Tax Changes in the Offing? “Close Scrutiny” of Business Owners’ Economic Benefits Remains a ConstantJune 21, 2021 | Louis Vlahos |
I Read the News Today
Much of today’s news is dominated by the future of the Administration’s broadly defined infrastructure plan. Discussions among “those in the know” inevitably turn into debates over the wisdom of pursuing the bipartisan legislative approach favored by centrists from both sides of the political divide as contrasted with the “go-it-alone through reconciliation” budget process being pushed by the more progressive wing of the President’s party.
In weighing the merits of these alternative paths, one necessarily must determine the breadth of the plan that Congress “should” implement and, from there, how to pay for it. Inevitably, this leads to a consideration of taxes and of tax policy.[i]
In fact, so much of one’s reading these days revolves around the need for increasing the tax burden on the so-called “rich,” the elimination of the alleged “loopholes” in the Code from which these individuals alone, we are told, have benefitted, and the increased enforcement of the tax rules that will ensure this privileged class is no longer able to dodge its tax responsibilities and will be forced to pay its share of the government’s multi-trillion-dollar annual budget.[ii]
Separating the Wheat from the Chaff
Tax professionals try to sift through all the political hoopla that attends any proposed changes to the Code – let alone legislation as potentially far-reaching and politically charged as was introduced by Mr. Biden in late April[iii] – to find those themes and provisions that are most likely to be adopted and enacted under the circumstances. This requires a significant investment of critical analysis and a pinch of experience to produce some informed “prognostication.”
Unfortunately, tax advisers, unlike the Sunday morning political pundits and others of that species, cannot make a living by talking in circles[iv] or by making predictions with impunity.[v] Rather, they must advise – and responsibly assure – actual clients who need practical solutions to real world problems.
Thus, as much as we enjoy writing about the tax bills being considered by the often ill-informed, sometimes irresponsible, and always self-centered folks in Congress, it is time to return – at least for now – to more “ordinary course of business” matters.
Speaking of which, one of the most frequently encountered challenges in the case of a closely held business is determining the nature of an economic benefit bestowed, whether directly or indirectly,[vi] by the business upon one of its individual owners.
Sounds ridiculous, but there are circumstances in which the conclusion may not be crystal clear. Take, for example, the mid-year transfer of money from a business to an owner of the business where the nature of the transfer is not memorialized by the parties in writing in advance of, at the time of, or subsequent to the transfer.
Is it a loan, a return of capital, a dividend distribution,[vii] a redemption treated as an exchange,[viii] a distribution out of AAA by an S corporation,[ix] a current or a liquidating distribution,[x] a guaranteed payment for services or for the use of capital,[xi] consideration for property sold to the business,[xii] interest on a loan, rent for the use of real property, a royalty for the use of an intangible, compensation for services rendered, a gift[xiii] by another owner, etc.?
Of course, the parties’ intent is very important, though too often, unfortunately, they fail to memorialize their intent in writing. Sometimes, as alluded to above, they “forget” why a payment was made. In these and other cases, we must examine the context – the facts and circumstances – out of which the payment arose.
For example, was the owner also an employee of the business or otherwise provided services to the business, were they active in the business, did they own property – real or personal, tangible or intangible – that was used by the business?
In the case of an owner who wears many hats with respect to the business, in what capacity was the payment received? Stated differently, in exchange for what, if anything, was the payment made?
Sometimes, when I ask the owner or their tax return preparer why a certain payment was made, they respond by asking me – some more slyly than innocently – to tell them which characterization would be “better” from a tax perspective![xiv]
Always, we must be mindful of the axiom that interactions between a closely held business and its owners will be subject to heightened scrutiny by the IRS, and the labels attached to such interactions by the parties will have limited significance unless they are supported by objective evidence. Thus, arrangements between the parties that purport to be one thing may be examined by the IRS and possibly re-characterized to comport with their true character or with what would have occurred in an arm’s-length setting.
Even then, however, there are rare occasions on which a taxpayer may find support from unexpected sources, as illustrated by the decision described below.[xv]
Economic Benefit: Distribution or Compensation?
