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In Ruben De Los Santos, et ux. v. Commissioner, 156 T.C. No. 9 (2021), the Tax Court held that a split-dollar life insurance arrangement benefitting the sole shareholder of an S corporation, who is also an employee of the corporation, is a compensatory arrangement, with the economic benefit taxable as ordinary income and not as a tax-free S corporation distribution.

Facts

Dr. Ruben De Los Santos formed an S corporation (S Corp) in Texas to house his medical practice; he was the sole shareholder. S Corp employed Dr. De Los Santos, his wife (as office manager) and four other people. The couple received annual salaries during the years at issue (2011 and 2012) of $216,000 and $54,000. Dr. De Los Santos also included in his income 100% of S Corp's income and expense.

S Corp had adopted an employee welfare benefit plan (Legacy Plan) in 2006 to provide all six employees with life insurance and other benefits. Legacy Plan, a multiemployer welfare benefit plan under IRC Section 419A(f)(6), was funded by S Corp's contributions to a trust.

Only those who provided services to S Corp were eligible to receive benefits under the Legacy Plan; Dr. De Los Santos and his wife were entitled to a $12.5-million death benefit and the four other employees were each entitled to a $10,000 heath benefit. To cover the death benefit, the trust purchased a "flexible premium variable universal life" insurance policy on the De Los Santoses' lives.

Between 2006 and 2010, S Corp paid more than $1.86 million to the trust and treated the contributions as tax-deductible expenses. Between 2007 and 2012, the trust paid aggregate premiums of $884,534 on the life insurance policy.

The taxpayers' timely filed tax returns for 2011 and 2012 did not report any income stemming from their participation in the Legacy Plan. The IRS issued a timely deficiency notice asserting that the economic benefits the couple had received under the Legacy Plan constituted taxable ordinary income.

The taxpayers and the IRS each filed a summary judgment motion in the Tax Court regarding whether the Legacy Plan constituted a split-dollar life insurance arrangement under Reg. Section 1.61-22(b)(2). The IRS argued the split-dollar arrangement was "compensatory" in nature because the "Legacy Plan was 'entered into in connection with the performance of services.'" Despite acknowledging that their eligibility for benefits was due to their employment, the taxpayers contended that their arrangement did not meet other requirements in the regulations (Reg. Section 1.61-22(b)(2)(ii)(B) and (C)). The Tax Court granted summary judgment for the IRS (De Los Santos I, T.C. Memo. 2018-155) but left for later proceedings the question of exactly how much income must be included in the taxpayers' gross income for the two years at issue. The taxpayers filed a second motion for partial summary judgment on the gross income question.

Law and analysis

Split-dollar life insurance arrangements like the one at issue in this case can fall into one of two categories — compensatory arrangements and shareholder arrangements. Compensatory arrangements are those entered in connection with the performance of services, and shareholder arrangements are entered due to an individual's capacity as a shareholder in a corporation.

The economic benefits of a split-dollar arrangement involving life insurance coverage being provided to the nonowner of the life insurance contract must be taken into current taxable income by the nonowner. This generally equals the value of the life insurance coverage provided to the nonowner, less any consideration paid by the nonowner for those benefits. The economic benefits in a compensatory arrangement generally constitute the payment of compensation, while those in a shareholder arrangement generally constitute a distribution to the shareholder.

In the instant case, the taxpayers did not dispute that their life insurance arrangement was compensatory. But they contended that the economic benefits a shareholder receives from a split-dollar life insurance arrangement constitute corporate distributions under IRC Section 301 "even if the benefits are received in exchange for services performed by an employee in his capacity as an employee."

The Tax Court pointed out that not all payments a corporation makes to a shareholder constitute distributions under IRC Section 301. Instead, IRC Section "301(a) requires that the transfer be made 'by a corporation to a shareholder with respect to its stock,' [meaning] that the distributee must receive the payment in his capacity as a shareholder." Thus, a payment is not a distribution if the shareholder receives it in his capacity as a creditor or employee of the corporation.

