“While it would be nice if all tax shelters advertised as legitimate tax shelters were indeed legitimate, the fact of the matter is that not all marketed tax shelters are legitimate.” That sentence outlines the basic problem for the taxpayers in the case of Our County Home Enterprises, Inc., et al v. Commissioner, 145 TC No. 1.

The case is yet another in a series of unsuccessful attempts by owners of closely held businesses to use a purported welfare benefit plan (promoted as “single employer plans” or “419(e) plans”) to use life insurance in such programs to provide cash and other benefits on an extremely tax advantaged basis to the owners of the businesses.

The opinion describes such arrangements as follows:

Under these arrangements, the trustee uses the employer's contributions to the trust to purchase life insurance policies. The trustee typically purchases cash value life insurance policies on the lives of the employees who are owners of the business (and sometimes other key employees), while purchasing term life insurance policies on the lives of the other employees covered under the plan.

It is anticipated that after a number of years the plan will be terminated and the cash value life insurance policies, cash, or other property held by the trust will be distributed to the employees who are plan participants at the time of the termination. While a small amount may be distributed to employees who are not owners of the business, the timing of the plan termination and the methods used to allocate the remaining assets are structured so that the business owners and other key employees will receive, directly or indirectly, all or a substantial portion of the assets held by the trust.

Unfortunately for the owners, such plans have not fared well in Court (see Neonatology Assocs., P.A. v. Commissioner, 299 F.3d 221; id., 115 T.C. 43) and this case would prove no different. In the end the contributions to the plan would be disallowed and, for the C corporations in question, the amount includable in income would be taxed as dividends to the owners, with the contributions disallowed at the corporate level.

What was unique about this case, and why it is shown as a published Tax Court opinion, is that it ruled that the programs were split-dollar life insurance programs as defined by Reg. §1.61-22(b)(2) and that those IRS regulations were valid.

To be a compensatory split-dollar arrangement under Reg. §1.61‑22(b)(2) a program must meet three criteria as outlined in the opinion:

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 section 79”. Id. subdiv. (ii)(A). The second prong requires that “[t]he employer or service recipient pays, directly or indirectly, all or any portion of the premiums”. Id. subdiv. (ii)(B). The third prong requires that 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.” Id. subdiv. (ii)(C). A compensatory (or shareholder) arrangement that falls within the special rule is a split-dollar life insurance arrangement even if it does not meet the general rule of section 1.61-22(b)(1), Income Tax Regs. See id. subdiv. (i).

The Court found the plan in front it met these rules:

The life insurance arrangements related to the Our Country and the Environmental single employer plans are split-dollar life insurance arrangements in that they are compensatory arrangements within the meaning of the special rule. They fall within the special rule because each prong of the three-prong test is met as to the arrangements. First, each of those 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 section 79. Second, each single employer plan paid the premiums on the life insurance policies through the employer's payments to the Sterling Plan. Third, 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. We also find 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.

The Court then considered the taxpayers’ objections to meeting the first and third tests. With regard to whether the plans qualified as group term insurance under §79, the Court notes that such a group term program must preclude individual selection and it found in this case that, while the amount of death benefit was not based on individual selection, that did not mean the policies did not have an individual selection taint.

As the Court noted:

We conclude that the issuance of the insurance policies on the lives of Our Country and Environmental shareholder/employees (and as it appears on the lives of all of the Our Country and the Environmental participating employees) was based on individual selection. While the employers participating in the Sterling Plan formally set the amount of life insurance provided to their employees as a multiple of compensation, the mere fact that the Sterling Plan stated on its face that it would pay death benefits in amounts that turn on employee compensation does not necessarily mean that the underlying life insurance is group term life insurance. The life insurance issued as to the Our Country and the Environmental shareholder/employees was not group term life insurance given our finding above that the multiple-of-compensation formula did not actually correspond to death benefits payable and otherwise failed to always limit the amount of insurance that actually was provided to those shareholder/employees. Cf. Towne v. Commissioner, 78 T.C. 791 (1982) (holding that an insurance policy was not part of a group term life insurance plan because it individually selected only the company’s president as a participant to receive excess insurance).

We also agree with respondent’s argument that the life issuance related to Our Country and Environmental was not group term life insurance because the issuance of the insurance took into account the personal risks characteristics of at least those corporations’ shareholder/employees (and most likely all of those corporations’ participating employees). In Towne v. Commissioner, 78 T.C. at 799-800, the Court discussed the genesis of the “individual selection” test and noted that individual selection has never been allowed to occur in the case of group term life insurance. The Court explained:

The reason why the insurance industry has traditionally defined group insurance as not including policies of insurance providing for individual selection is that a group insurer has less opportunity to exercise underwriting judgment with respect to particular persons in the group. Group insurance is usually issued without medical examination or other evidence of insurability. If there were no requirement that the amount of insurance per participant be determined under some formula applicable to all the employees, there would necessarily be adverse selection against the insurance company because the older employees and those in poor health would naturally take disproportionately large amounts of insurance. * * * [Id. at 799 n.5; citations omitted.]

