The Sixth Circuit concluded that, by its terms, this reg applies to all three types of split-dollar arrangements: traditional arrangements defined by Reg. § 1.61-22(b)(1); compensatory arrangements defined by Reg. § 1.61-22(b)(2)(ii); and shareholder arrangements defined by Reg. § 1.61-22(b)(2)(iii).
The Sixth Circuit found that Reg. § 1.301-1(q)(1)(i) was dispositive and rendered irrelevant whether John Machacek received the economic benefits through a compensatory or shareholder split-dollar arrangement.Reg. § 1.301-1(q)(1)(i) treats economic benefits provided to a shareholder pursuant to any split-dollar arrangement as a distribution of property within the ambit of Code Sec. 301. And, although another sub-section of that reg, Reg. § 1.301-1(c), states that the regulation as a whole “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”, the explicit inclusion in Reg. § 1.301-1(q)(1)(i) of all arrangements described in Reg. § 1.61-22(b)(2) — which includes compensatory arrangements — makes 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.
IRS offered no alternative interpretation that gives meaning to the inclusion of compensatory arrangements in Reg. § 1.301-1(q)(1)(i). The Sixth Circuit further found that its interpretation was further supported by the fact that Reg. § 1.61-22(d) states that the tax treatment of the economic benefits depends on the “relationship between the owner and the non-owner”. The Court rejected IRS’s argument that this language shows that the tax treatment depends on the nature of the split-dollar arrangement (compensatory or shareholder), finding that if that were the controlling factor, the regs could have said so, but they did not.
The Sixth Circuit held that the Tax Court erred by relying on the compensatory nature of John Machacek’s split-dollar arrangement to conclude that the economic benefits were not distributions of property to a shareholder. Where, as here, a shareholder receives economic benefits from a split-dollar arrangement, Reg. § 1.301-1(q)(1)(i) requires that those benefits be treated as a distribution of property to a shareholder.