General Rules of Life Insurance

August 23, 2024

1 / What is life insurance?

Life insurance is a contract under which, in exchange for premium payments, an insurance company agrees to pay a death benefit if the person whose life is insured dies while the contract is in force. There are two general categories of life insurance: term coverage and permanent coverage. Term coverage is for a specific period of time, which can last for as little as one year or possibly as long as 30 years. Permanent insurance is intended to cover an insured for the rest of the insured s life. Permanent life insurance can be financed with a single premium, a fixed number of premiums over several years, or premiums paid over the remainder of the insured s life.

March 13, 2024

7 / Is the interest increment earned on prepaid life insurance premiums taxable income?

<div class="Section1">Yes. Any increment in the value of prepaid life insurance or annuity premiums or premium deposit funds constitutes taxable income in the year it is applied to the payment of a premium or is made available for withdrawal, whichever occurs first.<a href="#_ftn1" name="_ftnref1">1</a> The interest treated as taxable income, however, will be included in the cost basis of the contract. Thus, for purposes of IRC Section 72, the cost of the contract would be the amount of premiums paid other than by discount, plus the amount of discounted funds and any increments on such funds that were subject to income taxation. The rule taxing interest increments has no applicability, however, to single premium policies. A later ruling explains in detail how the interest will be taxed.<a href="#_ftn2" name="_ftnref2">2</a></div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Rev. Rul. 65-199, 1965-2 CB 20. <a href="#_ftnref2" name="_ftn2">2</a>. Rev. Rul. 66-120, 1966-1 CB 14. </div>

March 13, 2024

6 / Can the rules that disallow a deduction for interest paid on a loan to purchase or carry a life insurance, endowment or annuity contract be avoided by having one spouse use funds borrowed by the other spouse?

<div class="Section1">These disallowance rules cannot be avoided by having one spouse use funds borrowed by the other. When a husband borrowed money and transferred it to his wife, who used it to buy tax-exempt securities, the interest deduction was denied on the basis that the transfer of the borrowed funds was without economic substance because the purpose of the husband’s borrowing was to enable the wife to buy tax-exempt securities.<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Rev. Rul. 79-272, 1979-2 CB 124 (citing Drybrough v. Commissioner, 42 TC 1029 (1964)). </div>

March 13, 2024

9 / Is the owner of a limited-pay life insurance policy liable for any tax when the policy becomes paid-up?

No. Taxable income is not realized unless the policy is sold or surrendered.

March 13, 2024

2 / Are premiums paid on personal life insurance deductible for income tax purposes?

<div class="Section1">No. Premiums paid on personal life insurance are a personal expense and are not deductible.<a href="#_ftn1" name="_ftnref1">1</a> Internal Revenue Service (IRS) regulations specifically provide that “[p]remiums paid for life insurance by the insured are not deductible.”<a href="#_ftn2" name="_ftnref2">2</a> It is immaterial whether the premiums are paid by the insured or by some other person. For example, premiums paid by an individual for insurance on the life of his or her spouse are nondeductible personal expenses of the individual. Premiums are not deductible regardless of whether the insurance is government life insurance or regular commercial life insurance.<a href="#_ftn3" name="_ftnref3">3</a> Although personal life insurance premiums, as such, are not deductible, they may be deductible as the payment of alimony (prior to 2018, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="109">109</a>), as charitable contributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="120">120</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="127">127</a>), or as ordinary and necessary business expenses.<div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC §§ 262(a) and 264. <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.262-1(b)(1). <a href="#_ftnref3" name="_ftn3">3</a>.     Kutz v. Commissioner, 5 BTA 239 (1926). </div></div>

March 13, 2024

8 / Are annual increases in the cash surrender value of a life insurance policy taxable income to the policyholder?