The taxpayer was the sole shareholder of Corp (“Taxpayer-SH”), an S corporation. Corp employed Taxpayer-SH, Taxpayer-SH’s spouse (“Spouse”; together with Taxpayer-SH, the “Taxpayers”), as well as four rank-and-file employees. Taxpayer-SH and Spouse each received annual salaries. Taxpayer-SH also included in income, as the sole shareholder of Corp, all its items of income and expense.[xvi]
Corp adopted an employee welfare benefit plan (“Plan”) to provide its employees with life insurance and other benefits. The form of plan selected was funded by Corp’s contributions to a trust (“Trust”). To be eligible to receive benefits, a person was required to “provide services to an Employer.”
Taxpayers were “eligible employees” under the Plan because they provided services to Corp. Under the Plan, Taxpayers were entitled to a significant death benefit, and the four rank-and-file employees were entitled to a much smaller death benefit and certain other benefits. To fund the promised death benefits, Plan required the purchase of life insurance. Accordingly, Trust purchased a life insurance policy (Policy) insuring the lives of Taxpayer-SH and Spouse. Policy was a form of “permanent” life insurance policy with accumulation values based on the investment experience of a separate fund. Policy provided base insurance coverage equal to the death benefit that Corp had selected for Taxpayer-SH and Spouse. The Policy was a “survivor policy,” under which the insurer would pay the death benefit to Trust when the survivor of Taxpayer-SH and Spouse died. Trust in turn was required to pay this amount to whatever beneficiaries Taxpayers had designated.
Corp contributed money to Trust, which Corp treated as tax-deductible business expenses. These contributions were sufficient to fund the death benefit promised to Taxpayers. Trust used these funds to pay premiums on Policy.
Taxpayers timely filed joint Federal income tax returns for the years in question. They did not report on these returns any income related to their participation in the Plan.
The IRS issued Taxpayers a timely notice of deficiency, determining that the economic benefits they received under Plan were currently taxable to them as ordinary income. Taxpayers timely petitioned the U.S. Tax Court for redetermination.
Taxpayers conceded that Corp provided welfare benefits to them in exchange for their performance of services, and they acknowledged their eligibility to receive benefits “was based solely on factors related to employment.” Yet they asserted that the arrangement was not compensatory.
The Court agreed with the IRS and held that Plan constituted a compensatory split-dollar life insurance arrangement and that the economic benefits flowing to Taxpayers therefrom generated current taxable income.
Taxpayers, however, asserted that the economic benefits at issue were taxable to Taxpayer-SH as distributions in respect of Taxpayer-SH’s shares of Corp stock. The IRS disagreed, contending that the economic benefits were taxable as ordinary income because the split-dollar arrangement was a “compensatory arrangement” that afforded benefits to Taxpayer-SH in their capacity as an employee.
Taxation of Split-Dollar Life Insurance Arrangements
At this point, a brief digression into the taxation of split-dollar life insurance arrangements of the sort involved here – “compensatory arrangements” and “shareholder arrangements” – may be in order.[xvii]
Any split-dollar arrangement involves the provision of an economic benefit, directly or indirectly, by one party to the arrangement (the business) to another party (the insured[xviii]). Depending on the underlying economic relationship between the business and the insured, the economic benefits may constitute a payment of compensation, a distribution in respect of one’s equity, or a transfer having some other tax character.
A “compensatory arrangement” is entered into in connection with an employee’s performance of services for an employer; the employer pays, directly or indirectly, all or any portion of the premiums for a policy on the life of the employee; and the beneficiary of all or any portion of the death benefit is designated by the employee.
A “shareholder arrangement” is entered into between a corporation and another person in that person’s capacity as a shareholder in the corporation; the corporation pays, directly or indirectly, all or any portion of the premiums for a policy on the life of the shareholder; and the beneficiary of all or any portion of the death benefit is designated by the shareholder.
Thus, an economic benefit under a “compensatory arrangement” will generally constitute the payment of compensation to the employee, and an economic benefit under a “shareholder arrangement” will generally constitute a distribution to the shareholder.
Taxpayers did not dispute that the life insurance arrangement at issue was a “compensatory arrangement.” They conceded that Corp provided them with death benefits “in exchange for the performance of services,” and they acknowledged that their eligibility to receive these benefits “was based solely on factors related to employment.” They consistently characterized the benefits provided by Plan to all six employees of Corp as employee benefits. For all these reasons, the arrangement was necessarily a “compensatory arrangement.”
