Taxation of corporate-owned life insurance policy proceeds payable to shareholders.

Generally, amounts received under a life insurance contract paid by reason of the death of the insured are excluded from gross income. This general exclusion rule of Sec. 101(a)(1) certainly applies when a corporation purchases a key-man life insurance policy on one of its shareholder-officers and the proceeds are paid directly to the corporation. However, there is a question as to whether this exclusion is applicable if the beneficiaries of the corporate-owned life insurance policy are the insured's family or estate.

Case law history

The leading case in this area is Golden, 113 F2d 590 (3d Cir. 1940). In Golden, a corporation purchased 11 life insurance policies on the life of its president, under which the corporation was the sole beneficiary. All policies were subsequently transferred to a trust company that was instructed by the corporation to collect and distribute all proceeds from the policies to the corporation's stockholders in direct proportion to their stock ownership on the date of distribution. The corporation did reserve the right to receive any dividends paid on the policies, to change the beneficiaries with the permission of the trustee and the trust beneficiaries [the stockholders}, and to sell the policies. The corporation paid all premiums on the policies out of its own funds through the date of the insured's death.

When the insured died, the trust collected and distributed the policy proceeds according to the trust agreement. The IRS assessed a deficiency on the trust beneficiaries on the theory that the corporation had retained valuable incidents of ownership, and therefore the distributions were dividends. The taxpayers argued that Section 22(b)(1} of the 1939 Code (predecessor to Sec. 101} controlled, making the proceeds exempt from gross income. The court found the Service's argument more persuasive, and held that dividend distributions did occur, since sufficient earnings and profits existed at the time of the distribudons.

This dividend distribution theory was argued successfully by the IRS several times until the Ducros decision, 272 F2d 49 (6th Cir. 1959}, rev'g 30 TC 1337 (1958). In Ducros, a closely held corporation caused a life insurance policy to be purchased on the life of its president with the intention of distributing the proceeds to various shareholders by making them beneficiaries. The corporation paid all the premiums and had all the incidents of ownership, including the right to change the beneficiaries.

When the president died, the insurance company paid the full amount of the policy coverage to the designated beneficiaries. The Service convinced the Tax Court that the arrangement with the insurance company was not a "life insurance contract" as that term was defined in the Internal Revenue Code. The Tax Court held that the contract was in fact a wagering contract, thereby making the exclusionary clause provided in Section 221b)(1} of the 1939 Code inapplicable and requiring the full amount of the proceeds to be included in gross income.

The Sixth Circuit, however, dismissed the notion of a wagering contract by determining that there was a valid life insurance contract under state law. It then addressed the dividend distribution issue and determined that, while the policy was a corporate asset, the insurance proceeds never were. The court further qualified its position by stating that at no time did the corporation have either legal or equitable title, or possession, or control of the insurance proceeds. It narrowly focused on the fact that the proceeds were paid directly to the beneficiaries. Once the court determined that the life insurance proceeds were in no sense a dividend, it then held that the full amount of the proceeds qualified for the exclusion from gross income.

In light of Ducros, the IRS quickly announced that it would not follow this holding. The Service reiterated its position in Rev. Rul. 61-134 that when life insurance proceeds are paid either directly or indirectly to shareholders, they are taxable as dividends if the corporation used its earnings to pay the insurance premiums and had all the incidents of ownership. A review of Ducros by the Supreme Court was not requested by the IRS, but the Service stated that

the decision would not be followed as precedent.

The Tax Court has now come full circle on this issue, as evidenced by its decision in Est, of Horne, 64 TC 109.0 {1975}, and has adopted the Sixth Circuit's position in Ducros. In Home, a corporation purchased two insurance policies and named a major shareholder as the sole beneficiary of both policies on the life of her husband, who was the controlling shareholder and an officer. The corporation paid all the premiums and carried the policies' cash surrender values as an asset on its books, and retained all the incidents of ownership.

On the death of her husband, Mrs. Home received a check from the insurance company/or the policies' full face value. The IRS argued that the corporation, by directing that the lffe insurance proceeds be paid to the decedent's wife (who was also a shareholder), in substance made a distribution of corporate property to her that should be characterized as a dividend, since sufficient earnings and profits existed at the date of the distribution.

The court, however,/ocused on the estate tax regulations, specifically Regs. Sec. 20.2042-1(c}{6), which states that if the proceeds of a corporate-owned life insurance policy are not payable to or for the benefit of the corporation, the incidents of ownership held by the corporation should be attributed to the insured shareholderdecedent and the proceeds included in his gross estate. While the court acknowledged that estate and income tax laws are not always symmetrical, it did not believe that the same insurance proceeds could be simultaneously treated as a transfer to Mrs. Home from a decedent for estate tax purposes and as a distribution to her from the corporation/or income tax purposes. Accordingly, the court dismissed the notion of a constructive dividend and held instead that the proceeds were excludible as paid from a life insurance contract.

The Service announced its acquiescence to the Home decision, stating that life insurance proceeds paid to a shareholder do not constitute a dividend if the corporation is the policy's owner and pays all premiums. The IRS also indicated, however, that it disagreed with some or all of the rationale/or the decision.

Latest IRS position

IRS Letter Ruling (TAM) 8144001, while over 10 years old, is the most recent published pronouncement on this subject. It dealt with a corporation that owned a life insurance policy on a shareholder, paid all the premiums and had all the incidents of ownership. When the shareholder died, the policy proceeds were distributed directly to the shareholder's wife (the policy's designated beneficiary), who was not a shareholder. While the decedent's estate was a shareholder in the corporation after his death, the IRS focused on the fact that the estate was not the beneficiary of the policy and did not have actual or beneficial control of the proceeds. The Service held that the estate did not recognize a dividend for the amount of the policy proceeds. It further stated that Rev. Rul. 61-134could not be used to make the proceeds taxable as a dividend to the beneficiary, since she was not a shareholder of the corporation.

Planning

The IRS's position has eroded significantly since its initial victory in Golden. Even with the current trend in Ducros and Home pointing to the Sec. 101(a)(1) exclusion rule, clients' strategies for designating corporate-owned life insurance policy beneficiaries should be reviewed. If business reasons exist that would allow for direct payment of proceeds to a corporate shareholder, such policies should be structured correctly.

In those situations in which a Golden-type trust or similar arrangement is in place, clients should be alerted to the potential risk of a constructive dividend that would make tax-exempt income fully taxable. Clients should also be warned that some risk still exists in this area since the Service continues to challenge these arrangements. From Richard A. Heaclley, CPA, MS, Knight, Vale & Gregory, Tacoma, Wash.