328 / Are proceeds of life insurance under a split dollar plan or under a reverse split dollar plan includable in an insured’s gross estate when a corporation owns split dollar insurance on the life of a controlling stockholder?

It depends. In the case of split dollar insurance owned by a corporation on the life of a controlling stockholder, special rules apply. Estate tax regulations provide the following:

[I]f any part of the proceeds of the policy are not payable to or for the benefit of the corporation … any incidents of ownership held by the corporation as to that part of the proceeds will be attributed to the decedent through his stock ownership when the decedent is the sole or controlling stockholder. Thus, for example, if the decedent is the controlling stockholder in a corporation, and the corporation owns a life insurance policy on his life, the proceeds of which are payable to the decedent’s spouse, the incidents of ownership held by the corporation will be attributed to the decedent through his stock ownership and the proceeds will be included in his gross estate under Section 2042. If in this example the policy proceeds had been payable 40 percent to the decedent’s spouse and 60 percent to the corporation, only 40 percent of the proceeds would be included in decedent’s gross estate under Section 2042.¹

The above-quoted regulation attributes to a stockholder incidents of ownership held by a corporation “as to that part of the proceeds” not payable to or for the corporation. Apparently, the quoted phrase originally led the IRS to take a position as to which it later reversed itself. In Revenue Ruling 76-274 (Situation 3),² the IRS held that if, under a split dollar agreement, the corporation’s incidents of ownership were limited to those appropriate to protecting its position as a lender of premium dollars (an incident such as the right to borrow against the policy but only to the extent of the portion of premiums it has advanced) so that the corporation’s exercise of those rights could not impair the interests of the insured or the insured’s personal beneficiary, the corporation’s incidents of ownership would not be attributed to the insured.

In Revenue Ruling 82-145,³ the IRS ruled that its conclusion in Situation 3 of Revenue Ruling 76-274 was incorrect and indeed was inconsistent with Revenue Ruling 79-129, discussed in Q 326. The IRS concluded that the incident of ownership described in Situation 3 of the 1976 ruling was attributable to the insured and that this attribution warrants inclusion of the entire amount of policy proceeds under IRC Section 2042(2). The IRS added, however, that “pursuant to the rule in section 20.2042-1(c)(6) adopted to prevent double taxation, to the extent that the proceeds are payable to the corporation, they are considered in valuing the decedent’s stock under Section 2031, rather than included under Section 2042(2).” A grandfathering provision in the ruling reads as follows: “the conclusion in this revenue ruling reversing the holding in Situation 3 of Rev. Rul. 76-274 will not be applied with respect to insurance policies obtained before [August 4, 1982], except to the extent, if any, that there has been an increase, after [August 4, 1982], in the amount of the insurance proceeds payable other than to or for the benefit of the corporation.” (See Q 319.)

Estate of Thompson v. Commissioner,⁴ a 1981 Tax Court case that supports the IRS’ position in Revenue Ruling 82-145, addressed a situation involving an employer-pay-all split dollar whole life policy owned by a corporation on the life of its president and sole owner, the decedent. Under the plan, death proceeds were divided between the corporation (the cash value portion) and beneficiaries designated by the decedent (the balance). The Tax Court found that the decedent held incidents of ownership in the policy and concluded that an amount equal to the insurance proceeds payable to the beneficiary designated by the decedent was includable in the decedent’s estate under IRC Section 2042(2). The portion of the proceeds payable to the corporation would be reflected in the value of the corporation’s stock, all of which was owned by the decedent and therefore includable in the decedent’s estate under IRC Section 2031.

The Tax Court agrees that in the split dollar context, any incident of ownership ( Q 86) possessed by a corporation is attributable to a sole or controlling stockholder.⁵

Letter Ruling 9348009 appears to conclude that an S corporation does not have incidents of ownership in insurance on the life of its owners held in a split dollar arrangement if the only interest the corporation has in the policy is to be reimbursed for its outlay for premiums paid. This conclusion appears to be inconsistent with the official position of the IRS and of courts that have addressed this issue. It may be, although the ruling does not say so, that the ruling concluded that because the owners were not controlling shareholders, incidents of ownership held by the corporation would not be attributed to the owners. The issues of whether a corporation holds incidents of ownership and whether an owner is treated as holding incidents of ownership held by the corporation ordinarily are treated as separate issues, however.

In a later letter ruling involving a collateral assignment split dollar life insurance arrangement, the IRS determined that a corporation would not be treated as holding incidents of ownership in a policy where the only right the corporation would hold would be, in essence, the right to be reimbursed for premiums paid by the corporation. As a result, the life insurance proceeds would not be includable in a controlling shareholder’s estate.⁶

The importance of this ruling may have been undercut by its reliance on Revenue Ruling 76-274, which was later reversed by Revenue Ruling 82-145.⁷ Nevertheless, several rulings since then have stated that a corporation or S corporation that has no interest in a collateral assignment split dollar arrangement other than to be reimbursed for its outlay for premiums paid does not hold incidents of ownership, an issue that need not be reached where there is no controlling shareholder.⁸

Any transfer by a corporate employer of incidents of ownership in a split dollar policy on the life of a controlling stockholder to an insured’s transferee within three years of the insured’s death is considered a transfer by the insured for purposes of the bringback rule of IRC Section 2035 ( Q 96).⁹

In Estate of Levy v. Commissioner,¹⁰ dealing with estate taxation of split dollar life insurance, a corporation owned two split dollar policies on the life of a stockholder who owned 80.4 percent of the voting stock. The corporation owned all incidents of ownership except that it could not change the beneficiary, at least for any amount in excess of the cash value, without the approval of the insured’s wife. The corporation was beneficiary of proceeds equal to the net cash value at death; the insured’s widow was beneficiary of the excess proceeds. The executors of the insured’s estate did not include any of the insurance proceeds in the estate because the insured at death did not directly hold any incidents of ownership in the policies. The IRS, in a deficiency notice, determined that the portion of policy proceeds payable to the insured’s widow was includable in the estate. The Tax Court strongly supported the position of the government that the incidents of ownership held by the corporation were properly attributable to the insured. Moreover, the Tax Court indicated that had the deficiency notice called for inclusion in the estate of the entire proceeds rather than just the portion payable to the insured’s widow, it would have supported the IRS. As it was, only the proceeds payable to the insured’s widow were held includable in the insured’s estate.