Guardian and Minnesota Life required that the Our Country and Environmental shareholder/employees tender information on their health, traveling tendencies, and/or driving traits. The need to submit that type of personal information as a condition to receiving the insurance strongly suggests, and we find, that the insurers were exercising underwriting judgment with respect to at least the Our Country and Environmental shareholder/employees in connection with the issuance of the life insurance related to them. This finding is further strengthened by the fact that, in the case of Guardian at least, Guardian specifically rated each of Our Country’s participating employees for purposes of setting the premiums payable on their policies and offered to try to find a way to reduce the premium attributable to the Blake policy. The mere fact that an insurer such as Guardian or Minnesota Life may add up the premiums that apply to separate policies that it sells on a specific group of insureds and then tender the total as the amount due on a “group policy” does not necessarily recharacterize the separate policies as part of a single group term life insurance plan. Instead, as we have stated, the exercise of underwriting judgment with respect to the specific persons in a group is indicative of the issuance of individual insurance policies rather than group policies. We hold that the insurance policies at hand are not group term life insurance policies for Federal income tax purposes.

The taxpayers also claimed that the employees did not designate beneficiaries nor did they have an interest in the cash value of the policies, thus failing the third test.

The Tax Court found that the plan failed on both counts. With regard to the question of the owners designating the beneficiaries of the policies the Court found:

The shareholder/employees named the beneficiaries of the death benefits payable under their insurance policies by designating through the Sterling Plan the individuals who would receive the death benefits under the plan, which, in turn were the death benefits under the policy. In addition, those shareholder/employees were assured that their designated beneficiaries would receive any death benefits payable on those policies to the extent that the shareholder/employees died while participants in the plan. Petitioners seek a contrary holding essentially by looking at the life insurance policies through the wider end of a telescope towards its narrower end and seeing that the Sterling Plan is named as the beneficiary on the policies. They conclude from this view that none of the individuals who the participating employees designate to receive the death benefits payable by the Sterling Plan is “[t]he beneficiary of all or any portion on the death benefit” for purposes of section 1.61-22(b)(2)(ii)(C), Income Tax Regs. We, on the other hand, look telescopically at the life insurance benefit from the narrower end towards the wider end, as one commonly does, and see the ultimate recipient of the death proceeds as the person designated by the shareholder/employees. The fact that the death proceeds from the life insurance policies are funneled through the Sterling Plan to each of the ultimate recipients does not blur our view (or our conclusion) that each of those recipients is the beneficiary of the death benefit for purposes of section 1.61-22(b)(2)(ii)(C), Income Tax Regs. Cf. Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945) (“To permit the true nature of a transaction to be disguised by mere formalisms * * * would seriously impair the effective administration of the tax policies of Congress.”); Minn. Tea Co. v. Helvering, 302 U.S. 609, 613 (1938) (“A given result at the end of a straight path is not made a different result because reached by following a devious path.”). The light at the end of the tunnel brightly illuminates our conclusion, given that the Sterling Plan would pay no death benefit were it not for the life insurance policies, and the employee to whom a policy relates, rather than the Sterling Plan, is assured of receiving the entire amount that is payable under the terms of the policy.

The Court also found that, in reality, the owners had an interest in the cash value of the policies, finding:

We also conclude that the shareholder/employees of Our Country and Environmental had interests in the their [sic] life insurance policies and the cash values thereof. This conclusion is supported by at least five facts. First, each life insurance policy and any funds related thereto were intended to be received by the corresponding employee or his or her designee(s) and no one else, and those employees were the only ones who had the right to receive or otherwise to redirect to someone else the cash value of the life insurance policies related to them. Second, the employees could elect to receive their policies upon retiring from employment with the employer. Third, the funds in the Sterling Plan could not be accessed by either the employer or by the employer’s creditors, and Our Country and the Environmental employees, upon retiring or alternatively upon their employers’ ceasing participation in the Sterling Plan, were certain to get those funds in the form of the policies that then passed to the employees. Fourth, a participating employee, before actually receiving the funds in his or her account, could be allowed to direct the investment of those funds and thus enjoy the benefit of any investment gain or suffer the detriment of any investment loss. Fifth, if the participating employee were to die while his or her insurance policy was in force, then the death benefit under that policy would ultimately be paid to his or her beneficiary in accordance with the terms of the policy.

