Split-Dollar Life Insurance and S Corps: Distribution or Compensation?
October 22, 2018
How Does It Work?
Many employers struggle to hire and retain key employees. In addressing this challenge, employers will sometimes add unique benefits to the compensation package offered to such individuals. In fact, it is not unusual for the employer and the key employee to jointly structure the terms of such a benefit, often in response to a particular need of the employee.[i]
One of the more common benefits that a key employee may request to be included in such a compensation package is the provision of a “permanent” life insurance policy on the life of the employee; i.e., a policy that does not expire within a specified number of years, and which includes an investment component in addition to a death benefit.[ii] Of course, permanent insurance is more expensive than term life insurance, and may be too costly for the employee to acquire and carry alone.
Enter the split-dollar arrangement.
In general, a “split-dollar life insurance arrangement” entered into in connection with the performance of services is one between an employer (the “owner” of the policy) and a key employee (the “non-owner)”[iii] that satisfies the following criteria:
- The employer pays the premiums on the policy, and
- The employer is entitled to recover all, or a portion, of such premiums, and such recovery is to be made from, or is secured by, the life insurance proceeds.
The employee in this arrangement will typically designate the beneficiary of the death benefit,[iv] and may also have an interest in the cash value of the policy.
This arrangement is said to be compensatory, and certain economic benefits are treated as being provided by the employer-owner to the employee-non-owner.
Specifically, in determining gross income, the employee must take into account as compensation the value of the economic benefits provided to the employee under the arrangement.[v]
In general, the value of such benefits equals the cost of the current life insurance protection provided to the employee, plus the amount of the policy cash value to which the employee has “current access.”[vi]
But it’s Not Just for Employees
Although most split-dollar arrangements employed[vii] in the context of a business are compensatory in nature, it is possible for an arrangement to be entered into between a corporation and an individual in their capacity as a shareholder in the corporation.
In that case, the corporation would still pay all or a portion of the premiums, and the individual shareholder would designate the beneficiary of the death benefit, and may have an interest in the policy cash value.
However, the economic benefits provided by the corporation to the insured shareholder would constitute a distribution with respect to the shareholder’s stock in the corporation, which may represent a dividend to the shareholder,[viii] depending upon the corporation’s C corporation earnings and profits. In that case, the shareholder would be taxed at a much lower federal rate (23.8%), as compared to the rate applicable to compensation income (37%). If the corporation is an S corporation, it is possible that the distribution may not be taxable to the shareholder at all.[ix]
Thus, it is important, in determining the proper tax treatment of a split-dollar arrangement, that the parties thereto understand the capacity in which the benefit is being provided to the individual insured; i.e., as an employee or as a shareholder.
A recent decision by the Sixth Circuit Court of Appeals addressed this very issue.
Taxpayer as Employee or Shareholder?
Taxpayer was the sole shareholder of Corp, which was an S corporation. Taxpayer was also an employee of Corp.
Corp adopted a benefit plan in order to provide certain benefits to its employees. Pursuant to the plan, Corp provided Taxpayer a life insurance policy and paid a $100,000 annual premium in Tax Year. Because Corp was an S corporation, all of its income and deductions were “passed through” to Taxpayer for tax purposes.[x] On its Form 1120S return for Tax Year, Corp deducted the $100,000 premium as a business expense; thus, that amount of Corp’s income was not included in Taxpayer’s individual income as a pass-through item.[xi] However, Taxpayer also did not include as wages the economic benefits flowing from the life insurance policy.
The IRS challenged Taxpayer’s treatment of the split-dollar arrangement and issued a notice of deficiency, in response to which Taxpayer petitioned the Tax Court.
The Tax Court determined that Corp was not entitled to deduct the $100,000 premium payment.[xii] Because the $100,000 premium payment was not deductible, Corp underreported its income for that year and, due to its pass-through nature as an S corporation, the increased income was passed through to Taxpayer, who was then required to pay income tax on that amount. Taxpayer conceded that he had to report an amount equal to the premium payment as pass-through income.
The dispute before the Tax Court concerned whether Taxpayer was required to report as taxable wage income – in addition to the pass-through amount – the economic benefits flowing from the increase in the cash value of the life insurance policy caused by the payment of the premium.
The Tax Court ruled against Taxpayer, and found that he was required to account for the economic benefits in his individual income as wages:
[Corp’s] deduction, when disallowed . . . increased the S corporation’s gross income, which additional income was then passed on to [Taxpayer] as the shareholder of [Corp]. However, [Taxpayer], in addition to being a shareholder of the corporation, was also one of its employees. . . . , when the previously unreported and untaxed portion of the accumulation value of his policy was determined, the value of the $100,000 contribution by [Corp], was properly attributed to [Taxpayer] as an employee of the S corporation and a non-owner of the life insurance contract. While this result may seem aberrational in view of the pass-through treatment generally afforded to S corporations, it is a result mandated by the split-dollar life insurance regulations . . . . In instances other than those governed by the split-dollar life insurance regulations, the general rule of the non-taxability of previously taxed S corporation income is unperturbed. [Emph. added]
The Tax Court found that Taxpayer’s life insurance policy qualified as a compensatory arrangement. Moreover, the parties conceded that Taxpayer’s life insurance policy was not a shareholder arrangement.
