Cash Value of Life Insurance Policy Was Taxable Under Split-Dollar Insurance Rules

(Parker Tax Publishing October 2023)

A district court held that a taxpayer who put in place a life insurance policy product referred to as a restricted property trust (RPT) was not entitled to a refund of taxes assessed as a result of the IRS's determination that the split-dollar insurance rules in Reg. Sec. 1.61-22 applied to the RPT. The court found that the taxpayer had access to the policy cash value as defined by Reg Sec. 1.61-22(d)(2)(ii) and it should have been included as part of the value of economic benefits provided to the taxpayer and taxed accordingly. McGowan v. U.S., 2023 PTC 254 (N.D. Ohio 2023).

Background

Dr. Peter McGowan established his current dental practice, Peter E. McGowan DDS, Inc. (the Company), in 1994. The Company is taxed as a C corporation, and Dr. McGowan is its sole shareholder. The Company adopted a whole life insurance policy called a Restricted Property Trust in 2011.

The structure of the Restricted Property Trust is governed by the Benefits Trust Agreement. The Benefits Trust Agreement created two irrevocable "subtrusts:" the Death Benefit Trust (DBT)

and the Restricted Property Trust (RPT). The trustee of both subtrusts was Aligned Partners Trust Company. Dr. McGowan's company paid $37,222 to the DBT each year and $12,778 to the RPT each year.

The DBT then used its yearly contribution to pay the premium on a whole life insurance

policy. The RPT transferred its yearly contribution to the DBT, which then invested the RPT's

contribution as a "paid-up addition" to the policy to increase its cash value and death benefit. In return, the DBT subtrust gave the RPT subtrust a security interest in the insurance policy. The policy structure had terms of five years; as long as the premium is paid by the DBT each year, the transaction remained in effect for the five-year term. During this time, the insurance policy was owned by the DBT, which, along with the RPT, was owned by the trustee. The contract stated that Dr. McGowan and the Company had no "interest or right in or to" the policy while owned by the DBT.

If Dr. McGowan died during the term, the insurance company would pay the death benefit to the DBT, which then pay it to Dr. McGowan's designee. At the end of the term, the Company could extend the transaction for another five-year term; if it was not extended, the transaction ended and the life insurance policy was transferred to Dr. McGowan. Dr. McGowan's designee was his wife, Michelle McGowan. If the Company did not pay the premium to the DBT, the DBT would surrender the policy for its cash value, transfer that cash to the RPT to satisfy the RPT's security interest, and the RPT would pay the cash value to a charity designated by Dr. McGowan.

Dr. McGowan and the Company purchased the Restricted Property Trust and adopted the Benefits Trust Agreement in 2011. The initial value of the insurance policy's death benefit was $2,096,062. After five years of paying the premiums, the Company did not renew the transaction, and the insurance policy was transferred to Dr. McGowan. Dr. McGowan apparently attempted to renew the transaction in 2016, according to an amendment to the Benefits Trust Agreement, but this attempted renewal was made a year too late by the terms of the original agreement, and in 2017, counsel for Dr. McGowan informed the IRS the transaction and its trusts were no longer in effect.

The Company reported the $12,778 paid yearly by the Company to the RPT as part of its income in each applicable tax year. According to the Company's 2012 tax return, this figure was included as income under Code Sec. 83(b), which allows a taxpayer who receives income subject to a substantial risk of forfeiture to elect to pay tax on the income when it is received instead of when the forfeiture either occurs or expires. Dr. McGowan referred to the possibility the cash value of the policy being transferred to charity in the event the Company failed to pay the policy premiums as the substantial risk of forfeiture. The Company also deducted this amount as compensation paid to an employee each year.

The Company did not report the $37,222 contributed to the DBT as part of its income each year. The Company did list the payment to the DBT each year as a deduction on its tax return as a contribution to a welfare benefit trust for an employee's benefit. According to a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc, provided to Dr. McGowan by the trustee, the gross value of the policy at the time of vesting was $186,691 and the taxable amount was $115,227, the difference being the $12,778 annual RPT payments reported as income "and appreciation thereto." Dr. McGowan reported the $115,227 figure as taxable income on his 2016 tax return.

