Dividends Or Compensation

In the spring, the FTC issued a final rule that bans the use of non-compete agreements nationwide, including both prospective and existing non-compete agreements. The ban requires that employers notify employees who are subject to non-compete agreements that they will not be enforcing those agreements (unless the employee is a senior executive who is exempt from the ban). Shortly after the FTC announced the final rule, the U.S. District Court for the Northern District of Texas issued a preliminary injunction to prevent the FTC from enforcing its ban on non-compete agreements, staying the anticipated September 4 effective date (<em>see Ryan, LLC v. Chamber of Commerce</em>). The court stated that it will issue a final decision on or before August 30, 2024.<br /> <br /> We asked two professors and authors of ALM's <em><i>Tax Facts </i></em>with opposing political viewpoints to share their opinions about whether employers should currently be taking steps to comply with the FTC non-compete ban.<br /> <br /> Below is a summary of the debate that ensued between the two professors.<br /> <br /> <strong>Their Votes:</strong><br /> <br /> <img class="alignnone size-medium wp-image-62919" src="https://imageserver.amlaw.com/tax-facts/uploads/2019/02/BloinkThumbsUp-300x105.png" alt="" width="300" height="105" /><br /> <br /> <img class="alignnone size-medium wp-image-62921" src="https://imageserver.amlaw.com/tax-facts/uploads/2019/02/ByrnesThumbsDown-300x105.png" alt="" width="300" height="105" /><br /> <br /> <strong>Their Reasons:</strong><br /> <br /> <strong>Bloink:</strong> It's very likely that we're going to see some type of nationwide restriction on the use of non-compete agreements. The use of non-compete agreements severely limits the ability of employees to choose where they will use their skills. Non-competes create an extremely unfair situation between employer and employee—where the employee is essentially forced to remain with the employer or start a career in an unrelated industry. Now that the FTC has stepped in to stop this type of unfair practice, we have to expect that we will end up with some type of ban.<br /> <br /> <strong>Byrnes:</strong> The FTC's broad and sweeping ban on non-compete agreements is very likely to be struck down as an impermissible exercise of power. However, even before that date, it's most likely that the court will issue an injunction that applies on a nationwide basis. There's simply no reason for employers to begin the process only to find it was a waste of time. In fact, the court should act sooner rather than later to provide clarity to impacted businesses.<br /> <br /> __________________________________________<br /> <br /> <strong>Bloink:</strong> Multiple states have already enacted similar prohibitions on the use of non-compete agreements in employment situations at the state level. Ignoring the reality and hoping for a nationwide injunction isn't going to do anything to help employers. Even if we assume that this nationwide ban will take effect in its current form, employers should be taking steps now to review agreements and make changes to modernize their practices.<br /> <br /> <strong>Byrnes:</strong> We're now dealing with a split in court thinking on the FTC ban, which means that it's very unlikely that the court will simply do nothing. Either we'll see the rule vacated by the end of August or we'll be dealing with a nationwide injunction--meaning there's no reason to invest the resources to begin complying with the ban now.<br /> <br /> __________________________________________<br /> <br /> <strong>Bloink:</strong> The rule is scheduled to go into effect on September 4--just a few short weeks away. Employers who don't take steps to comply will likely find themselves in a difficult situation, as it's incredibly unlikely that the FTC will grant additional time to comply--especially because employers are already on notice that the ban is about to take effect. Now is the time for employers to evaluate their agreements and form policies to ensure compliance.<br /> <br /> <strong>Byrnes:</strong> The ban is simply so overly broad that there is no way that the courts are going to allow it to stand. Sure, it's always a good idea for employers to review the agreements they have in place to ensure those agreements are advisable and in line with the business' existing needs. But there's no need for employers to panic and expect that all of their agreements will be unenforceable come September.

