In a recent memorandum opinion, the Tax Court ruled that the economic benefit provided to a business principal from life insurance purchased by the business through an Internal Revenue Code section 419A(f)(6) multiple-employer welfare benefit fund was currently taxable to the principal under the split-dollar life insurance rules. De Los Santos v. Commissioner (Sept. 18, 2018).
- The business principal was the sole owner and an employee of an S corporation, which also employed his spouse and four other individuals during the tax years in controversy.
- In a prior year, the S corporation had joined a multiple-employer welfare benefit plan funded with a taxable trust. Under the plan, the corporation selected a survivor death benefit for the principal and his spouse – provided as required by the plan through a cash value life insurance policy owned by and with proceeds payable to the trust – in the amount of $12.5 million. The other employees received far less valuable welfare benefits that varied over time.
- Contributions to pay for the benefits were made solely by the S corporation, which it deducted, and were irrevocable. The S corporation and its creditors had no access to trust assets, which could be used solely to provide benefits to participants and beneficiaries and defray administrative expenses of the plan.
- Once death benefits were fully funded in accordance with the plan terms, they became vested, and the plan participants would receive that benefit for the remainder of his or her life. During the tax years in controversy, the death benefit for the business principal and spouse was vested.
The Internal Revenue Service (IRS) disagreed with the position taken by the business principal and spouse (taxpayers) on their tax return – that they realized no current income from this benefit – and asserted deficiencies of approximately $600,000 for each of the two tax years in controversy as well as accuracy-related penalties. On a motion for partial summary judgment and following its decision in Our Country Homes Enterprises, Inc. v. Commissioner (2015), the Tax Court agreed that this structure generated current taxable income as a split-dollar life insurance arrangement described in Treas. Reg. § 1.61-22(b).
- The Tax Court rejected the taxpayers’ argument that neither the welfare benefit plan nor its contractual death benefit constituted life insurance, and instead looked through the trust to the life insurance policy in reliance on the attribution rule cited above.
- The Tax Court also found that the insurance was not group-term life insurance, in part because of the nature of the insurance product and in part because the amount of insurance was not determined under “a formula that precludes individual selection” as required by the section 79 regulations.
- Finally, the court ruled that the premium payment and beneficiary designation components of the compensatory arrangement definition were met indirectly through the welfare benefit plan and trust.
The parties agreed that if the arrangement was a split-dollar arrangement, the taxpayers would be taxed under the economic benefit regime of the regulations on:
- The cost of current life insurance protection provided to the non-owner, i.e., the taxpayers, which was not in dispute, plus
- The amount of policy cash value to which the non-owner has “current access,” which was in dispute. Although the business principal and spouse had no current right to withdraw policy cash values – indeed, their only contractual right was to the plan death benefit upon the second to die – the regulations treat as currently accessible the portion of the cash value to which the non-owner has a future right if that portion is inaccessible to the owner or the owner’s creditors. As in Our Country Home Enterprises, the court determined that the right to designate the beneficiary for the death proceeds was a future right to cash value, and that the policy values were inaccessible to the S corporation and its creditors.
Accordingly, the Tax Court held that the business principal and spouse were taxable on the entire amount of the cash value of the life insurance policy during the years in controversy (to the extent not already taxed), to be determined in further proceedings along with the applicability of accuracy-related penalties.