In Uncategorized on 04/12/2021 at 16:20

There’s a full-dress T. C. today about corporate welfare, but it’s not political. Ruben De Los Santos and Martha De Los Santos, 156 T. C. 9, filed 4/12/21, had an employee welfare benefit plan for themselves and four (count  ’em, four) other employees of their Sub S. Judge Albert G (“Scholar Al”) Lauber reminds us that Ruben’s welfare plan was a SDLIA, and got his tax benefits taxed back to him as ordinary income per Reg. Section 1.61-22(b), as more particularly bounded and described in 2018 T. C. Memo. 155, filed 9/18/18.

I didn’t blog Ruben’s loss, as I had a full-dress T. C. to deal with that day, and Ruben’s deal was much of a muchness.

But today, Ruben’s trusty attorney earns a Taishoff “Good Try,” claiming that the benefits are a corporate distribution, entitled to Section 301 treatment. Tight-fisted ol’ IRS says no, the SDLIA was a “‘compensatory arrangement’ that afforded benefits to petitioner husband in his capacity as an employee.” 156 T. C. 9, at p. 3.

Ruben (that’s Doc Ruben, MD) incorporated his medical practice as a Sub S, and took all the flow-throughs on the MFJ 1040s for the years at issue. He set up one of the Legacy plans. Legacy was a lead hawker of split-dollar life insurance plans; for the backstory on SDLIAs, see my blogpost “The Split,” 8/27/12.

For Ruben and Martha to be eligible for plan benefits, they had to be employees of the Sub S.

“Under the Legacy Plan as adopted by the S Corp., petitioners were entitled to a $12.5 million death benefit, and the four rank-and-file employees were entitled to a $10,000 death benefit and certain flexible benefits. To fund the promised death benefits the Legacy Plan required the purchase of life insurance. The Trust accordingly purchased a life insurance policy (Policy) insuring petitioners’ lives. The Policy was a ‘flexible premium variable universal life’ policy with accumulation values based on the investment experience of a separate fund. The Policy provided base insurance coverage of $12.5 million, equal to the death benefit that the S Corp. had selected for petitioners. The Policy was a ‘survivor policy,’ under which the insurer would pay $12.5 million to the Trust when the second of petitioners died. The Trust in turn was required to pay $12.5 million to whatever beneficiaries petitioners had designated.” 156 T. C. 9, at p. 5.

So Doc Ruben deducted the $1.862 million the policy cost him as a business expense, while in a couple following years (hi, Judge Holmes) the policy accumulated about $800K in cash surrender value. IRS bounced the deal. Ruben and Martha lost summary J on split-dollarism. So why am I writing this?

Because IRS, Ruben and Martha, and Judge Scholar Al left figuring out what part of the cash surrender build-up gets taxed for what years. Ruben and Martha and trusty attorney claim the benefits are corporate distributions of property, notwithstanding that they agree that the benefits were employee compensation.

Ya see, back in 2018, 6 Cir overturned Machacek, to which I had given short shrift when it was a T. C. Memo. (see my blogpost “A Scrap About Scrap,” 3/28/16). I had cavalierly dismissed Machacek: “And as these SDLIA deals have been blown sky-high so many times, it’s not likely any of my readers will encounter any new ones.” Boy, was I wrong!

6 Cir went off on Reg. Section 1.301-1(q)(1)(i), which says all SDLIA distributions are corporate distributions, and that provision overrides Reg. Section 1.61-22(b).

Judge Lauber isn’t buying.

Golsen to the rescue. Machacek was 6 Cir, but Ruben and Martha are Texians, hence 5 Cir. “To adopt the Sixth Circuit’s construction of section 1.301-1(q)(1)(i), Income Tax Regs., would require us to ignore the plain language of section 301(a), the statute under which the regulation was promulgated. We are not permitted to construe a regulation in a manner that ignores its governing statute or that adds to the statute ‘something which is not there.’” 156 T. C. 9, at p. 16. (Citation omitted).

Section 301(a) says a distribution to a shareholder is only a distribution if it is made in the shareholder’s capacity as such.

“These general rules, unambiguously stated at the outset of the section 301 regulations, necessarily apply to (and limit) the subsequent, more granular provisions. Those subsequent provisions often refer to “distributions to shareholders” or “property transferred by a corporation to a shareholder,” without explicitly saying–each and every time–that the distribution or transfer is being made to the shareholder “in his capacity as such.” But there was no need for Treasury to include that verbiage in these more granular provisions because the general rules stated at the outset limit the scope of the regulations to distributions by a corporation with respect to its stock.” 156 T. C. 9, at pp. 18-19. (Footnote omitted).

And since it’s compensation, it’s subject to FICA/FUTA. Adopting 6 Cir would mean an employer could give each employee a couple shares stock (hi again, Judge Holmes) and dodge withholding on the benefits.

Finally, Ruben and Martha elected to have their Sub S taxed as a partnership, and there are no Section 301 “distributions” to partnerships.

Ch J Foley, and Judges Gale, Gustafson, Paris, Morrison, Kerrigan, Buch, Nega, Pugh, Ashford, Urda, Copeland, Jones, Toro, Greaves, Marshall, and Weiler all agree.

I bet IRS is hoping Ruben’s trusty attorney appeals.


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