31 / Are there any exceptions to the rule that interest paid on a policy loan is nondeductible for key-person policies?

Yes. The general nondeductibility rule does not apply to any interest paid or accrued on any indebtedness with respect to policies or contracts covering an individual who is a “key person” to the extent that the aggregate amount of the indebtedness with respect to policies and contracts covering the individual does not exceed $50,000.¹ A “key person” is an officer or 20 percent owner of the taxpayer. The number of persons who may be treated as key persons is limited to the greater of: (1) five individuals, or (2) the lesser of 5 percent of the total officers and employees of the taxpayer or 20 individuals. If the taxpayer is a corporation, a 20 percent owner is defined as any person who directly owns
(1) 20 percent or more of the outstanding stock of the corporation or (2) stock possessing 20 percent or more of the total combined voting power of all of the corporation’s stock. If the taxpayer is not a corporation, a 20 percent owner is any person who owns 20 percent or more of the capital or profits interest in the taxpayer.²Generally, all members of a controlled group are treated as a single taxpayer for purposes of determining a 20 percent owner of a corporation and for applying the $50,000 limitation. This limitation is allocated among the members of a controlled group in the manner prescribed by the IRS.³Interest in excess of the amount that would have been determined had the “applicable rate of interest” been used cannot be deducted. The applicable rate of interest for any month is the interest rate described as “Moody’s Corporate Bond Yield Average – Monthly Average Corporates” as published by Moody’s Investors Service (the Moody’s Rate).⁴

The IRC also specifies the manner in which to determine the applicable rate of interest for pre-1986 contracts. For a contract purchased on or before June 20, 1986 with a fixed interest rate, the applicable rate of interest for any month is the Moody’s Rate for the month in which the contract was purchased. If a contract with a variable interest rate was purchased on or before June 20, 1986, the applicable rate of interest for any month in an applicable period is the Moody’s Rate for the third month preceding the first month in such period. “Applicable period” is the twelve-month period beginning on the date the policy is issued, unless the taxpayer elects a number of months (not greater than twelve) other than such twelve-month period to be its applicable period. Such an election, if made, applies to the taxpayer’s first taxable year ending on or after October 13, 1995, and all subsequent taxable years.⁵

If any amount was received from a life insurance policy, or endowment or annuity contract subject to IRC Section 264(a)(4), upon the complete surrender, redemption, or maturity of the policy or contract during calendar years 1996, 1997, or 1998 or in full discharge during these years of the obligation under the policy or contract that was in the nature of a refund of the consideration paid for the policy or contract, then the amount is includable in gross income ratably over the four-taxable-year period beginning with the taxable year the amount would have been included in income but for this provision.⁶

---

1. IRC § 264(e)(1).