Pointing out that Dr. De Los Santos did not contend his salary qualified as a distribution under IRC Section 301, the court commented "it is hard to see why split-dollar insurance benefits, when received by a shareholder in exchange for the performance of services, should be subject to a different rule." Emphasizing the taxpayers' concession that the split-dollar arrangement was entered in connection with the performance of services, the court concluded it was not a "shareholder arrangement" and IRC Section 301 did not apply.

Rejecting a Sixth Circuit decision

The taxpayers' argument relied on a Sixth Circuit decision that reversed the Tax Court (Machacek v. Commissioner, 906 F.3d 429 (6th Cir. 2018), rev'g and remanding T.C. Memo. 2016-55).

The instant case is appealable to the Fifth Circuit, so the Tax Court was not bound by the Sixth Circuit here and ultimately found itself "unable to embrace the reasoning or result of the Sixth Circuit's opinion in Machacek." In 2016, the Tax Court concluded in Machacek that an S corporation's employee benefit plan constituted a split-dollar life insurance arrangement. The court held that the taxpayers received economic benefits from the arrangements, taxable as ordinary income. The Sixth Circuit reversed, based on an argument the appellants raised for the first time on appeal that, if taxable at all, the economic benefits from the compensatory arrangement at issue were taxable as distributions under IRC Section 301.

Reg. Section 1.301-1(q)(1)(i) states that the "provision by a corporation to its shareholder [under] a split-dollar life insurance arrangement, as defined in [Reg. Section] 1.61-22(b)(1) or (2), of economic benefits described in [Reg. Section] 1.61-22(d) … is treated as a distribution of property." The Sixth Circuit concluded that the reference to Reg. Section 1.61-22(b) "covers the entire universe of split-dollar arrangements," including both compensatory and shareholder arrangements. Ultimately, the Sixth Circuit held these regulations were dispositive and made it irrelevant whether the taxpayers received the economic benefits at issue through a compensatory or shareholder split-dollar arrangement. Although IRC Section 301 expressly does not apply to an amount a corporation pays a shareholder "unless the amount is paid to the shareholder in his capacity as such," the Sixth Circuit concluded that a more specific rule (Reg. Section 1.301-1(q)(1)(i)), expressly including all arrangements described in Reg. Section 1.61-22(b)(2), controlled. After the Sixth Circuit issued its decision, the IRS requested a panel rehearing, but the court denied the petition.

Opting not to follow the Sixth Circuit's reasoning in the instant case, the Tax Court stated that adopting the appeals court's construction of Reg. Section 1.301-1(q)(1)(i) "would require us to ignore the plain language of [IRC Section] 301(a), the statute under which the regulation was promulgated. We are not permitted to construe a regulation in a manner that ignores its governing statute or that adds to the statute 'something which is not there.'" Further, the Tax Court states, it cannot "interpret a regulation 'to thwart the statutory mandate it was designed to implement.'" Upon codifying IRC Section 301(a) in 1954, Congress explained that the new section applied "only to distributions of property to shareholders in their capacity as such." The regulations under IRC Section 301(a) "must (and can) be interpreted to be consistent with this statutory mandate," the Tax Court concludes.

Implications

While the holding of the case is important, it is also worth noting that this fully reviewed Tax Court case affirmatively rejected a decision by the Sixth Circuit Court of Appeals. Although not readily apparent, the Tax Court chose a path to deal with the case at hand without the negative collateral consequences associated with the Sixth Circuit's approach, namely the termination of S corporation status due to disproportionate distributions. As a matter of policy, taxpayers should appreciate that the Tax Court subtly chose to deal with the situation in a way that doesn't impact entity classification.

This case is also interesting because it highlights the broad definition of "split-dollar life insurance arrangement" contained in the cited regulations. The regulations arguably capture within the definition, life insurance arrangements that historically might not have been considered to be split-dollar life insurance arrangements for nontax purposes. The Tax Court's finding that the arrangement in this case met that definition provides a reminder for taxpayers to be aware of these rules.

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