Machacek v. Comm'r of Internal Revenue

• Decision Date: 12 October 2018
• Docket Number: No. 17-1131,17-1131
• Citation: 906 F.3d 429
• Parties: John J. MACHACEK, Jr.; Marianne Machacek, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

906 F.3d 429

John J. MACHACEK, Jr.; Marianne Machacek, Petitioners-Appellants,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 17-1131

United States Court of Appeals, Sixth Circuit.

Argued: December 5, 2017

Decided and Filed: October 12, 2018

COUNSEL ARGUED: Howard L. Richshafer, WOOD & LAMPING LLP, Cincinnati, Ohio, for Appellants. Regina S. Moriarty, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee. ON BRIEF: Howard L. Richshafer, Jeffrey R. Teeters, WOOD & LAMPING LLP, Cincinnati, Ohio, for Appellants. Regina S. Moriarty, Michael J. Haungs, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.

Before: BATCHELDER, GRIFFIN, and WHITE, Circuit Judges.

HELENE N. WHITE, Circuit Judge.

Petitioners-appellants John J. Machacek, Jr. (John Machacek) and Marianne Machacek (together, the Machaceks), a married couple, were the sole shareholders of John J. Machacek, Jr., Inc. (Machacek, Inc.), a corporation organized under Subchapter S of the Internal Revenue Code (an S corporation). John Machacek was also an employee of Machacek, Inc. The Machaceks appeal the Tax Court’s ruling requiring them to treat as income the economic benefits resulting from Machacek, Inc.’s payment of a premium on John Machacek’s life insurance policy under a compensatory split-dollar arrangement. Relying on the compensatory nature of the arrangement, the Tax Court rejected the Machaceks’ argument that the economic benefits should be treated as a shareholder distribution.

Because the Tax Court did not consider the impact of a provision of the tax regulations specifically requiring that such economic benefits be treated as shareholder distributions, we reverse the Tax Court’s decision and remand for further proceedings consistent with this opinion.

I. Background

In 2002, Machacek, Inc. adopted the Sterling Benefit Plan in order to provide certain benefits to its employees. Pursuant to the plan, Machacek, Inc. provided John Machacek with a life insurance policy and paid the $100,000 annual premium in the 2005 tax year; both Machacek, Inc. and the Machaceks filed timely tax returns for that year. Because Machacek, Inc. is an S corporation, its income, losses, deductions, and credits are "passed through" to shareholders for tax purposes. Machacek Inc. deducted the $100,000 premium, and that amount was thus not included in the Machaceks’ individual income. The Machaceks also did not include as individual income the economic benefits flowing from the increase in value of the life insurance policy.

The Tax Court determined that Machacek, Inc. was not entitled to deduct the $100,000 premium payment. Because the $100,000 premium payment was not deductible, Machacek, Inc. underreported its income for that year and, due to the pass-through nature of S corporations, the increased income was passed through to the Machaceks, who were then required to pay income tax on that amount. The non-deductibility of the premium payment is not disputed, and the Machaceks concede that they must report the amount of the premium payment as pass-through income.

The dispute here concerns the tax treatment of the economic benefits flowing to John Machacek as a result of Machacek, Inc.’s payment of the premium. The parties dispute whether the Machaceks are required to report as taxable income—in addition to the pass-through amount of the premium—the economic benefits flowing from the increase in value of the life insurance policy caused by the payment of the premium.¹

The Tax Court ruled against the Machaceks and found that they were required to account for the economic benefits in their individual income:

Machacek, Inc.’s deduction, when disallowed in 2005, increased the S corporation’s gross income, which additional income was then passed on to petitioners as the shareholders of Machacek, Inc. However, Mr. Machacek, in addition to being a shareholder of the corporation, was also one of its employees. And in 2006, when the previously unreported and untaxed portion of the accumulation value of his policy was determined, the value of the $100,000 contribution by Machacek, Inc., was properly attributed to Mr. Machacek as an employee of the S corporation and a non-owner of the life insurance contract. While this result may seem aberrational in view of the pass-through treatment generally afforded to S corporations, it is a result mandated by the split-dollar life insurance regulations .... In instances other than those governed by the split-dollar life insurance regulations, the general rule of the non-taxability of previously taxed S corporation income is unperturbed.

(R. 73 at 6.)

II. Discussion

This dispute turns on the interplay of the split-dollar life insurance regulations and Subchapter S.

