Creditor Insurance

<div class="Section1">If the insured stockholder pays the premiums, the stockholder is denied a deduction on the ground that the premium payments are not an ordinary and necessary expense of carrying on the stockholder’s business.<a href="#_ftn1" name="_ftnref1">¹</a> If the corporation pays the premiums, they are nondeductible under IRC Section 264(a)(1) because the corporation is indirectly a beneficiary under the policy.<a href="#_ftn2" name="_ftnref2">²</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     <em>Morison v. Commissioner</em>, TC Memo 1960-243.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     See Rev. Rul. 68-5, 1968-1 CB 99.<br /> <br /> </div>

<div class="Section1"><br /> <br /> Based on the reasoning of the cases cited in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="132">132</a>, it appears unlikely that the creditor can secure a nonbusiness expense deduction. Moreover, when proceeds are receivable as tax-exempt life insurance proceeds, it would appear that IRC Section 265(a)(1) prohibits that deduction of premiums ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8794">8794</a>).<br /> <br /> If the debtor is directly or indirectly a beneficiary under the policy, IRC Section 264(a)(1) prohibits the deduction ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="262">262</a>). The IRS has allowed a business expense deduction for premiums paid by a taxpayer in the business of selling property for one-year term insurance purchased on the lives of installment purchasers where no separate charge was made for the insurance and where the death proceeds (payable to the seller) were in the amount of the unpaid balance of the purchase price. Proceeds receivable by the seller were treated as collections on the purchase price, <em>not</em> as life insurance proceeds excludable under IRC Section 101(a).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 70-254, 1970-1 CB 31.<br /> <br /> </div></div><br />

<div class="Section1">The deduction has been denied on the ground that the premium payments are a capital investment rather than expenses incurred “for the production or collection of income, or for the management, conservation and maintenance of property held for the production of income.”<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     <em>U.S. v. Mellinger</em>, 228 F.2d 688 (5th Cir. 1956); <em>Home News Publishing Co. v. Commissioner</em>, TC Memo 1969-167; <em>see also Blumenthal v. Commissioner</em>, TC Memo 1963-269, <em>aff’d</em>, 14 AFTR 2d 5094 (4th Cir. 1964).<br /> <br /> </div>

<div class="Section1">Yes, provided the cash surrender value of the policy is less than the debt. The creditor may deduct the difference between the cash surrender value and the debt or, if the policy has no cash surrender value, the creditor may deduct the full amount of the worthless debt. The creditor may take the deduction even though the creditor continues to hold the policy and the face of the policy exceeds the debt. Collateral need not be liquidated to establish the worthless portion of the debt.<a href="#_ftn1" name="_ftnref1">¹</a> If a deduction was not previously taken, a deduction for the uncollectible balance may be taken in the year the creditor surrenders the policy.<a href="#_ftn2" name="_ftnref2">²</a> No bad debt deduction will be allowed at any time, however, for advances that were made when prior loans exceeded the face of the policy and the debtor was insolvent.<a href="#_ftn3" name="_ftnref3">³</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     <em>Hatboro Nat’l Bank v. Commissioner</em>, 24 TC 786 (1955).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     <em>Mattlage v. Commissioner</em>, 3 BTA 242 (1925).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     <em>Blumenthal v. Commissioner</em>, TC Memo 1963-269, <em>aff’d</em>, 14 AFTR 2d 5094 (4th Cir. 1964).<br /> <br /> </div>