<div class="Section1"> The Internal Revenue Code does not explicitly provide for the tax treatment of increases in the cash surrender value of a life insurance policy unless those values are accessed, directly or indirectly. In a case involving a cash basis taxpayer, the Tax Court held that the cash values were not constructively received by the taxpayer where the taxpayer could not reach them without surrendering the policy. The necessity of surrendering the policy constituted a substantial “limitation or restriction” on their receipt.<a href="#_ftn1" name="_ftnref1">1</a> Likewise, the Tax Court has held that the cash surrender values of paid-up additions are not constructively received by the policyholder.<a href="#_ftn2" name="_ftnref2">2</a> Similarly, it would appear that the same “limitation or restriction” would prevent accrual for an accrual basis taxpayer, because income does not accrue until “all the events have occurred” that fix the right to receive the income.<a href="#_ftn3" name="_ftnref3">3</a> The same rule applies whether the policy is a single premium policy or a periodic premium policy. Tax on the “inside buildup” of cash surrender values generally is not deferred in the case of contracts issued after December 31, 1984 that do not meet the statutory definition of a “life insurance contract” ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>).<a href="#_ftn4" name="_ftnref4">4</a> In such cases, the excess of the sum of (1) the increase in net surrender value (cash surrender value less any surrender charges) during the taxable year and (2) the cost of life insurance protection for the year over premiums paid under the contract during the year is taxable to the policyholder as ordinary income.<a href="#_ftn5" name="_ftnref5">5</a> “Premiums paid” generally means those paid under the contract less amounts received but excludable from income under IRC Section 72(e) (e.g., dividends).<a href="#_ftn6" name="_ftnref6">6</a> The cost of life insurance protection is the lesser of the cost of individual insurance on the life of the insured determined on the basis of uniform premiums or the mortality charge, if any, stated in the contract.<a href="#_ftn7" name="_ftnref7">7</a> If the contract originally meets the statutory definition and then ceases to do so, income on the contract for all prior years is included in gross income in the year it ceases to meet the definition.<a href="#_ftn8" name="_ftnref8">8</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="36">36</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="37">37</a> for a discussion of the new rules for determining basis under the 2017 tax reform legislation. If a variable insurance contract is an insurance contract under applicable state law and would otherwise meet the definitional requirements of IRC Section 7702, the annual increases in cash surrender value may nevertheless be taxed under the rules in the above paragraph if the underlying segregated asset account is not adequately diversified ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="553">553</a>). If a policy does not meet the IRC Section 7702(a) definition of a life insurance contract, the income on the contract for the year is considered a nonperiodic distribution and is subject to certain reporting and withholding requirements. The same is true for a variable life insurance contract that does not meet the diversification requirements of regulations under IRC Section 817(h).<a href="#_ftn9" name="_ftnref9">9</a> The “inside buildup” of cash surrender values of corporate-owned life insurance is generally included in the calculation of the alternative minimum tax ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="316">316</a>). (Note that the corporate AMT was repealed for tax years beginning after 2017). On December 7, 2015, the U.S. Congressional Joint Committee on Taxation issued a report containing a change of its procedure: <blockquote>Historically, the Joint Committee staff has included in its report on tax expenditures some items for which no provision of the Federal tax law specifically allows an exclusion, but which are nonetheless excluded from income. Among these are the exclusion of all Medicare benefits from taxation, the exclusion of investment income on life insurance and annuity contracts, and the exclusion of cash public assistance. This report no longer includes tax expenditure estimates for these items. [Emphasis added.]</blockquote> By no longer listing the exclusion of inside buildup of life insurance and annuities as a “tax expenditure,” the Committee appears to join the broadly held and long-standing view that despite specific provisions of the Internal Revenue Code exempting (or deducting) such buildup, the proper taxation of life insurance and annuities does not include such amounts. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>     Cohen v. Commissioner, 39 TC 1055 (1963), acq. 1964-1 CB 4. <a href="#_ftnref2" name="_ftn2">2</a>     Nesbitt v. Commissioner, 43 TC 629 (1965). <a href="#_ftnref3" name="_ftn3">3</a>     Treas. Reg. § 1.446-1(c)(1)(ii). <a href="#_ftnref4" name="_ftn4">4</a>     IRC § 7702(g). <a href="#_ftnref5" name="_ftn5">5</a>     IRC § 7702(g)(1)(B). <a href="#_ftnref6" name="_ftn6">6</a>     IRC § 7702(f)(1). <a href="#_ftnref7" name="_ftn7">7</a>     IRC § 7702(g)(1)(D). <a href="#_ftnref8" name="_ftn8">8</a>     IRC § 7702(g)(1)(C). <a href="#_ftnref9" name="_ftn9">9</a>     Rev. Rul. 91-17 1991-1 CB 190, as amplified by Rev. Proc. 2008-41, 2008-2 CB 155. </div></div>

March 13, 2024

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?

<div class="Section1"> There are four exceptions to this disallowance rule.<a href="#_ftn1" name="_ftnref1">1</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="30">30</a>, or denied entirely, even if one of the four exceptions to this disallowance rule is met. The four exceptions are: <blockquote>(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.<a href="#_ftn2" name="_ftnref2">2</a> 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.<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> 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).<a href="#_ftn7" name="_ftnref7">7</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="3">3</a>.) 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.<a href="#_ftn8" name="_ftnref8">8</a> (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).<a href="#_ftn9" name="_ftnref9">9</a> (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.<a href="#_ftn10" name="_ftnref10">10</a> (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.<a href="#_ftn11" name="_ftnref11">11</a> 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.<a href="#_ftn12" name="_ftnref12">12</a> 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.<a href="#_ftn13" name="_ftnref13">13</a> 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.<a href="#_ftn14" name="_ftnref14">14</a></blockquote> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="30">30</a>). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.       IRC § 264(d). <a href="#_ftnref2" name="_ftn2">2</a>.       Rev. Rul. 71-309, 1971-2 CB 168. <a href="#_ftnref3" name="_ftn3">3</a>.       Rev. Proc. 92-57, 1992-2 CB 410; Let. Rul. 9239026. <a href="#_ftnref4" name="_ftn4">4</a>.       Let. Rul. 9737007. <a href="#_ftnref5" name="_ftn5">5</a>.       Treas. Reg. § 1.264-4(c). <a href="#_ftnref6" name="_ftn6">6</a>.       Rev. Rul. 72-609, 1972-2 CB 199. <a href="#_ftnref7" name="_ftn7">7</a>.       Treas. Reg. § 1.264-4(c)(ii). <a href="#_ftnref8" name="_ftn8">8</a>.       Treas. Reg. § 1.264-4(d)(1). <a href="#_ftnref9" name="_ftn9">9</a>.       Treas. Reg. § 1.264-4(d)(2). <a href="#_ftnref10" name="_ftn10">10</a>.     Treas. Reg. § 1.264-4(d)(3). <a href="#_ftnref11" name="_ftn11">11</a>.     Treas. Reg. § 1.264-4(d)(4). <a href="#_ftnref12" name="_ftn12">12</a>.     Let. Rul. 9138049. <a href="#_ftnref13" name="_ftn13">13</a>.     American Body & Equipment Co. v. U.S., 511 F.2d 647 (5th Cir. 1975). <a href="#_ftnref14" name="_ftn14">14</a>.   Rev. Rul. 81-255, 1981-2 CB 79. </div></div>

