An Examination of McGowan v. United States: Unpacking Split-Dollar Life Insurance Taxation
For tax professionals navigating complex compensation and wealth transfer arrangements, the Sixth Circuit’s recent decision in Peter E. McGowan; Michele L. McGowan; Peter E. McGowan DDS, Inc. v. United States of America, No. 24-3228 (July 9, 2025), offers crucial insights into the application of split-dollar life insurance regulations and the deductibility of related employer contributions. This case affirms the district court’s award of summary judgment to the government, largely upholding the IRS’s assessments against both Dr. Peter E. McGowan and his dental practice, Peter E. McGowan DDS, Inc. (the "Company").
Factual Background of the Tax Dispute
The case traces its origins to the formation of the Toledo Zoo, sparked by a groundhog in 1900, which has since grown into a significant community treasure supported by generous donors. Peter McGowan, a Toledo-area dentist and sole owner of his C corporation, the Company, was one such donor.
McGowan’s dispute with the IRS arose from a sophisticated life insurance "Plan" that his solely owned dental practice participated in from 2011 through 2015. The Plan was designed as a tax-efficient alternative to his existing whole-life insurance policy, aiming to minimize the tax burden for both McGowan and the Company.
The Plan operated through a Benefits Trust Agreement that established two subtrusts:
- Death Benefit Trust (DBT): This subtrust purchased and owned a whole-life insurance policy on McGowan from Penn Mutual (the "Policy"). The Company annually contributed $37,222 to the DBT to cover the Policy’s base premium.
- Restricted Property Trust (RPT): This subtrust received up to $12,778 annually from the Company, which it then transferred to the DBT. These funds were invested as "paid-up additions" to increase the Policy’s cash value and death benefit. In return, the DBT granted the RPT a security interest in the Policy’s cash value.
The Plan outlined three potential end scenarios within its five-year increments:
- If McGowan died during the Plan’s operation, the RPT would release its security interest, and the DBT would pay the death benefit to McGowan’s designated beneficiary: his wife.
- If the Company chose not to renew the Plan after five years, the Plan would terminate, and McGowan would take direct ownership of the Policy.
- If the Company failed to contribute the base premium to the DBT, the DBT would surrender the Policy for its cash value, transfer the cash to the RPT, and the RPT would then donate the proceeds to a charity chosen by McGowan, specifically the Toledo Zoo.
Although Aligned Partners Trust Company served as the trustee for both subtrusts, its independence was limited, as the Company could "immediately remove" the trustee "at any time and for any reason". McGowan primarily sought personal financial benefits from the Plan, with the only noted Company benefit being the purportedly deductible contributions.
Tax Positions and IRS Assessment
During the Plan’s operation, the taxpayers adopted positions favoring them on their tax returns:
- McGowan: Did not report the value of the death benefit or the accumulated cash value of the Policy as taxable income. He did report the annual $12,778 contributions to the RPT as income, a point not disputed in the litigation.
- The Company: Claimed annual deductions of $50,000 for its total contributions to the subtrusts.
After five years, McGowan failed to extend the Plan, leading him to take direct ownership of the Policy in 2016. For that year, he reported $115,227 as taxable income, representing the Policy’s cash value less the appreciated value of the RPT contributions already reported.
The IRS subsequently audited McGowan and the Company, concluding that McGowan should have recognized the Policy’s accumulating cash value as taxable income each year and that the Company should not have deducted its annual contributions to the DBT. As a result, the IRS assessed over $100,000 in additional taxes and penalties for tax years 2014 and 2015: $65,589.80 for McGowan and $37,164.94 for the Company.
Taxpayers’ Request for Relief
Following the IRS assessments, McGowan and the Company paid the amounts and initiated a lawsuit in federal district court, seeking a refund of the additional sums paid. Their arguments centered on several key points:
- The split-dollar regulation (Treas. Reg. § 1.61-22) should not apply to their arrangement.
- Even if the regulation applied, McGowan did not understate gross income during the at-issue tax periods because his access to the Policy’s cash value was subject to a "substantial risk of forfeiture" and therefore had not yet "vested".
- The district court’s decision upholding the IRS’s assessment was invalid under Loper Bright Enterprises v. Raimondo, which had overruled Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., asserting that the split-dollar regulation contravened Congress’s commands in the Internal Revenue Code (I.R.C.).
- Specifically for the Company, the split-dollar regulation impermissibly foreclosed deductions that could otherwise be claimed under I.R.C. § 162(a).
Court’s Analysis and Application of Law
The Sixth Circuit reviewed the district court’s grant of summary judgment de novo, meaning it conducted a fresh review of the legal issues without deference to the lower court’s conclusions, while viewing evidence and drawing inferences in favor of the taxpayers. The court noted that because no material facts were in dispute, the typical burden-shifting rule under I.R.C. § 7491(a)(1) was irrelevant.
