Split-Dollar Life Insurance Benefits Taxed as Ordinary Income

Split-Dollar Life Insurance Benefits Taxed as Ordinary Income

U.S. Tax Court

The Tax Court held that economic benefits a doctor received as an employee of his S corporation from a split-dollar life insurance arrangement were taxable to him as ordinary income. Ruben De Los Santos operated his medical practice through an S corporation that established a welfare benefits program that provided life insurance to him and his wife as employees. In a <a href="/lr/resolve//28fn7" rel="noopener" target="_blank">prior opinion</a>, the Tax Court determined that their participation in the plan constituted a compensatory split-dollar life insurance arrangement under reg. section 1.61-22(b) and the resulting economic benefits were taxable as current income. The couple filed a motion for partial summary judgment, arguing that the economic benefits to the husband were taxable as distributions under section 301 as a shareholder of the S corporation. The IRS disagreed, arguing that the benefits were taxable as ordinary income because they were employee benefits to the husband in his capacity as an employee. Judge Albert G. Lauber, writing for the Tax Court, found that the IRS had the more persuasive argument. Lauber explained that split-dollar life insurance arrangements like the one in this case fall into two categories: compensatory arrangements in which the benefits constitute compensation for services; and shareholder arrangements in which the economic benefits constitute a distribution to the shareholder. Lauber further explained that section 301 governs distributions of property made to shareholders by a corporation and that distributions must be made by the corporation to a shareholder regarding its stock and received in the individual’s capacity as a shareholder. The court declined to follow the Sixth Circuit’s approach in <a href="/lr/resolve//rid:28hxd">another case</a> that would have the court conclude that economic benefits received by a shareholder would invariably constitute a section 301 distribution, finding that that approach cannot be reconciled with the text of section 301 or the split-dollar regulations. Lauber noted that the Sixth Circuit’s approach could allow a corporation to avoid employment taxes on split-dollar arrangements by giving employees a few shares of stock to convert them to shareholders. The court also found a distinct and independent basis for denying the couple’s motion for partial summary judgment based on its decision in <a href="/lr/resolve//1q4cx" rel="noopener" target="_blank">Our Country Home Enterprises Inc. v. Commissioner</a>, 145 T.C. 1 (2015). In that the case, the court held that split-dollar life insurance benefits are fringe benefits and that under section 1372, with regard to employee fringe benefits provided by S corporations, the S corporation should be treated as a partnership. The court concluded that the economic benefits are categorized as guaranteed payments under section 707(c), and the husband must recognize the amount as ordinary income under section 61.

The Tax Court held that economic benefits a doctor received as an employee of his S corporation from a split-dollar life insurance arrangement were taxable to him as ordinary income.

The Tax Court held that economic benefits a doctor received as an employee of his S corporation from a split-dollar life insurance arrangement were taxable to him as ordinary income. Ruben De Los Santos operated his medical practice through an S corporation that established a welfare benefits program that provided life insurance to him and his wife as employees. In a prior opinion, the Tax Court determined that their participation in the plan constituted a compensatory split-dollar life insurance arrangement under reg. section 1.61-22(b) and the resulting economic benefits were taxable as current income. The couple filed a motion for partial summary judgment, arguing that the economic benefits to the husband were taxable as distributions under section 301 as a shareholder of the S corporation. The IRS disagreed, arguing that the benefits were taxable as ordinary income because they were employee benefits to the husband in his capacity as an employee. Judge Albert G. Lauber, writing for the Tax Court, found that the IRS had the more persuasive argument. Lauber explained that split-dollar life insurance arrangements like the one in this case fall into two categories: compensatory arrangements in which the benefits constitute compensation for services; and shareholder arrangements in which the economic benefits constitute a distribution to the shareholder. Lauber further explained that section 301 governs distributions of property made to shareholders by a corporation and that distributions must be made by the corporation to a shareholder regarding its stock and received in the individual’s capacity as a shareholder. The court declined to follow the Sixth Circuit’s approach in another case that would have the court conclude that economic benefits received by a shareholder would invariably constitute a section 301 distribution, finding that that approach cannot be reconciled with the text of section 301 or the split-dollar regulations. Lauber noted that the Sixth Circuit’s approach could allow a corporation to avoid employment taxes on split-dollar arrangements by giving employees a few shares of stock to convert them to shareholders. The court also found a distinct and independent basis for denying the couple’s motion for partial summary judgment based on its decision in Our Country Home Enterprises Inc. v. Commissioner, 145 T.C. 1 (2015). In that the case, the court held that split-dollar life insurance benefits are fringe benefits and that under section 1372, with regard to employee fringe benefits provided by S corporations, the S corporation should be treated as a partnership. The court concluded that the economic benefits are categorized as guaranteed payments under section 707(c), and the husband must recognize the amount as ordinary income under section 61.

Sec. 301 Distributions of property

Sec. 1372 Partnership rules to apply for fringe benefit purposes

Sec. 707 Transactions between partner and partnership

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Split-Dollar Life Insurance Benefits Taxed as Ordinary Income