5 / How is a systematic plan of borrowing to buy life insurance treated?

In one revenue ruling, the IRS found systematic borrowing in a plan that contemplated purchase of mutual fund shares and a policy of whole life insurance, together with the insured’s use of the shares as security for notes executed each year in the amount of the cumulative premium and accrued interest.¹ When there is a systematic plan of borrowing, the borrowing will be treated as a plan for borrowing the increases in cash value of the policy, regardless of whether the borrowing is direct or indirect (that is, regardless of whether the borrowing is from the insurer, a bank, or some other person). Moreover, such a plan need not involve a pledge of the contract, but may contemplate unsecured borrowing or the use of other property.² When there is a systematic plan, and none of the exceptions applies, a deduction will be disallowed for interest on the entire amount borrowed, not just for interest on the borrowing equal to the increases in the cash value.³

Historically, the general disallowance rule applies only with respect to life insurance contracts purchased after August 6, 1963. However, IRS regulations state that this date relates to the date of purchase by the taxpayer, whether the purchase is from the insurer or from a previous policyowner. When a policy issued in 1959 was to be exchanged, the purchase date of the new policy was considered the date upon which the exchange was made, with the taxpayer losing the benefit of a policy issued prior to August 6, 1963.⁴

1. Rev. Rul. 74-500, 1974-2 CB 91.

2. Treas. Reg. § 1.264-4(c)(2).