131 / If a creditor pays premiums on a life insurance policy held as collateral for a business debt, can the creditor claim an income tax deduction for the premium payments?

The IRS takes the position that the creditor cannot claim a deduction unless the creditor shows that the creditor’s right to reimbursement for the premium payment was worthless in the year of payment. Thus, if the creditor has a right to proceed against the debtor for reimbursement, the debtor must be insolvent or the claim must be otherwise uncollectible. If the creditor has a right, express or implied, to reimbursement from the policy, the cash surrender value must be insufficient to cover the balance of the unpaid debt and the premium payment. If the creditor has both rights, both must be worthless.¹ Premiums that are not deductible are treated as additional advances that increase the debt.

Courts, however, have allowed the deduction without regard to the taxpayer’s ability to recover the premium out of the cash surrender value of the policies.²

The IRS would disallow a deduction for the premium payment if the creditor has taken a bad debt deduction for the debt and the cash surrender value of the policy is sufficient to provide reimbursement for the premium payment. In Charleston Nat’l Bank, however, the court held that the premium payment was deductible even though the creditor had taken a bad debt deduction for the debt and the cash surrender value exceeded the current premium and premium payments not deducted in prior years.

The deduction is allowable not as a bad debt but as an ordinary and necessary business expense, incident to the protection of the collateral.³

If premiums that have been deducted are later recovered from the proceeds, the recovery must be reported as taxable income. If the premiums have not been deducted, however, the recovery will be tax-free.⁴