In an apparent case of first impression, the 6th Circuit Court of Appeals in Machacek v. Commissioner
(No. 17-1131) held that the economic benefits under a split-dollar life insurance arrangement should be treated as distributions by the corporation-employer to a shareholder-employee, regardless of whether the split-dollar life insurance arrangement was a compensatory or shareholder arrangement.
The petitioners, a married couple, were the sole shareholders of an S corporation, with the husband also working as an employee of the S corporation. In 2002, the S corporation entered into a life insurance policy with the Sterling Benefit Plan (SBP), a trust that provided supplemental retirement and insurance plans for various employers. The life insurance policy covered the life of the husband, with the S corporation as the owner of the policy. In 2005 and 2006, the S corporation made over $100,000 of contributions to the SBP trust to fund the life insurance premiums, and the S corporation deducted the payment for the life insurance premiums in its 2005 return. However, the petitioners did not include any part of the increase in value of the life insurance policy in their gross income.
The IRS issued a notice of deficiency to the petitioners for taxable years 2005 and 2006, claiming that the life insurance policy was a split-dollar life insurance arrangement under the economic benefit regime pursuant to Treas. Reg. Sec. 1.61-22. As such, the IRS argued that the economic benefits of the split-dollar life insurance arrangement should have been included in the petitioners’ income for taxable years 2005 and 2006, and that the S corporation was not allowed to take a deduction for the payment of premiums under the split-dollar life insurance arrangement. The Tax Court agreed with the IRS and held the life insurance policy to be a compensatory split-dollar life insurance arrangement because the husband petitioner entered into the arrangement in connection with the performance of services as an employee of the S corporation.
The federal income tax consequences of a split-dollar life insurance arrangement are generally determined under one of two regimes – the economic benefit regime or the loan regime. Under the economic benefit regime, the non-owner 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-owner for those economic benefits. The split-dollar regulations provide that, depending on the relationship between the owner (S corporation) and the non-owner (shareholder-employee), the economic benefits may constitute a payment of compensation, a distribution under Section 301, a contribution to capital, a gift, or a transfer having a different tax character (see Treas. Reg. Sec. 1.61-22(d)(1)).
On appeal, the 6th Circuit Court held that the economic benefits provided to a shareholder pursuant to any type of split-dollar life insurance arrangement under the economic benefit regime to be a distribution of property under Treas. Reg. Sec. 1.301-1(q)(1)(i) and accordingly reversed the Tax Court’s decision and remanded it for further proceedings consistent with the opinion. The circuit court found that the explicit inclusion in Treas. Reg. Sec. 1.301-1(q)(1)(i) of all economic split-dollar life insurance arrangements described in Treas. Reg. Sec. 1.61-22(b)(2) – which includes both compensatory and shareholder arrangements – indicates that a shareholder-employee receiving economic benefits pursuant to a compensatory split-dollar arrangement must treat those benefits as a distribution of property, not as income.
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