135 / Are proceeds received by a creditor from insurance purchased on the life of the creditor’s debtor exempt from income tax as life insurance proceeds?

If a creditor has an insurable interest other than as creditor (e.g., the debtor also is a key person) and has the unconditional right to retain proceeds unaffected by the size of the debt, the proceeds are received tax-free.¹

In some states, a creditor’s insurable interest in the creditor’s debtor is limited to indemnification of the amount of the debt (plus premiums the creditor has paid) as of the insured’s death. The creditor must hold any excess for the debtor’s estate. Where this is so it would appear, based on the reasoning of Revenue Ruling 70-254 and the Landfield case ( Q 136), that the proceeds would not be considered to have been paid by reason of the insured’s death, and therefore would not be exempt as life insurance proceeds under IRC Section 101(a).

Courts in other states, however, have held that where (i) the creditor initiates the purchase of insurance and pays the premiums, (ii) the amount of the insurance is reasonably proportionate to the amount of the debt, and (iii) the debtor consents to the insurance, the creditor’s insurable interest, or right of recovery, goes to the full proceeds, not just to the amount of debt, expenses, and interest. Thus, even if the debtor has paid the debt before his or her death, the creditor is entitled to the full proceeds. Under this view, it would appear that the proceeds would be received “by reason of the death of the insured” and therefore should be entitled to the exemption of IRC Section 101(a). If the proceeds are receivable as tax-exempt life insurance proceeds, it would appear that deduction of the premiums would be denied by reason of IRC Section 265(a)(1), which provides that expenses incurred for acquiring tax-exempt income are not deductible.