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Machacek v. Commissioner of Internal Revenue

United States Court of Appeals, Sixth Circuit

October 12, 2018

John J. Machacek, Jr.; Marianne Machacek, Petitioners-Appellants,
v.
Commissioner of Internal Revenue, Respondent-Appellee.

          Argued: December 5, 2017

          Appeal from the United States Tax Court. No. 12701-11-David Laro, Judge.

         ARGUED:

          Howard L. Richshafer, WOOD & LAMPING LLP, Cincinnati, Ohio, for Appellants.

          Regina S. Moriarty, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.

         ON BRIEF:

          Howard L. Richshafer, Jeffrey R. Teeters, WOOD & LAMPING LLP, Cincinnati, Ohio, for Appellants.

          Regina S. Moriarty, Michael J. Haungs, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.

          Before: BATCHELDER, GRIFFIN, and WHITE, Circuit Judges.

          OPINION

          HELENE N. WHITE, CIRCUIT JUDGE.

         Petitioners-appellants John J. Machacek, Jr. (John Machacek) and Marianne Machacek (together, the Machaceks), a married couple, were the sole shareholders of John J. Machacek, Jr., Inc. (Machacek, Inc.), a corporation organized under Subchapter S of the Internal Revenue Code (an S corporation). John Machacek was also an employee of Machacek, Inc. The Machaceks appeal the Tax Court's ruling requiring them to treat as income the economic benefits resulting from Machacek, Inc.'s payment of a premium on John Machacek's life insurance policy under a compensatory split-dollar arrangement. Relying on the compensatory nature of the arrangement, the Tax Court rejected the Machaceks' argument that the economic benefits should be treated as a shareholder distribution.

         Because the Tax Court did not consider the impact of a provision of the tax regulations specifically requiring that such economic benefits be treated as shareholder distributions, we reverse the Tax Court's decision and remand for further proceedings consistent with this opinion.

         I. Background

         In 2002, Machacek, Inc. adopted the Sterling Benefit Plan in order to provide certain benefits to its employees. Pursuant to the plan, Machacek, Inc. provided John Machacek with a life insurance policy and paid the $100, 000 annual premium in the 2005 tax year; both Machacek, Inc. and the Machaceks filed timely tax returns for that year. Because Machacek, Inc. is an S corporation, its income, losses, deductions, and credits are "passed through" to shareholders for tax purposes. Machacek Inc. deducted the $100, 000 premium, and that amount was thus not included in the Machaceks' individual income. The Machaceks also did not include as individual income the economic benefits flowing from the increase in value of the life insurance policy.

         The Tax Court determined that Machacek, Inc. was not entitled to deduct the $100, 000 premium payment. Because the $100, 000 premium payment was not deductible, Machacek, Inc. underreported its income for that year and, due to the pass-through nature of S corporations, the increased income was passed through to the Machaceks, who were then required to pay income tax on that amount. The non-deductibility of the premium payment is not disputed, and the Machaceks concede that they must report the amount of the premium payment as pass-through income.

         The dispute here concerns the tax treatment of the economic benefits flowing to John Machacek as a result of Machacek, Inc.'s payment of the premium. The parties dispute whether the Machaceks are required to report as taxable income-in addition to the pass-through amount of the premium-the economic benefits flowing from the increase in value of the life insurance policy caused by the payment of the premium.[1]

         The Tax Court ruled against the Machaceks and found that they were required to account for the economic benefits in their individual income:

Machacek, Inc.'s deduction, when disallowed in 2005, increased the S corporation's gross income, which additional income was then passed on to petitioners as the shareholders of Machacek, Inc. However, Mr. Machacek, in addition to being a shareholder of the corporation, was also one of its employees. And in 2006, when the previously unreported and untaxed portion of the accumulation value of his policy was determined, the value of the $100, 000 contribution by Machacek, Inc., was properly attributed to Mr. Machacek as an employee of the S corporation and a non-owner of the life insurance contract. While this result may seem aberrational in view of the pass-through treatment generally afforded to S corporations, it is a result mandated by the split-dollar life insurance regulations . . . . In instances other than those governed by the split-dollar life insurance regulations, the general rule of the non-taxability of previously taxed S corporation income is unperturbed.

(R. 73 at 6.)

         II. Discussion

         This dispute turns on the interplay of the split-dollar life insurance regulations and Subchapter S.

         A. ...


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