Relying on the compensatory nature of the arrangement, the Tax Court rejected Taxpayer’s argument that the economic benefits (the “build-up” in cash value) should be treated as a shareholder distribution; instead, the Tax Court ruled that Taxpayer had to include as income the economic benefits resulting from Corp’s payment of a premium on Taxpayer’s life insurance policy.
Taxpayer appealed the Tax Court’s decision to the Sixth Circuit, which considered the interplay of the split-dollar life insurance regulations and Subchapter S.
The Court explained that the split-dollar life insurance regulations apply “to any split-dollar life insurance arrangement,” whether the arrangement is a compensatory or a shareholder arrangement. When an arrangement is governed by the split-dollar life insurance regulations, the Court continued, the non-owner of the policy “must take into account the full value of all economic benefits” provided to them. “Depending on the relationship between the owner and the non-owner,” the Court stated, “the economic benefits may constitute a payment of compensation, a distribution in respect of stock, or a transfer having a different tax character.”
However, the Court also pointed out that another regulation (the “Regulation”) governs the tax treatment of the economic benefits flowing from a split-dollar arrangement to an individual insured who is a shareholder of the corporation paying the premiums. In particular, the Regulation states that “the provision by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . of economic benefits . . . is treated as a distribution of property.” The Court noted that, by its terms, the Regulation applies to both compensatory and shareholder arrangements.[xiii]
The Court then observed that the split-dollar regulations make no specific reference to S corporations. It added that there was minimal case law concerning the interplay of Subchapter S and the split-dollar regulations, and that it was not aware of any case dealing with the application of the Regulation to the economic benefits provided to shareholder-employees pursuant to a compensatory arrangement.
The thrust of Taxpayer’s argument was that the economic benefits provided under the split-dollar arrangement should be treated as a distribution of property by an S corporation to its shareholder, notwithstanding that they flowed from a compensatory arrangement.[xiv]
Taxpayer relied on the statement in the Regulation that the provision of economic benefits “by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . is treated as a distribution of property.” Thus, Taxpayer argued, the economic benefits should be treated as a “distribution of property” from Corp to Taxpayer.[xv]
Taxpayer also relied on the statutory provisions governing the tax treatment of S corporations,[xvi] arguing that they “prevent double taxation otherwise imposed pursuant to an interpretative regulation addressing split dollar life insurance premiums that have been paid by S corporations.”
An S corporation’s income and deductions, Taxpayer asserted, are passed through to its shareholders, each shareholder is taxed on their allocable share thereof, and each shareholder’s stock basis is adjusted upward accordingly. In this case, $100,000 of Corp’s income – an amount equal to the nondeductible premium payment – was taxed to Taxpayer. How, then, Taxpayer argued, could he be taxed “again” as to the increase in the cash value of the policy attributable to premium?
The IRS argued[xvii] that the economic benefits should be treated as wage income – rather than as a shareholder distribution – because Taxpayer received the life insurance coverage as part of a compensatory split-dollar arrangement. The IRS noted that such treatment would be uncontroversial if the recipient of the economic benefits were an ordinary employee, rather than an S corporation’s shareholder-employee. The distinction between Taxpayer’s different roles – employee and shareholder – was, therefore, key to the IRS’s position.
The IRS pointed only to the distinction between compensatory and shareholder arrangements. The IRS recognized that the Regulation applies to both compensatory and shareholder arrangements but concluded that it “does not mean that in any situation where a compensatory arrangement covers a shareholder, the taxpayer’s status as a shareholder trumps his status as an employee, causing the economic benefit to be treated as a distribution to a shareholder,” because “[s]uch an interpretation of the regulation would make no sense, as it would defeat the reason for distinguishing between a compensatory arrangement and a shareholder arrangement.”
The Regulation is Dispositive
The Court rejected the IRS’s argument.
According to the Court, it was not clear that treating all economic benefits to shareholders as distributions – even to those who were also employed by the corporation –would undermine the purpose of the split-dollar regulations.
The Court noted that the Tax Court had not addressed the Regulation. However, the Court also added that if the economic benefits to Taxpayer were properly treated as a distribution of property to a shareholder – rather than as compensation to an employee – then the Tax Court had erred.
The Court decided that the Regulation was dispositive, and thereby rendered irrelevant whether Taxpayer received the economic benefits through a compensatory or shareholder split-dollar arrangement. The Regulation treats economic benefits provided to a shareholder pursuant to any split-dollar arrangement as a distribution of property with respect to the shareholder’s stock. The Court stated that the inclusion in the Regulation of all arrangements described in the split-dollar rules, which include compensatory arrangements – made clear that when a shareholder-employee receives economic benefits pursuant to a compensatory split-dollar arrangement, those benefits are treated as a distribution of property, and are thus deemed to have been paid to the shareholder in their capacity as a shareholder.
