In Neff v. Commissioner, T.C. Memo 2012-244 (8/27/12), the Tax Court addressed the tax consequences of the rollout of a split-dollar life insurance policy under guidance issued by the IRS under prefinal split-dollar regulations (T.D. 9092, 68 Fed. Reg. 54336 (9/17/03)) regarding the proper treatment of such policies applicable to split-dollar life insurance arrangements (SDLIAs) entered into after Sept. 17, 2003. Because many of these arrangements are still in effect, this case is important in determining the tax consequences of the termination of such an arrangement.
In an employment context, an SDLIA is an arrangement in which an employer and an employee (or an owner or a shareholder) divide responsibility for the payment of the life insurance policy. The life insurance policy is generally a part-term/part-whole life policy with the employee responsible for the cost of the term element of the policy and the employer responsible for the whole life element. For tax purposes, these arrangements are taxed under either the economic benefit regime or the loan regime. Under either form, the employer generally makes all policy payments, entitling the employer, upon the employee's death, to either the cash surrender value of the policy or the policy payments. A rollout of an SDLIA occurs when the arrangement is terminated other than by the death of the insured employee.
In Neff, the taxpayers were partners who owned several businesses. In 2002, the taxpayers formed an S corporation owned by an employee stock ownership plan (ESOP). One of the taxpayers served as the president of the corporation, and the other served as vice-president, secretary, treasurer and director. Also in 2002, the taxpayers and the corporation entered into four identical SDLIAs in which the corporation made premium payments due of six life insurance policies owned by the taxpayers and family limited partnerships (FLPs) that were owned by the taxpayers and their family members. Under the SDLIAs, the corporation agreed to pay the premiums on the life insurance policies, and the taxpayers agreed that upon either the termination of the policies or the termination of the SDLIAs, the corporation would be entitled to the lesser of the total premiums it paid or the cash surrender value of the policies.
In December 2003, the SDLIAs were terminated. Prior to the termination, the corporation had paid a total of $842,345 in premiums, and as of the date of termination, the cash surrender values of the life insurance policies were $877,432. Thus, under the SDLIAs, the corporation was entitled to receive $842,345 (the lesser of cash surrender value or premiums paid). The taxpayers' tax advisers determined that the $842,345 payment due should be discounted because under the SDLIAs, the corporation was not entitled to receive the payment upon the death of the taxpayers. After applying the discount, it was determined and agreed upon by the parties that the corporation was entitled to a payment of $131,969 to terminate its rights under the SDLIAs. The taxpayers made the payments from withdrawals from the accumulated cash value of the life insurance policies.
The taxpayers failed to include in income any benefits from the SDLIAs or the termination of the SDLIAs. On audit, the IRS determined that when SDLIAs were terminated, the taxpayers realized taxable income of $710,376 — the difference between the reimbursement they made to the corporation ($131,969) and the premium payments made by the corporation ($842,345). The IRS did not assess the partners in the FLPs with income during the 2002–03 period. The issue before the Tax Court was whether when the SDLIAs terminated in 2003, there was a transfer of $710,376 by the corporation to the taxpayers that should have been included in the taxpayers' incomes.
The Tax Court first looked at the rules governing the taxation of SDLIAs that existed at the time the SDLIAs where executed, noting that the SDLIAs were entered into before the final regulations were issued in 2003. Under these rules, for each year the SDLIAs were in effect, an employee was required to include in taxable income the total value or cost of the economic benefit received each year by the employee — less any amount contributed by the employee. The court noted, however, that the taxpayers had not included such economic benefit in their incomes for the years the SDLIAs were in effect.
The taxpayers argued that no termination or rollout of the SDLIAs occurred, claiming they purchased the corporation's contract rights in the SDLIAs from the corporation for a discounted value and that the SDLIAs remained in effect. The Tax Court disagreed, noting that as of the end of 2003, the SDLIAs were unwound and the corporation was released from its obligation to provide further premiums.
The Tax Court then determined that as of December 2003, the corporation was entitled to reimbursement of the $842,345 it made in premium payments, the taxpayers were obligated to make the reimbursement, and the cash value of the policies was secured to fund the reimbursement. The taxpayers, however, had reimbursed the corporation only $131,969. After reviewing the principles of sections 61 and 83, the court determined that the $710,376 difference was either income to the taxpayers under Section 61 or property transferred to them under Section 83.
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