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De Los Santos v. Commissioner (156 T.C. No. 9)

On April 12, 2021, the Tax Court issued its opinion in De Los Santos v. Commissioner, 156 T.C. No. 9. The underlying issue presented in De Los Santos was whether the benefits (a split-dollar life insurance arrangement) received by the petitioners were received in their capacity as employees or shareholders, and, in turn, whether such economic benefits or taxable to the petitioner’s as ordinary compensation income or as a distribution under IRC § 301.

The Petitioners’ (Unavailing) Argument

The petitioners contend that economic benefits received by a shareholder pursuant to a split-dollar life insurance arrangement constitute a distribution under IRC § 301 regardless of whether the taxpayer receives the benefits in his capacity as an employee or as a shareholder.

The IRS’s (Legitimate) Argument

Because the compensatory split-dollar life insurance arrangement afforded benefits to the petitioner-husband in his capacity as an employee of the S corporation, such benefits may not be characterized as a distribution “by a corporation to a shareholder with respect to its stock.”

Initial Thoughts

This opinion is authored by Judge Lauber, who, as we have seen from his prior decisions, is not prone to brevity. This case is not terribly complicated, although the underlying issue of compensatory split-dollar insurance plans is exceedingly complex.

The Complication

The case involves the S corporation that adopted and “employee welfare benefit plan” for the petitioner’s and four rank-and-file employees. Like the erstwhile bald guy on the late-night infomercial that said he was not only the founder, but he was also a client, the petitioner-husband is both a shareholder and an employee of the company that established the split-dollar insurance plan.

Thus, the real question that issue is whether the petitioner received the benefits of the split-dollar insurance plan as an employee or as a shareholder.

Split-Dollar Insurance Plans

Your fearless editors were inclined to skip Judge Lauber’s discussion of split-dollar insurance arrangements to actually get to the actual point, but this is a topic that we have never covered on Briefly Taxing, and so, we will allow it.

Split-dollar life insurance arrangements generally fall into one of two categories–“compensatory arrangements” or “shareholder arrangements.” Treas. Reg. § 1.61-22(b)(2)(ii) and (iii). In both types the “owner” of the life insurance contract pays the premiums, and the “non-owner” has a current interest in the policy.

The difference between these two types of arrangements is the underlying economic relationship. In a “compensatory arrangement,” the arrangement “is entered into in connection with the performance of services” by a service provider for a service recipient. Treas. Reg. § 1.61-22(b)(2)(ii)(A). In a “shareholder arrangement,” the arrangement “is entered into between a corporation and another person in that person’s capacity as a shareholder in the corporation.” Treas. Reg. § 1.61-22(b)(2)(iii)(A).

In the case of any split-dollar arrangement, “economic benefits are treated as being provided to the non-owner of the life insurance contract,” and the nonowner “must take into account the full value of all economic benefits,” less any consideration paid therefor. Treas. Reg. § 1.61-22(d)(1). Depending on the relationship between the owner and the non-owner, the economic benefits may constitute a payment of compensation, a distribution under IRC § 301, or a transfer having some other tax character. Id.

This means that economic benefits under a “compensatory arrangement” will generally constitute the payment of compensation to the service provider, and economic benefits under a “shareholder arrangement” will generally constitute a distribution to the shareholder. See Our Country Home Enters., Inc. v. Commissioner, 145 T.C. 1, 51 (2015) (ruling that a corporation’s provision of economic benefits to its shareholder-employee under a compensatory arrangement “generally is deemed to be the payment of compensation”).

The Petitioners’ Concession

The petitioners conceded that the S corporation provided them with death benefits “in exchange for the performance of services,” and they acknowledged that their eligibility to receive these benefits “was based solely on factors related to employment.” They have consistently characterized the benefits provided by the Legacy Plan to all six employees of the S Corp. as employee benefits. Indeed, in their first motion they argued (unsuccessfully) that the life insurance coverage they received was part of a “group-term life insurance plan.” Cf. Treas. Reg. § 1.61-22(b)(2)(ii)(A).

So, yeah, the petitioners gave up the farm on this one.

The “Logical” Conclusion

it is never a good thing when you are on the other side of an issue that the Tax Court characterizes the “logical.” In the present case, the Tax Court noted that it was “logical” that the benefits a person receives under a compensatory arrangement are in the nature of compensation. Nevertheless, the petitioners contended that, “where a shareholder receives economic benefits from a split-dollar life insurance arrangement…those benefits [must] be treated as a distribution of property.” In the petitioners’ view, such benefits constitute corporate distributions under IRC § 301 even if the benefits are received in exchange for services performed by an employee in his capacity as an employee.

