The Court of Appeals for the Fifth Circuit, affirming the Tax Court, has concluded that the supposedly borrowed amount that the sole shareholder of a corporation received from a welfare benefit fund, in connection with a life insurance policy funded by the corporation, was taxable income to the shareholder and not a bona fide loan.
Whether a transaction constitutes a loan for income tax purposes is a factual question involving several considerations. The Fifth Circuit has held that the central inquiry in determining if a transaction is a bona fide loan for tax purposes is whether the parties intended that the money advanced be repaid. ( Moore v. U.S., (CA 5, 1969) 24 AFTR 2d 69-5024) In determining whether a distribution is a nontaxable loan, courts have analyzed the following seven objective factors:
- Whether the promise to repay was evidenced by a note or other instrument;
- Whether interest was charged;
- Whether a fixed schedule for repayment was established;
- Whether collateral was given to secure payment;
- Whether repayments were made;
- Whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan; and
- Whether the parties conducted themselves as if the transaction was a loan.
Frederick D. Todd, a practicing neurosurgeon, was employed by his wholly owned corporation, Frederick D. Todd, II, M.D., P.A. (Corporation). He was also its director and president. Corporation employed several other individuals as well. Corporation became a member of the American Workers Master Contract Group (AWMCG), which represented it in labor negotiations with the union that represented Corporation's employees. Under a labor agreement AWMCG negotiated, Corporation would provide its employees with a death benefit only (DBO) plan organized through a welfare benefit fund established between AWMCG and the union. The welfare benefit fund, the American Workers Benefit Fund (AWBF), was later succeeded in a merger by the United Employees Benefit Fund (UEBF), another welfare benefit fund. AWBF's obligation to pay a death benefit ceased if Corporation's covered employee was voluntarily or involuntarily terminated or retired; if Corporation ceased making contributions; or if the master contract between the union and the master contract group wasn't renewed.
Todd obtained a $6 million universal life insurance on his life from Southland Life Insurance Co. (Southland) on behalf of AWBF. The annual premium on the policy was approximately $100,000. The policy was owned solely by AWBF to provide insurance to fund the death benefits owed by AWBF to Todd's wife. Corporation made yearly contributions to AWBF on Todd's behalf.
Under the UEBF trust agreement, the employer and employee trustees had discretionary authority to make loans to a plan participant on a nondiscriminatory basis upon application and written evidence of an emergency or serious financial hardship. Todd claimed “unexpected housing costs,” and obtained a $400,000 loan from UEBF. To effectuate the loan payment, UEBF reduced the face value of Todd's life insurance policy, rather than pay the 4.76% interest Southland would charge for the loan proceeds.
Todd signed a promissory note for the $400,000 loan some six months after the payment. Although the agreement required market rate interest to be paid on a loan, the note charged 1% interest, with loan payments to be made quarterly. In addition, the note included an alternative means of repayment (the “dual repayment mechanism”), under which, in the absence of quarterly payments by Todd, UEBF could instead deduct the outstanding loan balance from any payment or distribution due from UEBF to Todd or his beneficiary. Shortly thereafter, Corporation stopped making its annual contributions to UEBF on behalf of Todd's DBO plan, and UEBF ceased premium payments on the policy.
While Todd argued that the $400,000 payment was nontaxable, IRS characterized this “loan” as a taxable distribution.
The Tax Court concluded that $400,000 distribution from UEBF didn't constitute a bona fide loan. (Todd, TC Memo 2011-123) In reaching this conclusion, the Court analyzed the seven factors used to determine if a bona fide loan exists. It found that five factors indicated that the parties didn't intend to establish a debtor-creditor relationship at the time the funds were advanced (Factors 1, 2, 3, 5, and 7), while one factor did (Factor 6), and one indicated a possible intent to do so (Factor 4).
- Presence of a note. Despite the requirements in their agreement, the debt wasn't contemporaneously memorialized when the money was distributed. Further, the terms of the trust agreement and note weren't followed: UEBF failed to charge a market rate of interest, and Todd failed to make quarterly payments;
- Interest rate. Todd was charged 1% interest rate by UEBF on the promissory note, lower than the market rate. In comparison, Southland charged a rate of 4.76% on a similar loan;
- Repayment schedule. UEBF didn't provide Todd with an amortization schedule reflecting quarterly payments until three months after the first payment was due under the note's terms, and the note wasn't executed until almost four months after the first payment was due;
- Collateral. At the time of the purported loan, Todd didn't own the policy (UEBF did), had no access to the cash value of the policy, and had no rights to the proceeds from the policy. However, the Tax Court found that the dual repayment mechanism could serve as security between the parties for the promissory note. The dual repayment mechanism allowed UEBF to deduct the $400,000 distribution from the death benefit obligation;
- Repayments. As of the date of trial, Todd hadn't made any payments toward the purported loan. The Court rejected Todd's argument that the dual repayment mechanism served as a valid method of repayment (although it had accepted that it could serve as security). Because the purported benefits under the DBO plan were contingent on multiple future events (e.g., Corporation might cease participation in the UEBF plan, the covered employee might be terminated or retire, or the master contract group and the union might not renew their agreement), Todd couldn't reasonably rely on the death benefit as an alternative payment;
- Prospect of repaying. Todd earned a substantial living as a neurosurgeon, so there was a reasonable prospect of his repaying the purported loan; and
- Parties' conduct. Neither UEBF nor Todd conducted themselves in a manner indicating that the distribution was a loan. Neither strictly abided by the note's terms. There was no inquiry into the hardship justifying the loan. The interest rate was below market. No quarterly payments were made. UEBF never attempted collection when quarterly payments weren't made.
In light of the post hoc note execution and the fact that Todd never repaid any of the purported loan (despite his clear means to do so), the Fifth Circuit couldn't find that the Tax Court clearly erred in concluding that the $400,000 payment wasn't a bona fide loan. While the Court recognized that Todd and UEBF executed a note and payment schedule, the fact that the note and schedule were only adopted after the fact—in contravention of UEBF policies—suggested the possibility that doing so was merely a formalized attempt to achieve the desired tax result despite lacking in necessary substance.
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