McGowan v. Comm’r Provides Cautionary Tale of Too Good to Be True Insurance Tax Scheme

The Insurance Transactions
The taxpayer formed two trusts: (i) the death benefit trust (DBT) and (ii) the restricted property trust (RPT). Both trusts had the same institutional trustee that the C corporation could remove at will. Over five years (2011 – 2016), the C corporation dental practice made annual contributions to both trusts, 74.44% of which were made to the DBT and 25.56% of which were made to the RPT. The C corporation deducted both payments, but the taxpayer only reported the contributions to the RPT as taxable income. The DBT did not report the contributions from the C corporation as taxable income.

The DBT used the contributions from the C corporation to purchase a life insurance policy on the life of the taxpayer. The RPT paid the contributions that it received to the DBT. The DBT used those payments to pay additional premiums on the life insurance policy. The DBT gave the RPT a security interest in the cash value of the policy in exchange for the transferred cash. The trust transactions had three possible outcomes:

• If the taxpayer died while the arrangements were in effect, the death benefits on the insurance policy would be paid to his wife;
• If the plan expired, the DBT would transfer ownership of the policy to the taxpayer; and
• If the C corporation failed to make contributions to the DBT, the DBT would surrender the policy back to the insurer for its cash value and pay such amount to the RPT. The RPT would then make a contribution to a charity chosen by the taxpayer.

The taxpayer missed a deadline to extend the arrangements. As a result, in 2016, the DBT transferred the insurance policy to the taxpayer. The taxpayer reported taxable income equal to the cash value of the policy as a result of this transfer.

The basis upon which the C corporation deducted the contributions to the DBT, but on which the DBT did not report income as a result of the receipt of such contributions, is unclear to the author and is not addressed in the opinion itself. The court recites that, in the litigation, the C corporation claimed a business expense deduction for the contributions to the DBT. If the payment to the DBT was a business expense, it either should have been income to the DBT or the DBT was just a mechanism for the C corporation to purchase the insurance. As we’ll see below, however, the C corporation determined its taxes on the basis that the DBT was not a conduit for it to pay the insurance premiums.

The “Split-Dollar” Tax Regulations
The split-dollar tax regulations, when they apply to a compensatory insurance arrangement, have a particularly harsh result. The regulations require the employee to recognize income equal to the full value of economic benefit of the plan, but deny the employer a deduction for the premiums that it paid.^[3] A compensatory split-dollar insurance arrangement exists when the policy is owned by the employer and:

• the arrangement is entered into in connection with the provision of services;
• the employer directly or indirectly pays all or any portion of the premiums on the policy; and
• either (i) the beneficiary under the policy is designated by the employee (or a person that the employee would reasonably be expected to designate) or (ii) the employee has an interest in the cash value of the policy.^[4]

The IRS and the taxpayer agreed that the first two elements were met. The taxpayer asserted that the policy was not owned by the employer and the third requirement was not satisfied.

The taxpayer asserted that the DBT, not the C corporation, was the owner of the insurance policy. First, the court held that the DBT was “an economically meaningless subtrust” because the C corporation could replace the trustee at any time for any reason. Then, the court found that the third requirement of a compensatory split-dollar arrangement was met because the taxpayer’s wife was the designated beneficiary of the insurance policy. In the court’s view, the fact that the charity designated as the beneficiary of the RPT did not change this conclusion because it only related to the cash value (and not death benefit) of the insurance policy and the charity was chosen by the taxpayer.

The taxpayer contended that even if the split-dollar regulations did apply, he did not understate his income. The regulations specify that the employee must include in income the cash value to which he “has current access.”^[5] “Current access,” however, includes future rights if the employer cannot currently access such right.^[6] Thus, the court found that even though the taxpayer could not access the cash value of the policy, the fact that he had a right to receive the policy upon a non-renewal, could designate the beneficiary and had the right to designate the charitable beneficiary of the cash surrender value all provided him with future rights that were currently taxable. The C corporation could not access such benefits.

Mitigating Law
In a 2018 case, Machacket v. Comm’r,^[7] the Sixth Circuit Court of Appeals, the same court considering McGowan’s insurance arrangements, held that a compensatory split-dollar arrangement involving a shareholder should be treated as a distribution with respect to the stock of the employer and not as the payment of compensation. McGowan argued for the same treatment in his case. Since the dental practice was operated as a C corporation, a dividend would have been taxable at approximately half of the rate applicable to ordinary income (20% versus 37%). The court considered this argument and concluded that its prior decision “stands in tension with, and possibly contradicts, the Internal Revenue Code.” Accordingly, the court refused to follow its prior decision and held that the income to be recognized by the taxpayer should be treated as ordinary compensation income.

Concluding Observations
The tax consequences of the insurance arrangements completely flipped on the taxpayer in the most adverse possible way. In its initial reporting, the C corporation deducted the insurance premiums and the DBT did not report income. The court’s decision denied the C corporation a deduction and required the taxpayer to include the premiums in income. Maybe the taxpayer was in the alternative universe when he originally filed his returns, and the court walked the taxpayer back up the emergency staircase to reality.

^{[1] Haruki Murakami, 1Q84.}

^{[2] The taxpayer incurred taxes and penalties of $65,589.80. The C corporation dental practice incurred tax and penalties of $37,164.94. The insurance transactions were designed to shelter income on $155,227.}

^{[3] Treas. Reg. § 1.61-22(d)(1), (f)(2)(ii).}

^{[4] Treas. Reg. § 1.61-22(b)(2)(i)-(ii).}

^{[5] Treas. Reg. § 1.61-22(d)(4)(ii).}

^{[6] Treas. Reg. § 1.61-22(d)(4)(ii)(B).}

^{[7] 906 F.3d 429 (6th Cir. 2018)}