Applicability of the Split-Dollar Regulation
The core of the IRS’s position rested on Treasury Regulation § 1.61-22, often termed the "split-dollar regulation". This regulation clarifies the taxation of split-dollar agreements, which involve an employer paying premiums on an employee’s life insurance in exchange for shared policy benefits. The specific provision at issue was the compensatory split-dollar arrangement under Treas. Reg. § 1.61-22(b)(2)(i), which applies to arrangements:
- Between an owner and a non-owner of a life insurance contract.
- Entered in connection with the performance of services (taxpayers conceded this).
- Where the employer pays premiums (taxpayers conceded this).
- Where the employee designates the death benefit beneficiary or has an interest in the policy cash value.
The taxpayers disputed the "owner and non-owner" element, arguing the DBT, with its independent trustee, was the owner, making the Company a non-owner, thus an arrangement between two non-owners. The court rejected this argument, noting that Treas. Reg. § 1.61-22(c)(1)(iii)(C) treats an employer as the owner if the policy is held by a "welfare benefit fund" as defined by I.R.C. § 419(e)(1). The DBT qualified as such a fund, a point the taxpayers themselves had previously conceded in district court. The court emphasized that this interpretation aligns with the principle of substance over form, viewing the subtrust as an "economically meaningless" interposition that did not defeat the Company’s ownership rights. The ostensible independence of the trustee was also dismissed, given the Company’s unfettered right to remove the trustee.
The taxpayers also contended that the Plan failed to meet the third condition of the compensatory provision (subclause (C)). The court disagreed, finding that subclause (C)(1) was clearly satisfied because McGowan, as the employee, designated his wife as the beneficiary of the death benefit. The taxpayers’ argument that the potential donation of the cash value to the Toledo Zoo prevented this conclusion was rejected for several reasons:
- The charity’s interest was in the cash value, not the death benefit, which is the relevant consideration under subclause (C)(1).
- McGowan explicitly designated his wife as the death benefit recipient.
- Even if the charity had an interest in the death benefit, McGowan still designated the Toledo Zoo.
- The involvement of the DBT as an intermediary before paying the death benefit to McGowan’s wife was deemed a mere structural formality, as the agreement stated the DBT "shall distribute and pay" the death benefit to the beneficiary, indicating an obligation.
Therefore, the court concluded that the split-dollar regulation squarely applied to the Plan.
Understatement of Gross Income (McGowan)
The taxpayers argued that McGowan did not understate his gross income because he lacked "current access" to the policy’s cash value before taking direct ownership in 2016. They claimed the potential forced donation to charity created a "substantial risk of forfeiture".
The court rejected this argument by referring to the specific definition of "current access" in Treas. Reg. § 1.61-22(d)(4)(ii), which explicitly includes a "current or future right" to a portion of the policy cash value. McGowan possessed several such rights, including the right to receive the Policy upon Company non-renewal, the right to designate the death benefit beneficiary, and the right to designate the charity for the cash value.
Furthermore, the court clarified that the "substantial risk of forfeiture" concept, which the taxpayers cited, is derived from I.R.C. § 83(a)(1) and is inapplicable here, as § 83(a)(2) redirects the taxation of life insurance protection under split-dollar arrangements to the specific split-dollar regulation. The court also noted that McGowan derived an intrinsic value from selecting the Toledo Zoo as a potential beneficiary, making the charitable donation itself a "current or future right" for him.
Finally, the court found that the cash value was indeed "inaccessible to the owner" (the Company via the DBT), satisfying part of the "current access" definition under Treas. Reg. § 1.61-22(d)(4)(ii)(B). The Benefits Trust Agreement explicitly barred the Company from accessing the principal or income of the Trust Fund for purposes other than McGowan, his beneficiaries, or a designated charity, and stated that McGowan’s rights were not subject to alienation. The taxpayers themselves had asserted that "the cash value could not be accessed by anyone. Period.".
Thus, the court concluded that McGowan was required to include the full value of all economic benefits from the Plan in his gross income for the tax years 2014 and 2015.
Deductibility of Company Contributions (I.R.C. § 162(a) and § 419(a))
The taxpayers challenged the split-dollar regulation’s prohibition on the Company’s deductions, asserting it contradicted I.R.C. § 162(a).
Initially, the court noted that the taxpayers had forfeited their broader challenge to McGowan’s taxation under Loper Bright by raising it for the first time in a motion for reconsideration in the district court. On the merits, the court affirmed that I.R.C. § 61(a), which defines gross income broadly to include "all income from whatever source derived," provides ample statutory authority for taxing the economic benefits McGowan received.
Regarding the Company’s deductions, the court highlighted that I.R.C. § 419(a) generally prohibits deductions for employer contributions to welfare benefit funds unless "otherwise deductible". Deductions are "matters of legislative grace," requiring taxpayers to clearly demonstrate their right to the deduction.
