IRS Disagrees with 6th Circuit on Taxation of Split-Dollar for S Corporation Owner-Employees
On May 28, 2021, the IRS formally released an action on decision announcing its refusal to follow the decision of the 6th Circuit in Machacek v. Commissioner, 906 F.3d 429 (6th Cir. 2018). Meanwhile, in Ruben De Los Santos, et ux. v. Commissioner, 156 T.C. No. 9 (2021), the Tax Court sided with the IRS and expressly rejected the 6th Circuit’s decision in Machacek.
The question raised in these cases is whether the economic benefit of split-dollar life insurance policies owned by an S corporation that provide a benefit to an S corporation owner-employee should be treated as a non-taxable shareholder distribution or as taxable compensation. In Machacek, the 6th Circuit Court of Appeals overruled the Tax Court and held that those economic benefits should be treated as shareholder distributions that were not taxable to the S corporate owners. The Tax Court in De Los Santos – which arose in a jurisdiction outside of the 6th Circuit and therefore was not bound by the 6th Circuit’s Machacek decision – ruled the opposite – i.e., that the economic benefit was taxable as a compensatory split-dollar arrangement. The IRS sided with the Tax Court in both cases, and has now formally announced its decision not to follow Machacek, meaning that S corporation owner-employees who wish to treat the economic benefit of split-dollar policies as non-taxable shareholder distributions may be subject to challenge from the IRS if they are outside the 6th Circuit (which covers Kentucky, Michigan, Ohio and Tennessee).
These decisions set up a jurisdictional split as to whether the economic benefits of split-dollar arrangements are considered taxable compensation or non-taxable shareholder distributions for owner-employees of S corporations. S corporations with split-dollar arrangements should monitor the decisions in their jurisdictions, but if located outside the 6th Circuit, they should understand that the IRS position will likely be to challenge treatment of the economic benefit as a non-taxable shareholder distribution.
IRS Nonacquiescence to Machacek
On May 28, 2021, the IRS formally released an “action on decision” in which announced its intent to not acquiesce to the 6th Circuit’s position in Machacek. In this action, the IRS acknowledges that Machacek controls for tax cases appealable within the 6th Circuit that have substantially the same facts. But the IRS continues to state its objections to the reasoning in that decision, and favorably cites the De Los Santos Tax Court holding. For cases that are appealable outside the 6th Circuit, the IRS action on decision expressly states that the IRS intends to litigate any tax position taken contrary to the De Los Santos holding. Even inside the 6th Circuit, the IRS will narrowly construe Machacek and will look for any differences in facts that could lead to a different conclusion.
A copy of the IRS action on decision can be found here: https://www.irs.gov/pub/irs-aod/aod-2021-02.pdf
Eventually, other Courts of Appeal may weigh in on this issue, perhaps resulting in a split in circuits. A Supreme Court decision on this issue is probably unlikely, but not impossible if the various Courts of Appeal cannot agree.
In the meantime, S corporations that sponsor compensatory split-dollar arrangements should closely follow the continued developments on this issue in the courts. If the S corporation is in a jurisdiction covered by the 6th Circuit with facts that substantially mirror those in Machacek, the favorable tax position in Machacek could potentially be taken in reliance on the 6th Circuit’s position, although this should be done so carefully, after review with the corporation’s key tax and financial advisors. For S corporations located outside the 6th Circuit, reliance on the decision in Machacek will, for the time being, be much more precarious.
This material is intended for informational purposes only and should not be construed as legal or tax advice. It is not intended to replace the advice of a qualified attorney, tax advisor, or plan provider.