152 / May the grantor of a life insurance trust take a deduction for interest paid by the trust on a policy loan when the policy is held by the trust?
If the grantor is taxed as the owner of the trust, the grantor apparently is allowed an interest deduction, in the rare instances when a deduction is allowable, to the same extent as any other owner of the policy ( Q 3, Q 30). The IRC provides that when the grantor (or any other person) is treated as the owner of any part of a trust, the trust’s deductions, as well as income and credits against tax, attributable to that part of the trust will be taken into account in computing that person’s taxable income.1 Trusts that are treated as owned by the grantor are sometimes referred to as “defective” because, as a general rule, the pass-through of trust income is undesirable. A “defective” trust may be useful, however, if a deduction can be passed through to the grantor. (Where favorable estate tax results are sought, attention also should be given to the matters discussed in Q 178 to Q 186.)
The IRS has ruled privately that where nonadverse trustees had authority to use trust income to pay premiums on policies on the grantor’s life (not irrevocably payable for a charitable purpose), or had discretion to pay trust income or principal to the grantor’s spouse, the grantor would be taxed as owner of the trust and could take the trust’s deductions.2
1. IRC § 671.