Tax Court Applies Split-Dollar Regulations to “Welfare Benefit Plan” Participants
by Perry Lerner, Chairman & CEO of Crown Global
On July 13, 2015, the US Tax Court, in Our Country Home Enterprises, Inc, et al, v. Commissioner, (145 T.C. No 1), (“Our Country”) held that payments by a corporation to a purported “welfare benefit plan” providing life insurance to its shareholder- employees were not deductible and the economic benefits of the arrangement were taxable to the employees under the Treasury’s 2003 split-dollar Regulations (the “Regulations”), Regs Sec. 1.61-22. The Tax Court broadly confirmed the validity of the Regulations in circumstances where life insurance benefits are part of a compensatory arrangement. The Tax Court ruled that the Regulations “are not arbitrary or capricious in substance or manifestly contrary to the statute.” In reaching this conclusion the Tax Court dismissed the claim that the Regulations are inconsistent with “fundamental principles of federal tax law.”
In Our Country, the taxpayers (both the employers and employees) were advised by their accountants and insurance agents to adopt a plan known as the “Sterling Plan” (the “Plan”). Under the Plan, described as an employee “welfare benefit plan”, Our Country made payments to a trustee which was directed to use the payments to purchase life insurance policies on the lives of its shareholder-employees. Each of the policies was underwritten based on personal and medical information relating to each employee. The policies were issued to the Plan’s trustees, which held each policy for the benefit of the employee’s designated beneficiaries. Under the Plan, the insurance policies (including any cash value) were required to be distributed to each employee upon retirement or the cessation of the Plan by the employer. Once payments were made to the Plan, the employer could only recover the premiums or policy proceeds in the “atypical” case where the payments were the result of a “mistake of fact.” Neither the policies nor the cash value of the policies was available to the employer’s creditors.
The employers deducted the premiums as “welfare plan” contributions under Code section 162 and the employees failed to report income in respect of the premium payments. The Service also asserted accuracy related penalties.
The Service rejected the taxpayers’ claim that payments to the Plan were deductible welfare plan contributions and argued that the Plan should be taxed as a compensatory arrangement governed by Regs sec. 1.61-22(b)(2)(ii) of the split-dollar Regulations.
Under these Regulations an employee is taxable on the “economic benefit” of a life insurance arrangement given in connection with the performance of services where (a) the beneficiary of the policy is designated by the employee or (b) the employee has an interest in the cash value of the policy. It is immaterial whether the insurance premiums are repayable to the employer. These rules do not apply where the policy is a “group term” policy under Code section 79. The Court dismissed this argument by pointing out that group term policies cannot be based on “individual selection”, which is another way of saying that the benefits cannot, as under the Sterling Plan, be individually underwritten.
After finding that the policies were not part of a group term plan the Tax Court then applied the provisions of sections 1.61-22(d) through (g). Under the Regulations, the taxable amount is the sum of 1) the cost of the current life insurance protection that the non-owner (service provider) receives during the year, (2) the amount of the insurance policy cash value to which the non-owner has current access during the year and (3) any other economic benefit provided to the owner . The important issue here concerned the meaning of “current access”.
The Regulations provide that a service provider has current access to a policy’s cash value in which there is a current or future right (e.g., a death benefit), where the cash value currently is directly or indirectly accessible to the non-owner, inaccessible to the owner (the employer), or inaccessible to the owner’s general creditors.
The taxpayers argued that they did not have current access under “fundamental tax principles” because they could not compel the current distribution of the cash value of the policies. Their access was, in effect, limited to the ability to require a distribution of the policy on retirement (often referred to as a “roll-out”) or the receipt of death benefits by a beneficiary.
The Tax Court rejected this argument, holding that “current access” as defined in the Regulations overrode the taxpayer’s reliance on “fundamental tax principles.” The Court gave five reasons for its conclusion: first, no one other than the employee or his designee (the beneficiary) could receive the benefits or cash value of the a policy; second, each employee had the sole right to the ownership of the policies on retirement; third, the cash value in the policies could not be accessed by the employer or its creditors, only the employee could claim ownership of the policy; fourth, the employees were allowed to select the investment options available under the policies, and fifth, only the employee designated the beneficiary to receive the death benefits under the policy.
The Court makes it clear that the most important of all these factors is that “the money or property is beyond the reach of the employer’s creditors.” As a result, the employee is taxable on both the value of the insurance protection (annual term rate for the death benefit) and the policy’s cash value.
As noted above, the Court also dealt with the deductibility of payments to the Plan as an “ordinary and necessary” expense of the employer under Code section 162(a). Since the Plan was found to be a compensatory arrangement the Court relied on Regs sec. 1.83-6(a)(5), which allows a deduction only to the extent an employer transfers ownership of an insurance policy to an employee. See sec. 1.61-22(g)(1). Here, the policy was not transferred but was owned by the Plan.
Finally, the taxpayers argued that the Plan payments were deductible to a welfare benefit plan described in Code section 419. The Court disagreed, noting that the Plan was no more than an attempt to transfer funds from the corporations to their employees tax free, and that the Plan “was never intended to provide welfare benefits.”