Insurance Arrangement Found to be Split Dollar Insurance Arrangement

Split dollar life insurance arrangements can take on a number of forms, and the exact structure of the arrangement determines the tax consequences, which can become complicated quickly. In a recent case out of the District Court of Ohio, the court held that an insurance arrangement between a single member C corporation, Peter E. McGowan DDS, Inc. (the “Company”) and its sole shareholder, Dr. Peter McGowan (“McGowan”) was a split dollar arrangement and thus taxable as such.[1] Accordingly, adjustments were made by the IRS which denied deductions to the Company and included the cash value of the policy as income to McGowan. The split dollar arrangement in the present case was taxed under the economic benefit regime found in Treas. Reg. §1.61-22(d) as the Company was the owner of the policy under the regulations but McGowan was the nonowner receiving economic benefits. In general, this regime provides that, where the nonowner is a shareholder and the payments attributable to the premiums are made by the owner/corporation, such payments are not deductible by the owner/corporation but rather are considered distributions to the shareholder/nonowner, and the economic benefits of the arrangement that accrue to the nonowner are taxable, including the cash value that may be accessed by the nonowner.

Facts

As stated above, McGowan was the sole shareholder of the Company. In 2011, the Company entered into an insurance arrangement referred to as a Restricted Property Trust. When the policy vested in 2016, the cash value of the policy was transferred directly to McGowan. The Restricted Property Trust actually created two irrevocable “subtrusts”, the Death Benefit Trust (“DBT”) and the Restricted Property Trust (“RPT”), with the Company paying annually $37,222 to the DBT and $12,778 to the RPT. The DBT in turn purchased a whole life insurance policy. The RPT would then transfer its annual contribution to the DBT to be invested as “paid-up addition” to the whole life policy which in turn increased the policy’s cash value and death benefit. In exchange for such contribution, the DBT granted the RPT a security interest in the insurance policy.

The arrangement had a five-year term, and the DBT was the policy owner during such time. The contract clearly stated that neither McGowan nor the Company had any interest or right to the policy while held by the DBT. If McGowan had died during the five-year term, the insurance company would pay the death benefit to the DBT, which then would pay this amount to a designee selected by McGowan. At the end of the five-year term, the arrangement could be extended or terminated. If terminated, the policy and its cash value would be transferred to 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 then pay this cash value amount to a charity designated by McGowan.

At the onset of the arrangement, the death benefit of the policy was $2,096,062. While there was some attempt to renew the arrangement once the five-year term expired, this was done a year too late, as the arrangement expired in 2016 with the insurance policy being transferred to McGowan.

McGowan reported the $12,778 paid yearly by the Company to the RPT as part of his income in each applicable year but did not report the $37,222 contributed to the DBT even though the Company did list the payment to the DBT as a deduction each year.

In 2018, the IRS issued a Notice of Deficiency to McGowan for the cash value of the policy not being included in his income, and subsequently, in December 2019, the IRS issued a Notice of Deficiency to the Company, the primary adjustment of which was the denial of the deductions for the amounts paid to the DBT annually and the reclassification of such payments as distributions to McGowan. All assessments were paid and then a claim for refund was filed. While there were other motions at play in the case, this article discusses the cross motions for summary judgment. As noted below, McGowan’s motion was denied, and the IRS’ motion was partially granted and partially denied.

Analysis

The IRS argued that the arrangement was a split-dollar arrangement and thus taxable as such under Treas. Reg. §1.61-22(d). Accordingly, since the “owner” was the Company, and the “nonowner” was a shareholder, the amounts paid by the Company should be treated as a distribution to McGowan. Additionally, the cash value of the policy was taxable to McGowan under the economic benefits regime. McGowan countered, alleging that the arrangement was not a split-dollar arrangement in the first place. Accordingly, the case hinged on whether the arrangement was a split dollar arrangement as defined by Treas. Reg. §1.61-22(b), which in turn hinged on who the policy owner was and whether McGowan had access to the cash value of the policy.

Treas. Reg. §1.61-22(b)(1) defines a split-dollar life insurance arrangement as “any arrangement between an owner and a non-owner of a life insurance contract” where:

1. Either party to the arrangement pays, directly or indirectly, all or any portion of the premiums on the life insurance contract, including a payment by means of a loan to the other party that is secured by the life insurance contract;
2. At least one of the parties to the arrangement paying premiums…is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the life insurance contract; and
3. The arrangement is not part of a group-term life insurance plan described in section 79 unless the group-term life insurance plan provides permanent benefits to employees.