Considering the foregoing, it would seem logical that the benefits received under such a compensatory arrangement were in the nature of compensation.
But Taxpayers contended, “where a shareholder receives economic benefits from a split-dollar life insurance arrangement, * * * those benefits [must] be treated as a distribution of property.” In Taxpayers’ view, such benefits constituted corporate distributions even if the benefits were received in exchange for services performed by an employee-shareholder in their capacity as an employee.
The Court rejected the Taxpayers’ argument. Not all payments from a corporation to a shareholder, it stated, constitute “distributions.” Rather, a distribution requires that the transfer be made “by a corporation to a shareholder with respect to its stock.” The phrase “with respect to its stock” means that the distributee must receive the payment from the corporation in their capacity as a shareholder.[xix]
Accordingly, a payment is not a “distribution” if the shareholder receives it in their capacity as a creditor of the corporation, for example. Nor is a payment a “distribution” if the shareholder receives it in their capacity as an employee of the corporation.
Taxpayer-SH owned Corp but was also employed by Corp and was paid a salary from Corp; Corp also provided Taxpayer-SH and its other employees with various welfare benefits, including death benefits and other benefits. Taxpayers conceded that Corp provided these benefits “in connection with the performance of services” and that their eligibility to receive such benefits “was based solely on factors related to employment.”
Taxpayers did not contend that their annual salary qualified as a “distribution.” Nor did Taxpayers contend that welfare benefits generally, when received by a shareholder in exchange for the performance of services, should be treated as “distributions.” That being so, the Court continued, it was hard to see why split-dollar insurance benefits, when received by a shareholder in exchange for the performance of services, should be subject to a different rule.
Because Taxpayers conceded that the split-dollar arrangement was “entered into in connection with the performance of services,” it necessarily followed, the Court continued, that the arrangement was not a “shareholder arrangement” – an arrangement “entered into between a corporation and another person in that person’s capacity as a shareholder in the corporation.” Thus, there was no distribution.
The Tax Court then addressed the crux of Taxpayers’ position: their reliance on a decision of the Sixth Circuit Court of Appeals in which that Court, relying on an incorrect reading of the applicable regulation,[xx] held that the economic benefits realized by the individual shareholder under a split-dollar arrangement established by their corporation constituted a distribution without regard to the capacity in which the individual received the benefits.[xxi]
The Court explained that it was unable “to embrace the reasoning or result of the Sixth Circuit’s opinion” because doing so would require it to ignore the plain language of the Code[xxii] which “unambiguously applies only to a distribution of property made by a corporation to a shareholder with respect to its stock.” If a corporation makes a payment, it continued, other than with respect to its stock – for example, to a shareholder in their capacity as an employee – the payment is outside the scope of the Code’s distribution provisions. It added that the regulations issued thereunder were consistent with this statutory mandate.[xxiii]
According to the Court, the same analysis applies to split-dollar arrangements. The statement in the regulation relied upon by the Sixth Circuit and Taxpayers, 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, necessarily applies only to the provision of economic benefits to a shareholder in their capacity as such, because that is the only type of transfer to which the regulation applies.
The split-dollar regulations, the Court noted, state that the manner in which economic benefits are taxed “[d]epend[s] on the relationship between the owner and the non-owner.”[xxiv] Depending on the capacity in which the transfer is received, it “may constitute a payment of compensation, a distribution. . ., a contribution to capital, a gift, or a transfer having a different tax character.” Under the Sixth Circuit’s approach in Machacek, economic benefits received by a shareholder would invariably constitute a distribution . . ., regardless of the relationship that accounts for the payment. “We are unable to reconcile that approach either with the text” of the Code or with the split-dollar regulations.
For the foregoing reasons, as well as others, the Court concluded that the economic benefits received by Taxpayer-SH under the split-dollar arrangement could not be characterized as “distributions.” Rather, because the benefits were received under a compensatory arrangement, they were taxable as “compensation for services” and, thus, as ordinary income.