A. Subchapter S

The Machaceks rely on the statutory provisions governing the tax treatment of S corporations, arguing that such statutes "prevent double taxation otherwise imposed pursuant to an interpretative regulation addressing split dollar life insurance premiums that have been paid by S corporations." (Appellants’ Br. at 3.)

Subtitle A, chapter 1, subchapter S of the Internal Revenue Code establishes the legal framework governing S corporations. See 26 U.S.C. § 1361 et seq . S corporations are generally exempt from corporate income tax. 26 U.S.C. § 1363(a). Instead, an S corporation’s income, losses, deductions, and credits are passed through to its shareholders. See Maloof v. Comm’r , 456 F.3d 645, 647 (6th Cir. 2006) (citing 26 U.S.C. § 1366(a)(1).) Each shareholder in an S corporation "pays taxes at individual rates on the pro rata share of the corporation’s income (if there is any) and receives the pro rata tax benefits (e.g. , losses, deductions and credits) of the corporation." Id . As a result, "the S corporation’s income and losses become the individual shareholder’s income and losses." Id. (citing Bufferd v. Comm’r , 506 U.S. 523, 525, 113 S.Ct. 927, 122 L.Ed.2d 306 (1993) ).

The tax treatment of distributions of property by a corporation to its shareholders is generally governed by 26 U.S.C. § 301(c). However, Subchapter S provides its own rules for the treatment of a "distribution of property made by an S corporation with respect to its stock to which (but for this subsection) section 301(c) would apply." 26 U.S.C. § 1368(a).

B. Split-Dollar Life Insurance Regulations

The tax treatment of split-dollar life insurance arrangements is set out by regulation. See 26 C.F.R. § 1.61-22. Tax regulations "are entitled to great weight and are to be sustained unless unreasonable and plainly inconsistent with the revenue statutes." Brooks v. United States , 473 F.2d 829, 832 (6th Cir. 1973) (citing Bingler v. Johnson , 394 U.S. 741, 750, 89 S.Ct. 1439, 22 L.Ed.2d 695 (1969) ; Comm’r v. S. Tex. Lumber Co. , 333 U.S. 496, 501, 68 S.Ct. 695, 92 L.Ed. 831 (1948) ).

The regulations define a split-dollar life insurance arrangement as:

any arrangement between an owner and a non-owner of a life insurance contract that satisfies the following criteria—

(i) Either party to the arrangement pays, directly or indirectly, all or any portion of the premiums on the life insurance contract, including a payment by means of a loan to the other party that is secured by the life insurance contract;

(ii) At least one of the parties to the arrangement paying premiums ... is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the life insurance contract; and

(iii) The arrangement is not part of a group-term life insurance plan ... unless the group-term life insurance plan provides permanent benefits to employees ....

26 C.F.R. § 1.61-22(b)(1). Arrangements satisfying the criteria set out by § 1.61-22(b)(1) are generally referred to as "traditional" split-dollar arrangements. It is undisputed that John Machacek’s life insurance policy does not qualify as a traditional split-dollar arrangement.

However, the split-dollar regulations also apply to any arrangement qualifying either as a "compensatory" arrangement or a "shareholder" arrangement, regardless whether those arrangements satisfy the criteria for a traditional arrangement. See 26 C.F.R. § 1.61-22(b)(2).

An arrangement qualifies as a "compensatory" arrangement if:

(A) The arrangement is entered into in connection with the performance of services and is not part of a group-term life insurance plan ...;

(B) The employer or service recipient pays, directly or indirectly, all or any portion of the premiums; and

(C) 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.

26 C.F.R. § 1.61-22(b)(2)(ii). The Tax Court found that John Machacek’s life insurance policy qualifies as a compensatory split-dollar arrangement.

An arrangement qualifies as a "shareholder" arrangement if:

(A) The arrangement is entered into between a corporation and another person in that person’s capacity as a shareholder in the corporation;

(B) The corporation pays, directly or indirectly, all or any portion of the premiums; and

(C) Either—

(1) The beneficiary of all or any portion of the death benefit is designated by the shareholder or is any person whom the shareholder would reasonably be expected to designate as the beneficiary; or

(2) The shareholder has any interest in the policy cash value of the life insurance contract.

26 C.F.R. § 1.61-22(b)(2)(iii). The parties appear to concede that John Machacek’s life insurance policy is not a shareholder arrangement.

The split-dollar life insurance regulations apply "to any split-dollar life insurance arrangement," regardless whether the arrangement is a traditional, compensatory, or shareholder arrangement.² See 26...