Following a recent decision in their favor, the IRS has issued an Action on Decision (AOD 2021-02
) stating that it disagrees with the Sixth Circuit Court of Appeal’s holding on split-dollar life insurance in the IRS’s 2018 loss in Machacek v. Commissioner
(906 F.3d 429
), and it will continue to litigate its own position in similar cases in all other circuits.
The issue involves whether the economic benefit of a split-dollar life insurance arrangement with an S corporation employee who is a shareholder should be taxable as employee compensation income or a shareholder distribution.
Generally, under a split-dollar life insurance arrangement the corporation enters into a whole-life insurance contract on the life of either a shareholder or an employee. Any economic benefits from the plan are taxable to the employee or shareholder. For example, in a whole-life insurance contract, the current life insurance protection plus the cash surrender value are economic benefits that are taxable to the employee or the shareholder.
The IRS originally lost Machacek
when the Sixth Circuit reversed a 2016 Tax Court decision (T.C. Memo. 2016-55
) and determined that all economic benefits to shareholder-employees should be reported as a distribution — not as compensation income — regardless of whether the benefit arose out of the employment arrangement. The Sixth Circuit reached this conclusion using the reference in Treas. Reg. Sec. 1.301-1(q)(1)(i) that split-dollar life insurance is a distribution.
The new AOD from the IRS comes more than two years after the loss and only after a recent victory for the IRS on the same issue in the Tax Court in De Los Santos v. Commissioner
(156 T.C. No. 9
). The Tax Court disagreed with the Sixth Circuit’s reasoning in Machacek
, ruling in De Los Santos that because the insurance agreement arose out of an employment arrangement, as opposed to a shareholder arrangement, the economic benefit is taxable as compensation income. The Tax Court held that the reference to split-dollar life insurance under Treas. Reg. Sec. 1.301-1(q)(1)(i) was not intended to be applied to compensation arrangements versus shareholder arrangements.
Specifically, the Tax Court stated that Section 301 only applies to “a distribution of property … made by a corporation to a shareholder with respect to its stock.” The court was unable to reconcile the text of Section 301 or the split-dollar regulations to require the economic benefits of an employment arrangement with respect to a shareholder-employee to be distributions. De Los Santos is appealable to the Fifth Circuit Court of Appeals, and the time for filing an appeal has not yet expired.
The AOD effectively says the IRS will treat split-dollar life insurance as a distribution to shareholder-employees only in the Sixth Circuit to the extent it cannot be distinguished from the facts in Machacek
. The IRS will continue to litigate its own position in cases in other circuits.
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