The Court stated that its interpretation was further supported by the fact that the split-dollar rules state that the tax treatment of the economic benefits depends on the “relationship between the owner and the non-owner.” The IRS argued that this language showed that the tax treatment depended on the nature of the split-dollar arrangement—compensatory or shareholder—but the Court pointed out that if this were the controlling factor, the Regulation could have said so (it does not).
Thus, the Court found that the Tax Court had erred by relying on the compensatory nature of Taxpayer’s split-dollar arrangement to conclude that the economic benefits were not distributions of property to a shareholder. Where a shareholder receives economic benefits from a split-dollar arrangement, the Regulation requires that those benefits be treated as a distribution of property to a shareholder.
The Court reversed the Tax Court’s decision with respect to the tax treatment of the economic benefits flowing to Taxpayer from Corp’s payment of the $100,000 premium on Taxpayer’s life insurance policy and held, pursuant to the Regulation, that those economic benefits had to be treated as distributions of property by Corp to its shareholder. Because Corp was an S corporation, that meant that the deemed distribution would be at least partially exempt from tax.[xviii]
Are you kidding? Compensation is compensation, isn’t it? It is paid for services rendered or to be rendered by the recipient to the payor. Except, at least according to the Sixth Circuit, when it is paid as part of a split-dollar life insurance arrangement to a shareholder of the payor who is also employed by the payor?
It is a basic principle of taxation that the capacity in which an owner of a business entity deals with the entity determines the appropriate tax treatment of the transaction. Salary paid by a corporation to a shareholder-employee for services actually rendered to the corporation is taxed as compensation.[xix] Where the amount paid is excessive for the services provided, the excess may be treated as a distribution to the shareholder in respect of their stock in the corporation (a dividend), the premise being that no one would pay more for the services than they were actually worth. Case closed, right?
What if the compensation paid to the shareholder-employee had been below market? Would the benefits provided under what was conceded to be a compensatory split-dollar arrangement still be treated as a distribution rather than as additional compensation?
What about the IRS’s historical concern over S corporations that pay less than reasonable compensation to their shareholder-employees in order to reduce their employment tax liability?
In holding as it did, has the Court created a second class of stock issue where none would otherwise have existed? The constructive distribution to a shareholder-employee of an S corporation sets that individual apart from other shareholders of the employer-corporation who are not employed in the business. Might it be easier to find that “a principal purpose” of the split-dollar arrangement (a “commercial contractual agreement”) is to circumvent the one class of stock requirement?[xx]
The Court should have upheld the Tax Court’s decision. It should have recognized that the literal wording of the Regulation needs to be revised to comport with the intention and language of the split-dollar rules.
[i] Actual equity, restricted equity, phantom equity, equity appreciation, change-in-control, and other equity-flavored or profits-based incentive bonus arrangements are also not uncommon.
[ii] For example, a whole life policy. A permanent policy will generally include an investment or savings component, reflected as the so-called “cash value” of the policy, against which the owner of the policy may borrow, or which may be withdrawn, during the life of the insured. Compare this to term insurance, which promises only a death benefit if the insured dies within a specified number of years.
[iii] The person named as the policy owner is generally treated as the “owner” of the policy for purposes of these rules. Thus, if the insured is named as the owner, they will be treated as the owner for purposes of these rules. However, if the only benefit accorded the insured is current life insurance protection (the death proceeds; they have no access to the cash value of the policy), then the non-owner is treated as the owner.
[iv] Often a trust for the benefit of the employee’s family.
[v] The employer will not be entitled to a deduction where it is a beneficiary of the policy.
[vi] To the extent it was not taken into account in a prior year. In general, the cash value builds up tax-free within the policy when the premium exceeds the cost of the insurance.
[vii] Yes, pun intended.
[viii] As in the case of compensatory split-dollar, the premium would not be deductible by the corporation.
[ix] Depending upon the shareholder’s stock basis and the corporation’s AAA; the deemed distribution would be treated as a return of already-taxed income or as a return of capital.
[x] IRC Sec. 1366.
[xi] The deduction claimed on the corporate return reduced, dollar-for-dollar, the amount of profit allocated to the shareholder on their Sch. K-1.
[xii] The corporation was a beneficiary of the policy (IRC Sec. 264); moreover, under Sec. 83, the employee had not included the premium in income.
[xiii] Reg. Sec. 1.301-1(q)(1)(i).
[xiv] Yep. You heard right.
[xv] Reg. Sec. 1.301-1(q)(1)(i).
[xvi] IRC Sec. 1366 (pass-through of corporate income), 1367 (upward basis adjustment for pass-through of income and downward for distribution thereof), and 1368 (treatment of S corporation distribution that would otherwise be treated as a dividend – return of already-taxed income and basis).
[xvii] And the Tax Court concluded.
[xviii] See IRC Sec. 1368.
[xix] And may be deducted to the extent it was reasonable.
[xx] Reg. Sec. 1.1361-1(l).