<div class="Section1">As a general rule, if a property interest passing to a surviving spouse is subject to an encumbrance, only the value of the property interest in excess of the amount of the encumbrance qualifies for the marital deduction.<a href="#_ftn1" name="_ftnref1">¹</a> If the debt that is secured by the policy is actually paid from estate assets, or if the spouse-beneficiary has a right of subrogation against the estate and the estate is solvent, the full amount of the proceeds qualifies for the marital deduction despite the collateral assignment.<a href="#_ftn2" name="_ftnref2">²</a> (For a policy loan, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="187">187</a>.)<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;2056(b)(4)(B).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Estate of Gwinn v. Commissioner</em>, 25 TC 31 (1955), acq. 1956-1 CB 4; <em>Wachovia Bank &amp; Trust Co. v. U.S.</em>, 163 F. Supp. 832 (Ct. Cl. 1958); Treas. Reg. &sect;&nbsp;20.2056(b)-4(b).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> No.<br /> <br /> The answer is the same regardless of whether the debtor takes out a new policy for the benefit of the creditor or assigns an existing policy to the creditor. The deduction will be denied even though the debtor was required to take out the policy to obtain the loan. If the debt is personal, the premiums are nondeductible personal expenses.<a href="#_ftn1" name="_ftnref1">¹</a> If the debt is a business debt, the deduction is denied under IRC Section 264(a)(1), which provides that no deduction is allowed for premiums on any life insurance policy, endowment, or annuity contract if the taxpayer is directly or indirectly a beneficiary under the policy or contract. For this purpose, the insured debtor is at least indirectly a beneficiary under the policy because the proceeds may be used to satisfy the insured’s debt.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> IRC Section 264(a)(1) also acts as a bar to a nonbusiness deduction. Thus, the deduction was denied for premiums the taxpayer paid on insurance used as collateral for a bank loan to a company in which the taxpayer was a major stockholder; the premiums were paid to protect the taxpayer’s personal securities, which were also part of the collateral for the loan.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> The deduction is disallowed even when the person who pays the premiums is merely a guarantor and therefore only secondarily liable for the debt.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 262.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     <em>Glassner v. Comm</em>, 360 F.2d 33, <em>cert. denied</em>, 385 U.S. 819 (1966); <em>O’Donohue v. Commissioner</em>, 33 TC 698 (1960); <em>Hanson v. Commissioner</em>, TC Memo 1970-15; Rev. Rul. 68-5, 1968-1 CB 99.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     <em>Carbine v. Commissioner</em>, 85-2 USTC ¶ 9854 (11th Cir. 1985).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     <em>D’Angelo Assoc., Inc. v. Commissioner</em>, 70 TC 121 (1978), acq. in result, 1979-1 CB 1.<br /> <br /> </div>

<div class="Section1"><br /> <br /> The IRS takes the position that the creditor cannot claim a deduction unless the creditor shows that the creditor’s right to reimbursement for the premium payment was worthless in the year of payment. Thus, if the creditor has a right to proceed against the debtor for reimbursement, the debtor must be insolvent or the claim must be otherwise uncollectible. If the creditor has a right, express or implied, to reimbursement from the policy, the cash surrender value must be insufficient to cover the balance of the unpaid debt and the premium payment. If the creditor has both rights, both must be worthless.<a href="#_ftn1" name="_ftnref1">¹</a> Premiums that are not deductible are treated as additional advances that increase the debt.<br /> <br /> Courts, however, have allowed the deduction without regard to the taxpayer’s ability to recover the premium out of the cash surrender value of the policies.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The IRS would disallow a deduction for the premium payment if the creditor has taken a bad debt deduction for the debt and the cash surrender value of the policy is sufficient to provide reimbursement for the premium payment. In <em>Charleston Nat’l Bank</em>, however, the court held that the premium payment was deductible even though the creditor had taken a bad debt deduction for the debt and the cash surrender value exceeded the current premium and premium payments not deducted in prior years.<br /> <br /> The deduction is allowable not as a bad debt but as an ordinary and necessary business expense, incident to the protection of the collateral.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> If premiums that have been deducted are later recovered from the proceeds, the recovery must be reported as taxable income. If the premiums have not been deducted, however, the recovery will be tax-free.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Rev. Rul. 75-46, 1975-1 CB 55.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     <em>Commissioner v. Charleston Nat’l Bank</em>, 20 TC 253 (1953) <em>aff’d</em>, 213 F.2d 45 (4th Cir. 1954); <em>First Nat’l Bank &amp; Trust Co. v. Jones</em>, 143 F.2d 652 (10th Cir. 1944).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     <em>First Nat’l Bank &amp; Trust Co. v. Jones</em>, <em>supra</em>; <em>Blumenthal v. Commissioner</em>, TC Memo 1963-269, <em>aff’d</em>, 14 AFTR 2d 5094 (4th Cir. 1964). <em>See also</em> Rev. Rul. 75-46, 1975-1 CB 55.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     <em>St. Louis Refrigerating &amp; Cold Storage Co. v. U.S</em>., 162 F.2d 394 (8th Cir. 1947).<br /> <br /> </div>

