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"Welfare Benefit Fund" Was Really a Split-Dollar Insurance Arrangement.

(Parker Tax Publishing July 29, 2015)

The Tax Court determined that because a purported welfare benefit plan was really a split-dollar insurance arrangement, corporate employers could not deduct payments made to the plan. Further, the court held that the shareholder-employees for whom the insurance was purchased were required to realize income from the policies. Our Country Home Enterprises, Inc. v. Comm'r, 145 T.C. No. 1 (2015).


In the early 1990s Ronald Snyder began looking for a way for employers to fund greater benefits than pension plans allowed. Snyder established the Sterling Plan in October 2002 as a way for employers to fund and receive those greater benefits.

The Sterling Plan (Plan) is a purported welfare benefit plan consisting of the respective separate plans that each participating employer customizes to apply to its employees alone. The Plan pays death, medical, and disability benefits with respect to a participating employee to the extent that his or her participating employer selects. Each employer selects the general provisions, the participation requirements, and the vesting schedule applicable to its plan. Each employee designates to whom the Plan will pay the benefits with respect to him or her.

The death benefit that the Plan agrees to pay to a participating employee is the face amount of an insurance policy that the Plan purchases on the employee's life. The employer effectively pays the premiums on the insurance policy through its payments to the Plan, and the insurance policy usually has a cash value component that increases annually. The Plan's payment of any nondeath benefit to an employee is generally limited to the cash value of the insurance policy related to that employee. An employer may terminate its participation in the Plan and cause each of its employees to be fully vested in his or her policy (including its cash value). A participating employee, upon retiring, may take his or her insurance policy in satisfaction of any postretirement death benefit payable as to the employee.

Our Country Home Enterprises, Inc. and Netversity, Inc. are C corporations, each wholly owned by a single individual shareholder. Code Environmental Services, Inc. is an S corporation owned equally by three other individual shareholders. Each of the five shareholders was employed by the corporation he owned. Our Country and Environmental each participated in the Sterling Plan and caused the plan to purchase insurance on the lives of their shareholder-employees. Netversity participated in the Sterling Plan but did not cause the Plan to purchase insurance on an employee's life.

Between 2010 and 2011, the IRS mailed deficiency notices to Our Country, Environmental, and Netversity disallowing the claimed deductions each company had taken for payments made to the Plan on the grounds that the purchased policies were split-dollar insurance arrangements subject to the "economic benefit regime rules," which disallow such deductions. The IRS also sent deficiency notices to the shareholder-employees of the companies, asserting that each of the five individuals had realized income from participation in the Sterling Plan. In addition to disallowing the deductions, the IRS assessed a Code Sec. 6662(a) penalty for understatement of tax, and an additional Code Sec. 6662A penalty for an understatement with respect to a reportable transaction.

OBSERVATION: The parties consolidated the Our Country, Environmental, and Netversity cases to serve as test cases for issues related to the Sterling Plan. The parties in approximately 40 other cases pending before the Tax Court agreed to be bound by one or more of the final decisions.

Insurance Policies were Compensatory Arrangements

An arrangement between an owner and a nonowner of a life insurance contract is a split-dollar life insurance arrangement if it is a compensatory arrangement under the special rule of Reg. Sec. 1.61-22(b)(2)(ii).

An arrangement is a compensatory arrangement if it meets each of the three prongs of Reg. Sec. 1.61-22(b)(2)(ii):

(1) The first prong requires that the arrangement be entered into in connection with the performance of services and not as part of a group term life insurance plan described in Code Sec. 79.

(2) The second prong requires that the employer or service recipient pays, directly or indirectly, all or any portion of the premiums.

(3) The third prong requires that either: (a) 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 (b) the employee or service provider has any interest in the policy cash value of the life insurance contract.

The Tax Court determined that the life insurance policies provided to the employees of Our Country and Environmental through the companies' participation in the Sterling Plan were split-dollar life insurance arrangements because they were compensatory arrangements within the meaning of the special rule of Reg. Sec. 1.61-22(b)(2)(ii). The court noted that the parties had agreed the corporate employers were treated as the owners of the life insurance policies.