Irrespective of whether the above definition is met, Treas. Reg. §1.61-22(b)(2) defines a split-dollar life insurance arrangement as “any arrangement between an owner and a non-owner of a life insurance contract” where:

1. If between employer and employee:
   1. The arrangement is entered into in connection with the performance of services and is not part of a group-term life insurance plan described in section 79;
   2. The employer or service recipient pays, directly or indirectly, all or any portion of the premiums; and
   3. Either-
      1. The beneficiary of all or any portion of the death benefit is designated by the employee or service provider or is any person whom the employee or service provider would reasonably be expected to designate as the beneficiary; or
      2. The employee or service provider has any interest in the policy cash value of the life insurance contract.[2]
   4. If between corporation and shareholder, in such shareholder’s capacity as a shareholder:
      1. The arrangement is entered into between a corporation and another person in that person’s capacity as a shareholder in the corporation;
      2. The corporation pays, directly or indirectly, all or any portion of the premiums; and
      3. Either-
         1. The beneficiary of all or any portion of the death benefit is designated by the shareholder or is any person whom the shareholder would reasonably be expected to designate as the beneficiary; or
         2. The shareholder has any interest in the policy cash value of the life insurance contract.[3]

McGowan argued that the arrangement was not between an owner and a nonowner, so it was not a split dollar arrangement in the first place. During the five-year term, the policy was owned by the DBT, which was in turn held by a third party Trustee. However, as the IRS argued, the applicable regulation provides that “the employer … is treated as the owner of the life insurance contract if the owner … of the life insurance contract … is”:

1. A trust described in section 402(b);
2. A trust that is treated as owned (within the meaning of sections 671 through 677) by the employer or the service recipient;
3. A welfare benefit fund within the meaning of section 419(e)(1); or
4. A member of the employer or service recipient’s controlled group (within the meaning of section 414(b)) or a trade or business that is under common control with the employer or service recipient (within the meaning of section 414(c)).[4]

The Court concluded that the Restricted Property Trust was a welfare benefit fund, relying in part on prior case law.[5] As such, under the regulations and prior case law, the Court concluded that the Company was the owner of the policy for purposes of the application of the regulation, and thus the arrangement was a split dollar arrangement.

As such, the next step was to determine the appropriate tax consequences. Under the economic benefit regime, the nonowner must take into account the full value of all economic benefits of the arrangement.[6]  Treas. Reg. §1.61-22(d)(2) provides that the full value of the economic benefits is:

1. The cost of current life insurance protection provided to the non-owner;
2. The amount of policy cash value to which the non-owner has current access (to the extent that such amount was not actually taken into account for a prior taxable year); and
3. The value of any economic benefits not described above which are provided to the non-owner (to the extent not actually taken into account for a prior taxable year).

The primary dispute between the parties was whether McGowan had “current access” to the cash value of the policy. The IRS contended he did, and McGowan contended he did not. While the arrangement clearly stated that McGowan had no “interest or right in or to” the policy while it was owned by the DBT, the regulation states that “a non-owner has current access to that portion of the policy cash value … [t]o which, under the arrangement, the non-owner has a current or future right; and … [t]hat currently is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner’s general creditors.”[7] The Court noted that this is somewhat “counterintuitive” but nevertheless was clear, and under this definition of “current access”, McGowan had current access to the cash value of the policy. McGowan argued that the right was subject to forfeiture if the Company stopped paying the premiums, and thus the right was contingent. However, the Court noted that the regulation makes no reference to whether a non-owner’s future right to the policy value may be construed as “current access” where that future right is contingent.

Take-Away

As seen from the above (which is a high-level summary omitting some of the more minute details of the arrangement at issue), split dollar life insurance arrangements can be immensely complex and have numerous unintended tax consequences if not accounted for correctly. With so many products out there, including the Restricted Property Trust discussed herein, taxpayers would be wise to seek competent counsel anytime they are looking at a life insurance arrangement, especially one where premiums are paid by a third party, whether that third party is a family member or friend (gift tax consequences), an employer (income and employment tax consequences), or a corporation of which the intended beneficiary is a shareholder (income tax consequences, and employment tax consequences if the shareholder is also an employee).

[1] McGowan, et al, v. U.S., 132 AFTR 2d 2023-XXXX (DC OH).

[2] Treas. Reg. §1.61-22(b)(2)(ii).

[3] Treas. Reg. §1.61-22(b)(2)(iii).

[4] Treas. Reg. §1.61-22(c)(2)(iii).

[5] Our Country Home Enters., Inc. v. Commissioner,  145 T.C. 1, (2015).

[6] Treas. Reg. §1.61-22(d)(1).

[7] Treas. Reg. §1.61-22(d)(4)(ii).

Charles J. Allen, J.D., LL.M., CPA

View Full Profile.