The taxpayers attempted to claim deductions under I.R.C. § 162(a) for "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business". An expense must satisfy five elements to qualify: (1) paid or incurred during the taxable year, (2) for carrying on a trade or business, (3) an expense, (4) necessary, and (5) ordinary.
The court found the premiums did not meet the "ordinary" or "trade or business" requirements:
- Not Ordinary: The premiums were not commonplace among dentists.
- Not for Trade or Business: The premiums primarily served McGowan’s personal goal of leaving a substantial sum to his chosen beneficiary, rather than promoting the Company’s profit motive. The court stressed that tax avoidance alone does not constitute a "bona fide business purpose" for deductibility under § 162(a).
The taxpayers advanced two alleged business goals for the Plan: ensuring business continuity and motivating McGowan to remain with the Company. The court dismissed both arguments:
- Business Continuity: The death benefit amount was based on McGowan’s insurability and prior personal policy, not the estimated cost of finding a successor dentist (which was significantly lower). Furthermore, the Plan’s structure (where the cash value would be donated to charity if premiums weren’t paid) would hinder, not help, the Company’s survival if it faced financial distress.
- Motivation: As the sole owner of the Company, McGowan needed no "incentive to remain" with his own business.
The court concluded that the Plan functioned as an "investment" and "estate planning…vehicle[] for the sole benefit of the owners of the company," rather than a legitimate business expense to "compensate, incentivize, and retain key employees". This conclusion aligned with precedents from other circuits and the Tax Court.
Consequently, the Company was prohibited from deducting its annual premium payments to the DBT.
Impact of Machacek on Shareholder-Employee Taxation
A significant aspect of the McGowan case involved the prior Sixth Circuit decision in Machacek v. Commissioner, 906 F.3d 429 (6th Cir. 2018). Machacek held that whenever a shareholder-employee receives economic benefits from a split-dollar arrangement, even if deemed "compensatory," those benefits must be treated as a distribution of property to a shareholder rather than services-based compensation. This treatment typically results in taxation at lower capital gains rates for the shareholder, as opposed to ordinary income rates.
In McGowan, the parties stipulated that McGowan was entitled to a $40,978.07 refund (plus interest) if Machacek was not overruled, because the IRS had initially assessed his tax deficiency based on ordinary income rates.
The McGowan court acknowledged that Machacek is in tension with, and possibly contradicts, the Internal Revenue Code. Specifically, I.R.C. § 301(a) applies only to "distribution[s] of property… made by a corporation to a shareholder with respect to its stock," while Machacek overlooked the possibility of payments tied to services rather than stock.
The court noted that both the IRS and tax academics share skepticism about Machacek:
- The IRS issued a "nonacquiescence letter," indicating it disagreed with Machacek’s holding and would not follow it outside the Sixth Circuit.
- Tax academics have criticized Machacek for missing the mark by categorizing all such arrangements as property distributions.
- The Tax Court, in a reviewed decision, explicitly stated it was "unable to embrace the reasoning or result" of Machacek.
The McGowan court also pointed out that Machacek was decided under the Chevron deference framework, which required deference to agency interpretations. However, Loper Bright, which subsequently overruled Chevron, now mandates that courts "exercise independent judgment in construing statutes," implying that the plain meaning of I.R.C. § 301(a) should prevail over any contradictory regulatory interpretation. Regulations cannot amend or add to a statute. Despite these strong indications that Machacek’s "sun may soon set," neither party in McGowan asked the court to reconsider Machacek. Therefore, the court explicitly deferred overturning Machacek to another case. This deferral explains why McGowan was entitled to a partial refund despite the court otherwise affirming the IRS’s overall position on the applicability of the split-dollar regulation and the Company’s deductions.
Conclusion
The Sixth Circuit in McGowan v. United States affirmed the district court’s decision, upholding the IRS’s application of the split-dollar regulation (Treas. Reg. § 1.61-22) to the taxpayers’ arrangement. The court firmly established that Peter McGowan was required to include the full value of the economic benefits from the Plan in his gross income each year, and the Peter E. McGowan DDS, Inc. was prohibited from deducting its annual premium payments. This decision reinforces the IRS’s position on the taxation of such arrangements, particularly when they involve welfare benefit funds and are designed primarily for personal benefit rather than bona fide business purposes.
While the ultimate ruling for the government was an affirmation, the lingering effect of Machacek means that McGowan is due a refund reflecting the difference between ordinary income and capital gains tax rates, as the IRS had initially assessed him at ordinary income rates. This case serves as a critical reminder for tax professionals regarding the stringent requirements for deductibility of life insurance premiums in the corporate context and the broad reach of gross income definitions, even as the landscape of deference to agency interpretations continues to evolve.
Prepared with assistance from NotebookLM.