The court found the arrangements fell within the special rule because they met each prong of the three-prong test. First, the court noted each of the companies' single employer plans provided life insurance benefits to the employees in exchange for their performance of services, and the benefits were not provided as part of a group term life insurance plan described in Code Sec. 79. Second, the court observed that each single employer plan paid all the premiums on the life insurance policies through the employer's payments to the Plan. And third, the court noted the employees participating in the single employer plans designated the beneficiaries of the death benefits payable under the plans, which in substance were the death benefits payable under the insurance policies. The court also found, as to the third prong, that the employees in each single employer plan had an interest in the cash value of the respective life insurance policies that covered them.

OBSERVATION: No life insurance was purchased or outstanding by Netversity during the relevant years. Any arrangement involving Netversity and the Sterling Plan, therefore, was not a split-dollar life insurance arrangement during those years.

Deductions Disallowed for Payments to the Sterling Plan

Because the life insurance policies relating to the Our Country and Environmental shareholder-employees were split-dollar life insurance arrangements, the court stated that the two companies could deduct an expense related to the arrangements only if the deduction met the rules of Reg. Sec. 1.83-6(a)(5). That section provides that the amount of an allowable deduction in such a situation equals the income an employee must recognize upon the transfer to the employee of the ownership of the life insurance policy, plus the amount determined under Reg. Sec. 1.61-22(g)(1)(ii).

The court noted that Our Country and Environmental did not transfer any life insurance policy to their participating employees, nor did the shareholder-employees recognize any income from their participation in the Sterling Plan. The court thus concluded that Our Country and Environmental could not deduct their payments to the Plan.

With regard to Netversity, the court stated it had repeatedly held in similar settings that Code Sec. 162(a) does not allow an employer to deduct its payments to a purported welfare benefit plan as ordinary and necessary business expenses, citing Neonatology Assocs., P.A. v. Comm'r, 115 T.C. 43 (2000), White v. Comm'r, T.C. Memo. 2012-104, and cases cited therein. Although the referenced cases involved the actual purchase of life insurance and Netversity's case did not, the court stated the holdings in those cases applied with equal force, and concluded that Netversity could not deduct its payment to the Sterling Plan.

Shareholder-Employees Required to Recognize Income

The federal income tax consequences of a split-dollar life insurance arrangement are generally determined through either the economic benefit provisions of Reg. Sec. 1.61-22(d) through (g), or through the loan provisions of Reg. Sec. 1.7872-15. In general, the loan provisions apply where there is a "split-dollar loan" within the meaning of section 1.7872-15(b)(1), and the economic benefit provisions apply where there is not a split-dollar loan, unless the nonowner of the life insurance contract makes premium payments on the insurance contract as other than consideration for economic benefits (Reg. Sec. 1.61-22(b)(3)(i)).

The Tax Court found the economic benefit provisions applied to the shareholder-employees of Our Country and Environmental because no-split dollar loans were involved, and the shareholders did not make any premium payments on the insurance contracts. The corporate employers, the court stated, as the owners of the life insurance contracts, had therefore provided economic benefits to their shareholders, as the nonowners of the insurance contracts. The court held that the shareholders must recognize the full value of the economic benefits, net of any consideration that they paid to their employers for the benefits.

Because Netversity's payment to the Sterling Plan was not an ordinary and necessary business expense deductible under Code Sec. 162(a), and because it conferred an economic benefit on the owner for his primary (if not sole) benefit, the Tax Court concluded that the payment was a constructive distribution from Netversity to its owner. Since Netversity had sufficient earnings and profits to characterize the distribution as a dividend under Code Sec. 301(c)(1), the court held that it was a taxable dividend.

The Tax Court also upheld the Code Sec. 6662(a) and Code Sec. 6662A penalties, because the taxpayers were unable to show a reasonable cause for the understatements, and did not report their involvement with the Sterling Plan on their returns. (Staff Editor Parker Tax Publishing)

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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