The Tax Court in Neff v. Commissioner, TC Memo 2012-244 (8/27/2012) recently ruled on the income tax consequences of the termination of a split dollar life insurance arrangement (“SDLIA”), in ruling that the payment of a discounted amount by the employees on the termination of the SDLIA resulted in the recognition of income to the employees to the extent of the difference between the amount owed to the corporation under the SDLIA and the amount the employees paid. The Tax Court did not address the issue of the extent the equity portion of a SDLIA may be subject to income taxation on the termination of the SDLIA as that issue was not raised by the Service nor addressed by the Tax Court.

This case involves a pre-final regulation SDLIA to which the final regulations do not apply. Rather Rev. Ruls. 64-328 and 66-110 and Notice 2002-8 apply to determine the income tax consequences of the rollout of the SDLIA. Here the two employees/owners of the J & N Management Company (the “Company”) entered into split dollar arrangements whereby the Company was obligated to pay the premiums on six life insurance policies owned by the employees and family limited partnerships of the employees. In return, the Company was entitled to receive the lesser of the premiums paid and the cash value of the policies on the termination of the SDLIA. By the end of 2003, the Company had paid $842,345 in premiums and the cash value of the policies was $877, 432. The employees and the Company orally agreed to terminate the SDLIA with the employees paying the Company the discounted present value of the right to receive the premiums paid at the death of the employees. However, the Company was entitled to reimbursement of the premiums paid on the termination of the policy and were not required under the terms of the SDLIA to wait until the death of the employee to recover those funds. As a result of discounting the value of the Company’s entitlement, the employees paid the Company $131,969 instead of the $842,345 owed to the Company on termination of the SDLIA, and the Company released its interest in the policies. The IRS then included the difference of $710,376 in the taxable income of the employees for 2003 and assessed an income tax deficiency.

The Tax Court ruled that Neff and Jensen received substantial value from the Company related to their employment when they ended up with unrestricted rights to the remaining cash value of the policies, and that as a result, Neff and Jensen realized taxable compensation income. The Tax Court stated that “each year an SDLIA was in effect, an employee was required to include in taxable income the total value or cost of the economic benefit received each year by the employee, less any amount contributed by the employee.” However, the Tax Court noted that Neff and Jensen had not included any amount in income. Interestingly, the government did not assess a tax deficiency on this failure to include the economic benefit in taxable income for the several years the SDLIA was in place. Had the taxpayers included such economic benefit in taxable income, they could have asserted that they were entitled to a reduction in the taxable income from the economic compensation income on termination of the SDLIA.
The Tax Court then held that, notwithstanding the arguments of the taxpayers, the transaction constituted “an effective rollout of the SDLIAs and that the equity split dollar life insurance arrangements were terminated” despite the absence of a written termination agreement, and that as a result, Neff and Jensen realized the economic benefit of the difference between the premiums paid by the Company and the discounted amount repaid to the Company by Neff and Jensen, which economic benefit was includible in their taxable income.

The Tax Court did not rule on, and was not presented with, the question of the extent to which the equity in the policies at the time of the termination of the SDLIA, the difference between the premiums paid of $842,345 and the cash value of $877,436, would also be taxable to the employee on pre-final regulation policies on termination of the SDLIA. Therefore, the practitioner cannot assume that this equity would not be includible as taxable income on rollout of a SDLIA. At most, this case stands for the proposition that these taxpayers were not called upon to defend the inclusion of such equity in their taxable income. Perhaps this was because the easier case was the includibility of the economic benefit of not having to repay the Company the full amount of the premiums paid, and the amount of the equity on termination of these policies was small in relation to this much larger economic benefit.

As a final note, the Tax Court declined to impose a § 6662(a) penalty on the taxpayers, stating that the taxpayers “acted with reasonable cause and in good faith in relying on their professional tax advisers…” Really?? Was it really reasonable for Neff and Jensen to assume they could be relieved of the obligation to repay the Company for the $842,345 in premiums paid with a repayment of $131,969 without any income tax consequences?