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Tax Court Holds That Split-Dollar Insurance Benefits Are Guaranteed Payments

(Parker Tax Publishing April 2021)

The Tax Court held that the economic benefits the sole shareholder of an S corporation received from a split-dollar life insurance arrangement, in his capacity as an employee of the S corporation, were not distributions with respect to stock under Code Sec. 301 but instead were guaranteed payments taxable as ordinary income under Code Sec. 707(c). In so holding, the Tax Court declined to follow the Sixth Circuit's holding in Machacek v. Comm'r, 2018 PTC 347 (6th Cir. 2018), rev'g and remanding T.C. Memo. 2016-55, in which such distributions were treated as taxable under Code Sec. 301. De Los Santos v. Comm'r, 156 T.C. No. 9 (2021).


Ruben De Los Santos is a medical doctor. During 2011 and 2012, De Los Santos was the sole shareholder of Dr. Ruben De Los Santos MD, PA, an S corporation. The S corporation employed De Los Santos, his wife, and four other people.

The S corporation adopted an employee welfare benefit plan that provided benefits to De Los Santos, his wife, and the four employees. The De Los Santoses were entitled to a $12.5 million death benefit, which they received in their capacity as employees. The benefit plan was funded by employer contributions to a trust. During 2006-2010, the S corporation paid $1,862,349 to the trust, treating these contributions as tax-deductible expenses of the medical practice. These contributions were sufficient to fund the $12.5 million death benefit promised to the De Los Santoses. During 2007-2012, the trust paid aggregate premiums of $884,534 on the policy. Because of these premium payments and the investment gains thereon, the "accumulation value" of the policy was $640,358 at the end of 2011 and $744,460 at the end of 2012.

On their 2011 and 2012 tax returns, the De Los Santoses did not report any income related to their participation in the plan. In 2015, the IRS issued a notice of deficiency determining that the economic benefits the De Los Santoses received under the plan were currently taxable to them as ordinary income. The De Los Santoses petitioned the Tax Court to challenge the IRS's determination. In De Los Santos v. Comm'r, T.C. Memo. 2018-155, the Tax Court held that the benefit plan constituted a compensatory split-dollar life insurance arrangement and that the economic benefits flowing to the De Los Santoses generated current taxable income. The court left for further proceedings the computation of the exact amounts to be included in the De Los Santoses' gross income for each year.

In a motion for summary judgment, the De Los Santoses conceded that the S corporation provided them with death benefits in exchange for the performance of services. However, they 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 under Code Sec. 301. They claimed that the benefits constituted corporate distributions under Code Sec. 301 even if the benefits were received in exchange for services performed by an employee in his or her capacity as an employee. In support of this position the taxpayers relied on Machacek v. Comm'r, 2018 PTC 347 (6th Cir. 2018), rev'g and remanding T.C. Memo. 2016-55. In Machacek, the Sixth Circuit held that Reg. Sec. 1.301-1(q) explicitly treats economic benefits provided to a shareholder under any split-dollar arrangement, including a compensatory arrangement, as a distribution of property.

Observation: The tax treatment of distributions of property by a corporation to its shareholders is generally governed by Code Sec. 301(c). However, Subchapter S provides its own rules in Code Sec. 1368(a) for the treatment of a distribution of property made by an S corporation with respect to its stock to which Code Sec. 301(c) would otherwise apply. Where an S corporation has no earnings and profits, such a distribution is not included in gross income to the extent it does not exceed the shareholder's basis in the S corporation stock and any excess is treated as gain from the sale or exchange of property. In the case of a distribution of property made by an S corporation that has accumulated earnings and profits, the portion of the distribution that does not exceed the accumulated adjustments account (AAA) is nontaxable to the extent of the shareholder's stock basis. To the extent the distribution exceeds the shareholder's stock basis but not the AAA, the distribution is treated as gain from the sale or exchange of property. Any portion of a distribution that remains after that is treated as a dividend to the extent it does not exceed the accumulated earnings and profits of the S corporation. Any portion of the distribution that remains after that is treated as it would be if the corporation has no accumulated earnings and profits.


The Tax Court found that it was unable to embrace the reasoning or result of the Sixth Circuit's opinion in Machacek and that it was not bound to follow the Sixth Circuit's opinion since the case was appealable to a different circuit. In the Tax Court's view, to adopt the Sixth Circuit's construction of Reg. Sec. 1.301-1(q)(1)(i) would require the Tax Court to ignore the plain language of Code Sec. 301(a), the statute under which the regulation was issued. The court pointed out that Code Sec. 301 unambiguously applies only to distributions of property made by a corporation to a shareholder with respect to its stock and reasoned that if a corporation makes a payment other than with respect to its stock - e.g., to a shareholder in his or her capacity as an employee or lender - the payment is outside the scope of Code Sec. 301. The Tax Court said that Code Sec. 301 is clear as written and therefore had to be applied as written.

The court found that the same analysis applied to Reg. Sec. 1.301-1(q)(1)(i), which 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. According to the court, the regulation necessarily applies only to the provision of economic benefits to a shareholder "in his capacity as such," because that is the only type of transfer to which Code Sec. 301 applies. Therefore, interpreting "shareholder" to mean "shareholder in his capacity as such" was not only justified but was required by the statutory text and by the regulation's introductory provisions.

Next, the court found that, under Code Sec. 1372(a), the S corporation was treated as a partnership, and De Los Santos was treated as a partner, for purposes of determining the taxation of employee fringe benefits. The court further found that the life insurance benefits De Los Santos received under the split-dollar arrangement were "employee fringe benefits" within the meaning of Code Sec. 1372. Therefore, those economic benefits were taxed to De Los Santos as guaranteed payments under Code Sec. 707(c) and hence as ordinary income under Code Sec. 61 and Our Country Home Enterprises, Inc. v. Comm'r, 145 T.C. No. 1. (2015). In Our Country Home, the Tax Court ruled that an employer's provision of economic benefits to its employees under a compensatory split-dollar arrangement "generally is deemed to be the payment of compensation" but noted that an exception applies "where the employer is an S corporation that provides the benefits to a 2-percent shareholder in consideration for services rendered." In Our Country Home, the Tax Court reasoned that in the case of such an S corporation (1) the 2-percent shareholder is treated as a partner for purposes of applying the employee fringe benefit rules, (2) the economic benefits are categorized as guaranteed payments under Code Sec. 707(c), and (3) the 2-percent shareholder must recognize the amount of the guaranteed payments as gross income under Code Sec. 61(a).

The Tax Court declined the De Los Santoses' argument that the term "fringe benefit" is not defined in Code Sec. 1372 and that insurance benefits received by an employee under a split-dollar arrangement should be excluded from the ambit of this term. The court found that all available evidence suggested that Congress intended to adopt the common understanding of "fringe benefit" in Code Sec. 1372, which the court said includes any employer-provided benefit that supplements an employee's salary, specifically including life insurance benefits.

For a discussions of split-dollar life insurance arrangements, see Parker Tax ¶32,150.

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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