March 13, 2024

3 / Can a taxpayer deduct interest paid on a loan to purchase or carry a life insurance, endowment, or annuity contract?

<div class="Section1" style="text-align: center;">Single Premium Contract</div> <div class="Section1" style="text-align: left;"> Interest paid or accrued on indebtedness incurred to purchase or continue in effect a single premium life insurance, endowment, or annuity contract purchased after March 1, 1954, is not deductible.<a href="#_ftn1" name="_ftnref1">1</a> For this purpose, a single premium contract is defined as one on which substantially all the premiums are paid within four years from the date of purchase, or on which an amount is deposited with the insurer for payment of a substantial number of future premiums.<a href="#_ftn2" name="_ftnref2">2</a> One court has held that payment in the first four years of 73 percent of total annual premiums for a limited-pay policy did not constitute payment of “substantially all” of the premiums.<a href="#_ftn3" name="_ftnref3">3</a> Another court has ruled that payment of eight annual premiums in the first four years on a whole life policy was neither “substantially all” nor a “substantial number” of the premiums.<a href="#_ftn4" name="_ftnref4">4</a> When a single premium annuity is used as collateral to either obtain or continue a mortgage, the IRS has found that IRC Section 264(a)(2) disallows the allocable amount of mortgage interest to the extent that the mortgage is collateralized by the annuity. However, this result does not hold when a taxpayer’s use of available cash to purchase an annuity results in a larger home mortgage or when a taxpayer does not surrender an annuity even though cash obtained from the surrender would make it possible to reduce the amount of the mortgage.<a href="#_ftn5" name="_ftnref5">5</a> A general counsel memorandum has concluded that borrowing against the cash value of a single premium life insurance policy is equivalent to using the policy as collateral.<a href="#_ftn6" name="_ftnref6">6</a> In restating the rule concerning single premium contracts, the conference committee report accompanying the Tax Reform Act of 1986 (TRA ’86) states that “no inference is intended that universal life insurance policies are always treated as single premium contracts.”<a href="#_ftn7" name="_ftnref7">7</a> It is still unclear whether the four exceptions applicable to contracts other than single premium contracts can be used in the case of universal life contracts. Other than Single Premium Contract A deduction is denied under IRC Section 264(a)(3) for interest on indebtedness incurred or continued to purchase or carry a life insurance, endowment, or annuity contract that is not a single premium contract, if it is purchased pursuant to a plan of purchase that contemplates the systematic direct or indirect borrowing of part or all of the increases in the cash value of such contract (either from the insurer or otherwise). </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 264(a)(2). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 264(c). <a href="#_ftnref3" name="_ftn3">3</a>. Dudderar v. Commissioner, 44 TC 632 (1965), acq. 1966-2 CB 4. <a href="#_ftnref4" name="_ftn4">4</a>. Campbell v. Cen-Tex, Inc., 377 F.2d 688 (5th Cir. 1967). <a href="#_ftnref5" name="_ftn5">5</a>. Rev. Rul. 95-53, 1995-2 CB 30 (clarifying and superseding Rev. Rul. 79-41, 1979-1 C.B. 124). <a href="#_ftnref6" name="_ftn6">6</a>. GCM 39534 (7-17-86). <a href="#_ftnref7" name="_ftn7">7</a>. H.R. Conf. Rep. No. 99-841 (TRA ’86) reprinted in 1986-3 CB 341. </div>

March 13, 2024

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

<div class="Section1"> 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.<a href="#_ftn1" name="_ftnref1">1</a> 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.<a href="#_ftn2" name="_ftnref2">2</a> 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.<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Rev. Rul. 74-500, 1974-2 CB 91. <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.264-4(c)(2). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.264-4(b). <a href="#_ftnref4" name="_ftn4">4</a>. GCM 39728 (4-29-88). However, see also PLR 200804010 (acquisition as part of merger not a purchase for purposes of IRC Section 264(a)(3)). </div>