<div class="Section1"><br /> <br /> Proceeds that have been received tax-free by a C corporation lose their tax-exempt character as life insurance proceeds on distribution to employees or shareholders. Consequently, where a corporation is both owner and beneficiary of a policy, the proceeds generally will be tax-free to the corporation (<em>but see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8776">8776</a>). If the corporation distributes the proceeds to its shareholders, however, the shareholders will be treated as having received a taxable dividend.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> If an insured is an employee and proceeds are received by a corporation and then paid to the employee&rsquo;s widow or other personal beneficiary under the terms of an employment contract, they may be treated as taxable compensation for the employee&rsquo;s past services.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> On the other hand, if a corporation has no ownership rights in a policy and is not the beneficiary, proceeds should be received tax&ndash;free by the beneficiary as life insurance proceeds ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="63">63</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>).<a href="#_ftn3" name="_ftnref3">³</a> Where a corporation paid the premiums on a policy that was held by a trustee for the benefit of certain shareholders and the corporation had no ownership rights in the policy, the court held the proceeds received by the shareholders were tax-exempt life insurance proceeds.<a href="#_ftn4" name="_ftnref4">⁴</a> The IRS has indicated, however, that the premiums when paid by a corporation may, in some circumstances, be taxed to shareholders as dividends ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="269">269</a>).<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> Where a corporation owns a policy and is not the beneficiary, it appears that the proceeds are taxable as dividends and possibly as compensation. Where the proceeds of a policy were payable to a trustee for the benefit of shareholders but the corporation had substantial ownership rights in the policy, the court conceded that the proceeds were life insurance proceeds but said that they also were in the nature of dividends and under such circumstances, the dividend provisions of the tax law would prevail.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> The U.S. Court of Appeals for the Sixth Circuit reached an opposite conclusion in the <em>Ducros</em> case. There, a policy was owned by a corporation and individual stockholders were named as revocable beneficiaries in the policy. The court held that the proceeds received by shareholders directly from the insurance company were life insurance proceeds and, therefore, tax-exempt.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> The IRS has announced its refusal to follow <em>Ducros</em> as precedent in disposing of similar cases.<a href="#_ftn8" name="_ftnref8">⁸</a> Revenue Ruling 61-134 states that it is the position of the IRS &ldquo;that life insurance proceeds paid to stockholders of a corporation are taxable as dividends in cases where the corporation uses its earnings to pay the insurance premiums and has all incidents of ownership including the right to name itself beneficiary, even though the corporation does not name itself beneficiary and, therefore, is not entitled to and does not in fact receive the proceeds.&rdquo;<br /> <br /> The same principle should apply if proceeds of a corporate owned policy are payable directly to an insured employee&rsquo;s beneficiary, although the proceeds ordinarily would be taxable compensation rather than dividends. Nonetheless, a Technical Advice Memorandum has held that proceeds of a corporate owned and paid for life insurance policy naming as revocable beneficiary the wife of the insured-stockholder were not dividends because she was not a stockholder and the estate-stockholder was not a beneficiary. The proceeds were not income in respect of a decedent, but rather were life insurance death proceeds received tax-free under IRC Section 101(a).<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> Assuming, but not deciding on, the validity of Treasury Regulation Section 20.2042-1(c)(6) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="319">319</a>), the Tax Court has held that where a corporation owned insurance on the life of a controlling stockholder and where the beneficiary named by the corporation was the insured&rsquo;s wife, who owned stock in the corporation, death proceeds were not taxable to the beneficiary as a dividend but were excludable from her income as proceeds of life insurance under IRC Section 101(a)(1).<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> In the case of an S corporation, each shareholder increases basis in the stock by the share of the death proceeds received by the corporation, whether taxable or not. In the event a closing of the books election is made under IRC Section 1377(a)(2) for a cash basis S corporation, the basis increase will be allocated to the surviving shareholders rather than apportioning some of the basis increase to the decedent&rsquo;s shares.<a href="#_ftn11" name="_ftnref11">¹¹</a> Thereafter, any distribution of proceeds should be determined to be compensation or a distribution with respect to stock as if it were a regular C corporation ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="294">294</a>).<br /> <br /> Where insurance is used to fund a stock redemption agreement, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="307">307</a>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 71-79, 1971-1 CB 112.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Essenfeld v. Commissioner</em>, 311 F.2d 208 (2d Cir. 1962).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 101(a).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Doran v. Commissioner</em>, 246 F.2d 934 (9th Cir. 1957).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 59-184, 1959-1 CB 65.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Golden v. Commissioner</em>, 113 F.2d 590 (3d Cir. 1940).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Ducros v. Commissioner</em>, 272 F.2d 49 (6th Cir. 1959).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 61-134, 1961-2 CB 250.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp;&nbsp;&nbsp;&nbsp; TAM 8144001.<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp;&nbsp; <em>Est. of Horne v. Commissioner</em>, 64 TC 1020 (1975), acq. in result, 1980-1 CB 1.<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; &nbsp;<em>But see</em> Let. Rul. 200409010.<br /> <br /> </div></div><br />