• Termination of split-dollar agreements causes recognition of income—In Neff v. Commissioner, T.C. Memo. 2012-244 (Aug. 27, 2012), the Tax Court held that the taxpayers had terminated a split-dollar agreement with their employer, causing them to recognize income in an amount equal to the net premiums formerly paid by their employer on the life insurance policies. The taxpayers argued that they had simply sold the rights to future payments under the split-dollar agreement, and the rights were subject to a present value discount, but the Tax Court disagreed.
The taxpayers were the president and vice-president of a commercial concrete company (the Company). The taxpayers and two other entities (which were owned by the taxpayers and their families) purchased six life insurance policies to fund cross-purchase buy-sell stock agreements entered into between the taxpayers and to provide estate liquidity upon the taxpayers’ deaths.
In March 2002, the taxpayers and the Company entered into four equity split-dollar agreements, in which the Company was obligated to pay the premiums due on the six life insurance policies (the SDLIA agreements).
Under the SDLIA agreements, the taxpayers held the formal ownership rights in the six life insurance policies. However, the Company agreed and was obligated to pay the premiums due on the life insurance policies. In addition, upon either termination of the life insurance policies (such as upon a taxpayer’s death) or upon termination of the SDLIAs for some other reason (such as upon a third-party sale of the Company, regardless of whether the life insurance policies were canceled), the Company had the right to be reimbursed an amount equal to the lesser of the total premiums it had paid on the policies or the total cash surrender value of the policies.
In less than two years, the Company paid $842,345 in premiums on the policies. But, in late 2003, in part due to the new Treasury regulations issued on split-dollar agreements and on advice of counsel, the taxpayers decided to terminate the SDLIAs. After December 2003, the Company made no further payments on the policies and released its interest in the policies (that is, the premium reimbursement rights).
At the request of the taxpayers’ counsel, individuals at the taxpayers’ accounting firm calculated the fair market value of the Company’s rights to be reimbursed; in doing so, it valued the right to be reimbursed upon the taxpayers’ deaths. After applying a present value discount using the assumed life expectancy for each taxpayer of 85 years and an interest rate of 6 percent, the accounting firm calculated the present value of the Company’s right to reimbursement of $842,345 on the taxpayers’ deaths to be $131,969. As a result, the taxpayers paid the Company $131,969 in exchange for the release of its reimbursement right.
The taxpayers argued that: (1) they purchased the contractual reimbursement rights from the Company at a discounted present value, (2) they paid fair value, (3) the SDLIAs remain in effect and that they weren’t released from any indebtedness, and (4) they realized no compensation income.
However, the Tax Court disagreed. It found that the parties’ actions and agreements were consistent with a termination of the SDLIAs. Since the taxpayers paid the Company only $131,969, the difference ($710,376) was compensation income to the taxpayers, because they realized the economic benefit of that amount paid by the Company to the insurance companies on their behalf. The court noted that after the transaction, the reimbursement rights no longer encumbered the policy benefits and the taxpayers had no risk of forfeiture of the economic benefit of the $710,376; they had complete ownership of the policies and were free to transfer the cash value.
It’s likely that if the taxpayers and the Company hadn’t terminated the agreement, but, instead, another party (even one controlled by the taxpayers) purchased the company’s rights, then the taxpayers wouldn’t have recognized any income, presumably because the cash value of the policies would still have been subject to the reimbursement requirement, and the economic benefits of the insurance policies vis-à-vis the taxpayers would be unchanged.
• Internal Revenue Code Section 338(h) election triggers income recognition to QSST, not beneficiary—In Private Letter Ruling 201232003 (released Aug. 10, 2012), the Internal Revenue Service ruled on the income tax consequences of a sale of S corporation stock owned by a qualified subchapter S trust (QSST) as part of a sale of the S corporation to a purchaser. The beneficiary had filed an election under IRC Section 1361(d)(2) to have the trust treated as a QSST, and, therefore, the beneficiary reported all items of income, deduction and credit allocable to the shares on his income tax return. However, at a later date, the shareholders of the S corporation agreed to sell all of their shares in the S corporation to a purchaser (a
C corporation). As part of the stock purchase agreement, the C corporation and the S corporation made an election under IRC Section 338(h)(10). That election allows a transaction that’s a stock purchase to be treated as an asset purchase for federal income tax purposes. The basis of the target corporation’s assets is adjusted to reflect the purchase price, and gain is recognized on the sale.
The regulations provide that if an election is made under Section 338(h)(10), the target corporation is generally deemed to have sold all of its assets and distributed the proceeds in a complete liquidation. This causes gain recognition to the owner of the S corporation stock.
Here, the QSST owned the stock. Under IRC Section 1361(d)(1), the beneficiary of a QSST is treated as the owner of that portion of the trust that consists of S corporation stock. Generally, the beneficiary reports the income and gain of a QSST, potentially resulting in phantom income.
However, Treasury Regulations Section 1.1361-1(j)(8) provides that the beneficiary who’s treated as the owner of the QSST only by reason of Section 1361(d)(1) isn’t treated as the owner with respect to the consequences of a disposition of the stock by the QSST. Therefore, the QSST, rather than the beneficiary, reports any gain or loss on the sale of an S corporation. Applying the Treasury regulations, the IRS ruled that the gain or loss resulting from the Section 338(h)(10) election, which is a deemed sale of the S corporation’s assets, is a tax consequence of a disposition of stock by the QSST that’s taxed to the QSST, not the beneficiary.