IRC § 301 and Employees

IRC § 301 governs distributions of property by a corporation to its shareholders. Not all payments from a corporation to a shareholder, however, constitute “distributions” within the ambit of section 301. Rather, IRC § 301(a) requires that the transfer be made “by a corporation to a shareholder with respect to its stock.”

The phrase “with respect to its stock” means that the distributee must receive the payment in his capacity as a shareholder. “IRC § 301  is not applicable to an amount paid by a corporation to a shareholder unless the amount is paid to the shareholder in his capacity as such.” Treas. Reg. § 1.301-1(c) (emphasis added). Accordingly, a payment is not a “distribution” if the shareholder receives it in his capacity as a creditor of the corporation. See Loftin & Woodard, Inc. v. United States, 577 F.2d 1206, 1242 (5th Cir. 1978).

Neither is a payment a “distribution” if the shareholder receives it in his capacity as an employee of the corporation. See Haber v. Commissioner, 52 T.C. 255, 268 (1969), aff’d per curiam, 422 F.2d 198 (5th Cir. 1970). These transfers are not made with respect to stock because, if not for the obvious reason that the shareholder’s standing as a shareholder is incidental, the corporation receives equal value in return discharge of debt or services rendered.

Petitioner-Husband’s Arrangement

Petitioner-husband is a doctor, who owns his own practice (the S corporation in question).  He receives a salary.  Other benefits were provided to the S corporation’s employees, such as welfare benefits (death and flexible benefits).  These benefits were provided “in connection with the performance of services,” and the employees’ eligibility was based “solely on factors related to employment.”

The rub, as you might have guessed, is that the split-dollar life insurance plan’s benefits fit into this category of welfare benefits that the petitioner-husband received.

Not a “Plausible” Argument

As damning as a “logical conclusion” is, an argument that is characterized as not “logical” similarly does not bode well for the party on the arguing side. Because the economic benefits of life insurance coverage were not “paid by a corporation to a shareholder…in his capacity as such,” Treas. Reg. § 1.301-1(c), the Tax Court found that IRC § 301 had “no application here.”

If They Only Lived in Ohio…

The petitioners’ argument in support of a contrary conclusion rests on Machacek v. Commissioner, 906 F.3d 429 (6th Cir. 2018), rev’g and remanding T.C. Memo. 2016-55. That case involved married taxpayers who owned all the stock of their employer, an S corporation.  In Machacek, the Tax Court ruled that the S corporation’s employee benefit plan constituted a compensatory split-dollar life insurance arrangement and further held that the taxpayers received economic benefits from the arrangement and that these benefits were taxable to them as ordinary income. The taxpayers appealed, arguing that the economic benefits flowing from the compensatory arrangement, if taxable at all, were taxable as distributions under IRC § 301.

the Sixth Circuit held that Treas. Reg. § 1(q)(1)(i) “is dispositive and renders irrelevant whether the taxpayers received the economic benefits through a compensatory or shareholder split-dollar arrangement. The Sixth Circuit acknowledged that the regulations generally provide that IRC § 301 “is not applicable to an amount paid by a corporation to a shareholder unless the amount is paid to the shareholder in his capacity as such.” See Treas. Reg. § 1.301-1(c). Nevertheless, it concluded that this general rule must yield to Treas. Reg. § 1.301-1(q)(1)(i), as a more specific provision that sets forth an “explicit inclusion of all arrangements described in Treas. Reg. § 1.61-22(b)(2).”

The Tax Court called bullshit, and dedicated an inordinate amount of time to doing so, but they did it “with all due respect.”

The Tax Court was “unable to embrace the reasoning or result of the Sixth Circuit’s opinion in Machacek,” but, being that the petitioners lived in California, the Tax Court was not bound to follow the Sixth Circuit’s turrible opinion (paraphrasing). See Golsen v. Commissioner, 54 T.C. 742, 756-757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971).  The Tax Court, it seems, was unwilling to “ignore the plain language of IRC § 301(a).” Nor was it willing to interpret the cited regulation to “thwart the statutory mandate it was designed to implement.” See Jochum v. Pico Credit Corp. of Westbank, Inc., 730 F.2d 1041, 1047 (5th Cir. 1984).

(156 T.C. No. 9) De Los Santos v. Commissioner

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