Depending upon the outcome of the negotiations among the White House, Congressional moderates, and the progressive wing of the Democratic Party, the temptation for many owners of closely held businesses to construe the tax treatment of interactions with their businesses in all sorts of creatively tax efficient ways may be irresistible.[xxv]
As advisers, we should not succumb to such pressures. The “close scrutiny” to which such transactions are already subject, coupled with the prospect of a more aggressive, better staffed and better equipped IRS, should dissuade any questionable behavior.[xxvi]
[i] And of deficits, debt ceilings, and inflation.
As I write this, the moderates working toward a bipartisan legislative package are considering a much smaller and more focused approach toward infrastructure than was originally proposed by the President and endorsed by progressives. We will see how this plays out.
[ii] I have read that the Administration’s original infrastructure plan will generate annual trillion-dollar deficits for the next ten years.
[iii] https://www.rivkinradler.com/publications/a-night-to-remember/ . And as explained in greater detail by the Treasury in the Green Book released toward the end of May. https://www.rivkinradler.com/publications/the-biden-administrations-revenue-proposals-for-fiscal-year-2022-tax-increases-and-forced-recognition-of-capital-gains/ .
[iv] Though I have met, and even worked with, my fair share of such folks who inexplicably are among the exceptions to this rule.
[v] Indeed, even among the ancient Greek gods, none was omniscient, let alone clairvoyant. They were not even omnipotent – for example, Zeus could not change what had been decreed by the three Fates.
[vi] Constructive transfers play a significant part in the taxation of closely held businesses and their owners. For example, a payment from the business to a non-owner family member of an owner may be treated as a distribution or as compensation to the owner, followed by a gift from the owner to the family member. See, for example, Reg. Sec. 1.61-22(c)(2)(ii) and Sec. 1.61-22(d)(1) dealing with arrangements of split dollar life insurance.
[vii] IRC Sec. 301, Sec. 312, and Sec. 316.
[viii] IRC Sec. 302.
[ix] IRC Sec. 1368.basically, a distribution of S corporation earnings that have already been taxed to the shareholders. The accumulated adjustment account, or AAA, is a corporate (not shareholder) level account.
[x] IRC Sec. 301 or Sec. 331; Sec. 736.
[xi] IRC Sec. 707(c).
[xii] IRC Sec. 1001, Sec. 707(a).
[xiii] IRC Sec. 102, Sec. 2501.
[xiv] How many times have you encountered a business that has transferred money to an owner over the course of the taxable year without contemporaneously committing to its tax treatment? Rather, the business decides after the fact whether a deduction is needed, whether the owner has “too much” taxable income, etc., then settles upon the tax treatment (for example, a loan as opposed to a dividend).
[xv] De Los Santos v. Commissioner, 156 T.C. No. 9 (2021).
[xvi] IRC Sec. 1366.
[xvii] Reg. Sec. 1.61-22(b)(2)(ii) and (iii).
[xviii] The business has an insurable interest in the insured, whether the latter is an employee or an owner.
[xix] Reg. Sec. 1.301-1(c).
The rules governing the tax treatment of distributions made by an S corporation likewise are premised upon “a distribution of property made by an S corporation with respect to its stock.” IRC Sec. 1368.
[xx] Reg. Sec. 1.301-1(q).
[xxi] Machacek v. Commissioner, 906 F.3d 429 (6th Cir. 2018), rev’g T.C. Memo 2016-55.
The Office of the Chief Counsel formally recommended that the IRS not acquiesce in the 6th Circuit’s opinion. AOD 2021-02.
According to the 6th Cir., the cross-reference in Reg. Sec. 1.301-1(q)(1)(i) included “any split-dollar arrangement”; therefore, the 6th Cir, held that this regulation “is dispositive and renders irrelevant whether * * * [the taxpayers] received the economic benefits through a compensatory or shareholder split-dollar arrangement.”
[xxii] IRC Sec. 301(a).
[xxiii] Reg. Sec. 1.301-1(c) states that “[s]ection 301 is not applicable to an amount paid by a corporation to a shareholder unless the amount is paid to the shareholder in his capacity as such.”
[xxiv] Reg. Sec. 1.61-22(d)(1).
[xxv] Talk about a euphemistic sentence.
[xxvi] There are always exceptions, though, aren’t there? Folks who just cannot resist the urge.
- Louis Vlahos