<div class="Section1"><br /> <br /> Yes.<br /> <br /> This is true regardless of policy ownership or beneficiary designation. To the extent that the creditor has a right to collect the debt from the proceeds, the proceeds are considered to be receivable for the benefit of the estate ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="81">81</a>).<a href="#_ftn1" name="_ftnref1">¹</a> It is immaterial whether the debt is actually paid from estate assets or that the beneficiary has a right to recover from the estate the amount of proceeds paid to the creditor.<a href="#_ftn2" name="_ftnref2">²</a> The amount of the debt outstanding at the date of the insured&rsquo;s death, with interest accrued to that date, is deductible in determining the taxable estate even though the debt is paid from the proceeds.<a href="#_ftn3" name="_ftnref3">³</a> (For a policy loan, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="187">187</a>.)<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;2042(1); Treas. Reg. &sect;&nbsp;20.2042-1(b); <em>Fidelity Trust Co. (Matthews) v. Commissioner</em>, 3 TC 525 (1944); <em>Estate of Hofferbert v. Commissioner</em>, 46 BTA 1101 (1942); <em>Morton v. Commissioner</em>, 23 BTA 236 (1931); cf. <em>Prichard v. U.S.</em>, 397 F.2d 60 (5th Cir. 1968) and <em>Bintliff v. U.S.</em>, 462 F.2d 403 (5th Cir. 1972).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Estate of Gwinn v. Commissioner</em>, 25 TC 31 (1955).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&sect;&nbsp;20.2042-1(b)(1), 20.2053-4.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> 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.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> In some states, a creditor&rsquo;s insurable interest in the creditor&rsquo;s debtor is limited to indemnification of the amount of the debt (plus premiums the creditor has paid) as of the insured&rsquo;s death. The creditor must hold any excess for the debtor&rsquo;s estate. Where this is so it would appear, based on the reasoning of Revenue Ruling 70-254 and the <em>Landfield</em> case ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="136">136</a>), that the proceeds would not be considered to have been paid by reason of the insured&rsquo;s death, and therefore would not be exempt as life insurance proceeds under IRC Section 101(a).<br /> <br /> 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&rsquo;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 &ldquo;by reason of the death of the insured&rdquo; 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.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Thomsen &amp; Sons, Inc. v. U.S.</em>, 73-2 USTC &para;&nbsp;9637 (7th Cir. 1973); <em>Harrison v. Commissioner</em>, 59 TC 578 (1973), acq. 1973-2 CB 2.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> If a creditor is collateral assignee, the creditor receives the proceeds as a recovery on the collateral and not as life insurance proceeds.<a href="#_ftn1" name="_ftnref1">¹</a> Consequently, if the creditor has not taken a bad debt deduction, the proceeds are received tax-free as a return of capital. They are tax-free, that is, to the extent of the unpaid debt and any premiums the creditor has paid but not deducted ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="132">132</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="133">133</a>). If the creditor, however, has received the tax benefit of a bad debt deduction, the proceeds must be reported as taxable income (except to the extent they represent a recovery of premium payments for which no deduction has been taken). If a portion of the proceeds represents interest on the debt, that portion is taxed as ordinary income to the creditor.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If the creditor is named beneficiary as the creditor&rsquo;s &ldquo;interest might appear&rdquo; on a policy owned by the debtor, the creditor receives the proceeds as payment of the debt and not as life insurance proceeds. Because the creditor must prove the debt to collect the proceeds, the proceeds are received because of the insured&rsquo;s indebtedness rather than &ldquo;by reason of the death of the insured,&rdquo; and hence are not exempt under IRC Section 101(a). The proceeds, therefore, constitute taxable income to the creditor to the same extent that direct repayment of the loan would have resulted in income. This is so regardless of whether the debtor or the creditor has paid the premiums.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> A different situation arises if the creditor takes title to the insurance policy and releases the debtor from further obligation. Under these circumstances, the proceeds are received as life insurance proceeds, but a transfer for value has taken place ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a>). As a result, the proceeds are taxable income to the creditor to the extent that they exceed the value of the policy at the time of transfer and premiums and certain other amounts ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a>) paid after the transfer.<a href="#_ftn4" name="_ftnref4">⁴</a> There should be no tax liability under the transfer for value rule, however, if the creditor is a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is an officer or stockholder, unless the transaction qualified as a reportable policy sale (for tax years beginning after 2017).<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.101-1(b)(4).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>St. Louis Refrigerating &amp; Cold Storage Co. v. U.S.</em>, 162 F.2d 394 (8th Cir. 1947); <em>First Nat&rsquo;l Bank v. Commissioner</em>, TC Memo 1943.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>McCamant v. Commissioner</em>, 32 TC 824 (1959); Rev. Rul. 70-254, 1970-1 CB 31.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Federal Nat&rsquo;l Bank v. Commissioner</em>, 16 TC 54 (1951), nonacq. 1951-2 CB 5 (1951).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(a)(2)(B).<br /> <br /> </div></div><br />