4 / Are there any exceptions to the rule that disallows a deduction for interest paid on a loan to purchase or carry a life insurance, endowment or annuity contract?

There are four exceptions to this disallowance rule.¹ However, with respect to interest paid or accrued on policies or contracts covering an individual who is a “key person,” the deduction may be limited as explained in Q 30, or denied entirely, even if one of the four exceptions to this disallowance rule is met.

The four exceptions are:

(1)     The seven-year exception. The deduction will not be disallowed under this rule when no part of four of the annual premiums due during the seven-year period, beginning with the date of payment for the first premium on the contract, is paid by means of indebtedness. If there is a substantial increase in the premiums, a new seven-year period for the contract commences on the date the first increased premium is paid. However, a new seven-year period does not begin upon transfer of the policy, whether for value or by gift.² A new seven-year period does not commence if modification of a life insurance policy after December 31, 1990, becomes necessary because of the insurer’s financial insolvency.³ The addition to a policy of a provision that interest on policy loans is payable in arrears rather than in advance will not cause a new seven-year period to begin.⁴ A systematic plan of purchase will be presumed when there is borrowing in connection with more than three of the annual premiums due during the seven-year period, but will not be presumed earlier.⁵

Once a taxpayer has used borrowed funds to pay four of the first seven annual premiums, the taxpayer cannot undo the effect of this action by repaying the policy loan.⁶ If in any year during the seven-year period, the taxpayer, in connection with any premium, borrows more than an amount necessary to pay one annual premium, the excess will be treated as though he or she borrowed to pay premiums that were paid in prior years with non-borrowed funds (beginning with the first prior year and working backwards).⁷

Example. Taxpayer, in Year 1, purchased a $100,000 policy and the annual premium was $2,200. The taxpayer paid the first four premiums without borrowing. In Year 5, the taxpayer borrowed $10,000 with respect to the policy. The borrowing will be attributed first to paying the premium for Year 5 and then attributable to paying the premium for Years 4, 3, 2, and 1 (in part).

If borrowing in connection with any premium in any year exceeds the premium for that year plus premiums paid in prior years without borrowing, the excess will be attributed to premiums (if any) paid in advance for future years. However, once the seven-year exception has been satisfied, and the seven-year period has expired, there would appear to be no limit under this exception to the amount that might be borrowed (from the policy or otherwise) to pay premiums on the policy. (But if a substantial number of premiums are prepaid, the policy might be considered a single-premium policy – see Q 3.)

Thus, three of the first seven annual premiums may be borrowed, and the interest deduction would not be disallowed by reason of this rule, provided the balance of premiums during the seven-year period is paid with non-borrowed funds. But if the seven-year exception is not met, and the taxpayer cannot rebut the presumption of a systematic plan of borrowing, the interest deduction will be disallowed under this rule for all future years and for all prior years not closed by the statute of limitations. This assumes, of course, that none of the other exceptions to this rule applies.⁸

(2)     $100-a-year exception. Regardless of whether there is a systematic plan of borrowing, the interest deduction will not be disallowed under this rule for any taxable year in which the interest (in connection with such plans) does not exceed $100. But when such interest exceeds $100, the entire amount of interest (not just the amount in excess of $100) is nondeductible under IRC Section 264(a)(3).⁹

(3)     Unforeseen event exception. If indebtedness is incurred because of an unforeseen substantial loss of income or unforeseen substantial increase in the taxpayer’s financial obligations, the deduction will not be disallowed under this rule even though the loan is used to pay premiums on the contract. An event is not “unforeseen,” however, if at the time the contract was purchased it could have been foreseen.¹⁰

(4)     Trade or business exception. If indebtedness is incurred in connection with the taxpayer’s trade or business, the interest deduction will not be denied under IRC Section 264(a)(3). Thus, if an insurance policy is pledged as part of the collateral for a loan, the interest deductions will come within this exception if the taxpayer can show that the amounts borrowed actually were used to finance the expansion of inventory or other similar business needs.¹¹ The IRS has ruled privately that a company that borrowed against key-person life insurance policies to take advantage of the policies’ lower interest rate and generally to improve its financial position by reducing its overall debt was considered to have incurred the policy loan interest in connection with its trade or business.¹² But borrowing to finance business life insurance (such as key person, split dollar, or stock purchase plans) is not considered to be incurred in connection with the borrower’s trade or business.¹³ Systematic borrowing to finance a life insurance policy is not debt incurred in connection with an employer’s trade or business even when the net death proceeds and the amounts borrowed in excess of premiums are used to fund employee retirement benefits.¹⁴

The interest deduction will not be disallowed under IRC Section 264(a)(3) if any one of these exceptions applies. For example, even though the purchase of business life insurance does not come within the trade or business exception, the interest deduction may be allowed if the borrowing comes within the four-out-of-seven exception, provided no other IRC section operates to disallow or limit the interest deduction ( Q 30).