Tax Court rules on split-dollar life insurance question

Tax Hot Topics newsletter The U.S. Tax Court held in T.C. Memo. 2018-155 that a life insurance policy owned by a welfare benefit trust was a compensatory split-dollar life insurance arrangement. The petitioner, a medical doctor, and his wife were employed by an S corporation, with the husband petitioner as the sole shareholder. From 2006 to 2010, the S corporation made $1.8 million of contributions to an employee welfare benefit plan (the Plan) with multiple participating employers. The Plan then purchased a life insurance policy with a face value of $12.5 million covering the petitioners’ lives, with the Plan named as the owner and beneficiary of the life insurance policy.

In addition, the terms for participating in the Plan provided that if an employer made all required contributions to the Plan before Dec. 1, 2011, and thereafter terminated participation, employees entitled to death benefits would continue to receive coverage for the remainder of their lives. The S corporation at issue had made the required contributions to the Plan before the 2011 deadline, and thus the petitioners were fully vested in their $12.5 million death benefit during 2011 and 2012, the tax years at issue.

In 2015, the IRS issued a notice of deficiency to the petitioners for taxable years 2011 and 2012, claiming they had not included the full economic benefits from their participation in the Plan in their gross income. The IRS further argued that the life insurance policy held by the Plan was a compensatory split-dollar life insurance arrangement, although the petitioners disagreed. Upon review, the Tax Court agreed with the IRS and held the life insurance policy to be a compensatory split-dollar life insurance arrangement under Section 1.61-22(b)(2), of which the economic benefits were includible in the petitioners’ income.

The federal income tax consequences of a split-dollar life insurance arrangement are generally determined through either the economic benefit or loan regimes. The parties agreed that the former applied in this case. Under the economic benefit regime, the non-owners of the life insurance contract (petitioners in this case) must take into account the full value of all economic benefits provided under the arrangement, reduced by any consideration paid by the non-owners for those economic benefits.

As relevant to this particular case, the Tax Court explained that the value of the economic benefits provided to the non-owners equaled the sum of two amounts – (1) the cost of current life insurance protection provided to the non-owners (which the parties agreed was $178 for 2011 and $213 for 2012); and (2) the amount of policy cash value to which the non-owners had current access. For this purpose, Treas. Reg. Sec. 1.61-22(d)(4)(ii) provides that a non-owner has current access to that portion of the policy cash value – (i) to which, under the arrangement, the non-owner has a current or future right; and (ii) that currently is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s general creditors.

The Tax Court held that both conditions were satisfied, and therefore, the petitioners had “current access” to the entire cash value of the life insurance policy during 2011 and 2012 (the “accumulation value” of the policy was $640,358 at the end of 2011 and $744,460 at the end of 2012). The Tax Court found that the petitioners had a future right to the policy cash value because they had the exclusive right to designate who would receive death benefits under the policy. The Tax Court also found that, although the petitioners could not withdraw any funds from the policy, the policy cash value was inaccessible to the employer S corporation because its contribution of funds to the welfare benefit trust was thereafter irrevocable, and the employer and its creditors had no access to the income or assets held by the trust.

Jeff Martin
Partner, Washington National Tax Office
T +1 202 521 1526

Keith Mong
Managing Director, Washington National Tax Office
T +1 202 521 1554

James Sanchez

Senior Associate, Washington National Tax Office
T +1 202 861 4107

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