In 2018, the IRS issued a notice of deficiency to Dr. McGowan. It assessed deficiencies and penalties for 2014 and 2015. The IRS also issued a notice of deficiency to the Company. The largest adjustments to the Company's taxable income for 2014 and 2015 were the deductions listed for the $37,222 contributions to the DBT. The McGowans and the Company elected to pay the assessed deficiencies, penalties, and interest and filed suit in a district court for a refund.

In a motion for summary judgment, the IRS argued that the assessments were made because the split-dollar regulation, Reg. Sec. 1.61-22, applied to the Restricted Property Trust. The IRS asserted that under the regulation, the Restricted Property Trust was treated as a distribution of the Company's profits to Dr. McGowan. According to the IRS, because Dr. McGowan had to treat dividends as income, and the Company could not deduct its dividends, Dr. McGowan was required to pay tax on the cash value of the Policy and the Company could not deduct its payments.

Under Reg. Sec. 1.61-2(b)(2), one type of split-dollar arrangement is defined as an arrangement between an owner and a non-owner of a life insurance contract where the arrangement is entered into in connection with the performance of services, the employer pays all or any portion of the premiums, and either the beneficiary of the death benefit is designated by the employee or the employee has an interest in the policy cash value of the life insurance contract.

Under Reg. Sec. 1.61-22(d)(1), the nonowner of a split-dollar arrangement must take into account the full value of all economic benefits flowing from the arrangement. Reg. Sec. 1.61-22(d(2)(ii) provides that the full value of the economic benefits provided to the nonowner includes "the amount of policy cash value to which the non-owner has current access" within the meaning of Reg. Sec. 1.61-22(d)(4)(ii). Under that provision, a nonowner has current access to that portion of the policy cash value (1) to which, under the arrangement, the nonowner has a current or future right, and (2) that currently is directly or indirectly accessible by the nonowner, inaccessible to the owner, or inaccessible to the owner's general creditors.

In this case, the parties disagreed primarily over the correct accounting of the amount of "policy cash value" to which Dr. McGowan had current access for years 2014 and 2015. Dr. McGowan argued that he had no current access to the cash value because "the cash value could not be accessed by anyone." Dr. McGowan contended that because the death benefits were subject to a "substantial risk of forfeiture" (referring to the provision that if the Company stopped paying the premiums during the policy term, the cash value of the policy would be distributed to a charity of Dr. McGowan's choosing), Dr. McGowan did not have the exclusive right to designate who would receive the benefit and thus did not have "current access."

Analysis

The court found held Dr. McGowan had "current access" to the policy cash value as defined by the split-dollar regulation and it should have been included as part of the value of economic benefits provided to Dr. McGowan and taxed accordingly. The court found that under Reg. Sec. 1.61-22(d)(4)(ii), a nonowner has current access when he has a "future right" to cash inaccessible to the owner, and Dr. McGowan had a "future right" to the policy cash value because he had the exclusive right to designate who would receive death benefits under the policy.

The court noted that Reg. Sec. 1.61-22(d)(2)(ii) makes no reference to whether a nonowner's future right to the policy value may be construed as current access when the future right is contingent. In the court's view, the plain language of the regulation, including the absence of an exception for any "substantial forfeiture" provision in a policy, indicated that the regulation includes such contingent rights. Additionally, the court noted that no insurance policy's benefit is conferred if its premiums are not paid. The court reasoned that if potential cancellation of an insurance policy due to failure to pay premiums were enough to negate a future right to the policy's value or benefits, there would likely be no case in which paragraph Reg. Sec. 1.61-22(d)(2)(ii) would apply.

The court further found that under Reg. Sec. 1.61-22(f)(2), the Company was not entitled to deduct the premium payments. The court noted that under Reg. Sec. 1.301-1, the economic benefits flowing from split-dollar life insurance arrangements are "treated as a distribution of property" and are thus deemed to have been paid to the shareholder in his capacity as a shareholder. The district court concluded that, because the policy value ought to have been included in Dr. McGowan's income, and because the Company was not permitted to deduct the premium payments, the IRS's calculations of tax liability in the notices of deficiency were correct and government was entitled to summary judgment on those issues.

For a discussion of split dollar life insurance arrangements and Reg. Sec. 1.61-22, see Parker Tax ¶221,330.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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