Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.
• Position: TAX TRENDS

Gross Income

Compensatory split-dollar life insurance benefits are compensation

Despite a contrary decision of the Sixth Circuit, the Tax Court held that economic benefits an S corporation shareholder received from a split-dollar life insurance arrangement were payments of compensation taxed as ordinary income, not distributions of property under Sec. 301.

Medical practice's employee welfare benefit plan

Rueben De Los Santos is a medical doctor and, during 2011 and 2012, he was the sole shareholder of Dr. Ruben De Los Santos MD, PA, an S corporation, which employed De Los Santos and his wife, as well as four other individuals. De Los Santos included in his income, as the sole shareholder of the S corporation, 100% of its items of income and expense.

In 2006, the S corporation adopted an employee welfare benefit plan that provided benefits to De Los Santos, his wife, and the four other employees, which they received in their capacity as employees. On audit of De Los Santos's 2011 and 2012 tax years, the IRS determined that the plan was a compensatory split-dollar life insurance arrangement and that the economic benefits De Los Santos realized for those years by participating in the plan were taxable ordinary income. In De Los Santos, T.C. Memo. 2018-155, the Tax Court, agreeing with the IRS's determination, granted the IRS's partial cross-motion for summary judgment on the issue. The court, however, left the computation of the exact amount the taxpayers were required to include in income for further proceedings.

De Los Santos was not satisifed with this decision and filed a second motion for partial summary judgment on the income issue. In the motion, he contended that the economic benefits received by a shareholder pursuant to a split-dollar life insurance arrangement are a distribution under Sec. 301, regardless of whether the taxpayer receives the benefits in his capacity as an employee or as a shareholder. He relied on a Sixth Circuit decision, Machacek, 906 F.3d 429 (6th Cir. 2018), rev'g and remanding T.C. Memo. 2016-55.

Taxation of split-dollar life insurance arrangements

Under regulations issued in 2003, split-dollar life insurance arrangements like the one employed by De Los Santos's S corporation are categorized as either "compensatory arrangements" or "shareholder arrangements." A compensatory arrangement is an arrangement entered into in connection with the performance of services by a service provider for a service recipient. A shareholder arrangement is an arrangement entered into between a corporation and another person in that person's capacity as a shareholder in the corporation.

In both types of arrangements, the owner of the life insurance contract (here the S corporation) pays the premiums, and the nonowner (here De Los Santos) has a current interest in the policy. The economic benefits of the arrangement are treated as being provided to the nonowner of the life insurance contract, and the nonowner must take into account the full value of all economic benefits, less any consideration paid for them.

Depending on the relationship between the owner and the nonowner, the economic benefits may constitute a payment of compensation, a distribution under Sec. 301, or a transfer having some other tax character. Under a compensatory arrangement, the economic benefits will generally constitute the payment of compensation to the service provider, and under a shareholder arrangement, the economic benefits will generally constitute a distribution to the shareholder.

The Tax Court's decision

The Tax Court held that because the compensatory split-dollar life insurance arrangement provided benefits to De Los Santos in his capacity as an employee of the S corporation, they were not a distribution by a corporation to a shareholder with respect to its stock. It further held that for purposes of taxing employee fringe benefits, De Los Santos is treated as a partner of a...