As well, the owners had full discretion to vest themselves at any point, as the Court pointed out:

We also find important to our just-stated conclusion that the plan benefits were set to be fully vested either when a shareholder/employee satisfied the vesting requirements that he or she chose (or possibly could choose) in the name of the employer or when the employer terminated the plan. And as to vesting, the shareholder/employees were not necessarily bound by the vesting requirements that were initially set in their plans. Instead, at their whim they could accelerate or otherwise change the vesting requirements to their preference. In the case of Mr. Blake, for example, he executed an adoption agreement on July 30, 2006, retroactive to January 1, 2005, that lowered the normal retirement age for the employee participants in the Our Country plan and accelerated his complete vesting to the then-present time.

Turning to the inclusion of income issue, the Court noted that the issue in this case is the “economic benefit” rule of §1.61-22(d) through (g) as the arrangement (as all parties agreed) did not meet the rules to be treated under the “loan rule” for a split-dollar arrangement. The IRS claims the economic benefit rule applies while, not surprising, the taxpayers argue against it.

The Court describes the effect of the economic benefit rule on the employee as follows:

When applicable, the value of the economic benefits provided to a non-owner in a taxable year equals the sum of (1) the cost of current life insurance protection that the non-owner receives during the year; (2) the amount of the insurance policy cash value to which the non-owner has current access during the year (to the extent the amount was not previously included in income), and (3) any other economic benefit provided to the non-owner (to the extent not previously included in income). See id. para. (d)(2). The non-owner is treated as having current access to that portion of the insurance policy’s cash value (1) to which the arrangement gives the employee a current or future right and (2) that is directly or indirectly currently accessible by the employee, inaccessible by the employer, or inaccessible by the employer’s general creditors. See id. subpara. (4)(ii).

The taxpayers argue that the regulation, as summarized above, is simply invalid and thus there is no income for the shareholders to recognize. They argue:

Petitioners argue that the economic benefit provisions are inapplicable because, petitioners state, those provisions are invalid. According to petitioners, the Secretary lacked the authority to prescribe those provisions in that the provisions are inconsistent with “fundamental principles of federal tax law”. Petitioners assert that these fundamental principles require, contrary to the economic benefit provisions, that employees be able to compel current distributions of the cash values of the insurance policies in order to have an interest in the values. Petitioners conclude that the shareholder/employees have therefore not realized any of the cash value and need not include that value in income.

The Tax Court did not agree the IRS had overstepped its authority in requiring this treatment. The Court notes that to determine if a regulation is invalid, it must apply the Chevron test (Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 842-844 (1984)). That test generally requires first deciding if the issue is one for which Congress provided an unambiguous determination with regard to how the matter must be addressed—if so, then there is nothing for a regulation to interpret and the Court must apply the law. The Court notes that IRC §61 does not provide any specific definition with regard to economic benefit.

The second test looks at, given the ambiguity, does the regulation represent a (as opposed to necessarily the most) reasonable interpretation of the law that resolves the ambiguity as opposed to being an arbitrary or capricious interpretation of the statute.

With regard to the second test the Court states:

The economic benefit provisions, which operate in part to tax accessions to wealth resulting from split-dollar life insurance arrangements, fit reasonably within the wingspan of the broad definition of “gross income” set forth in section 61(a). We find instructive that the economic benefit provisions track longstanding judicial jurisprudence related to section 61(a). Respondent argues, and we agree, that the economic benefit provisions are reasonably tailored from the economic benefit doctrine applied in cases such as Brodie v. Commissioner, 1 T.C. 275 (1942), and Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d, 194 F.2d 541 (6th Cir. 1952). Those cases hold that the benefit derived from an employer’s irrevocable set-aside of money or property as compensation for services rendered is includible in the service provider’s gross income at the time of the set aside, where the money or property is beyond the reach of the employer’s creditors. See also Pulsifer v. Commissioner, 64 T.C. 245 (1975) (applying Sproull to hold that taxpayers were currently taxable on prize money that they would receive in the future but which was irrevocably set aside for their benefit). The economic benefit provisions state similarly that a non-owner of a life insurance policy has current access to the portion of the insurance policy’s cash value (1) to which the arrangement gives the employee a current or future right and (2) that is directly or indirectly currently accessible by the employee, inaccessible by the employer, or inaccessible by the employer’s general creditors. See sec. 1.61-22(d)(4)(ii), Income Tax Regs.; see also id. subpara. (6), Example (2), Income Tax Regs. (demonstrating that the split-dollar provisions apply there because the employer and the employer’s general creditors cannot access a portion of the cash value). We conclude that the economic benefit provisions are not arbitrary or capricious in substance or manifestly contrary to the statute.