Policy Loans

March 13, 2024

35 / If the beneficiary of life insurance pays the interest on a policy loan, is this a gift to the insured?

<div class="Section1">No, there is no gift to the insured, unless the insured owns the policy.<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>. Seligmann v. Commissioner, 9 TC 191 (1947). </div>

March 13, 2024

32 / How is interest expense allocated to life insurance policy cash values?

<div class="Section1"> No deduction is allowed for the portion of the taxpayer’s interest expense that is allocable to unborrowed policy cash values. The portion that is allocable to unborrowed policy cash values is an amount that bears the same ratio to the interest expense as the taxpayer’s average unborrowed policy cash values of life insurance policies and annuity and endowment contracts issued after June 8, 1997, bear to the sum of: (1) the average unborrowed policy cash values, in the case of the taxpayer’s assets that are life insurance policies or annuity or endowment contracts, and (2) the average adjusted bases of such assets in the case of the taxpayer’s assets that do not fall into this category.<a href="#_ftn1" name="_ftnref1">1</a> “Unborrowed policy cash value” is defined as the excess of the cash surrender value of a policy or contract (determined without regard to surrender charges) over the amount of any loan with respect to the policy or contract. For purposes of this provision, if the cash surrender value of a policy determined without reference to any surrender charge does not reasonably approximate its actual value, the amount taken into account is the greater of the amount of the insurance company liability or the insurance company reserve for the policy.<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>. IRC § 264(f). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 264(f)(3). </div>

March 13, 2024

29 / Are life insurance policy loans taxable?

<div class="Section1"> A loan taken from a life insurance policy that is not classified as a modified endowment contract under IRC Section 7702A is not includable in income because it is not treated as a distribution under IRC Section 72.<a href="#_ftn1" name="_ftnref1">1</a> By contrast, a loan taken from a life insurance policy that is classified as a modified endowment contract is treated as a distribution under IRC Section 72 and is includable in income at the time received to the extent that the cash value of the contract immediately before the distribution exceeds the investment in the contract ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="13">13</a>).<a href="#_ftn2" name="_ftnref2">2</a> Unless the loan is made under certain specific circumstances ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="13">13</a>), a 10 percent penalty tax is imposed on the amount of the loan that is includable in gross income.<a href="#_ftn3" name="_ftnref3">3</a> If a loan is still outstanding when a policy is surrendered or allowed to lapse, the borrowed amount becomes taxable at that time to the extent the cash value exceeds the owner’s basis in the contract, as if the borrowed amount was actually received at the time of surrender or lapse and used to pay off the loan.<a href="#_ftn4" name="_ftnref4">4</a> If a loan is outstanding at the time of death, the distribution of the face amount of the policy usually is reduced by the amount of the outstanding loan. <hr> Planning Point: Because withdrawals from life insurance policies not classified as modified endowment contracts are ordinarily not subject to income tax up to the amount of cost basis in the contract, it is typical to first take withdrawals until basis is exhausted and then take policy loans. By taking withdrawals up to basis and then by taking loans after that, amounts received from the policy during lifetime can be maximized and income taxes minimized. However, it is important that a program of withdrawals and loans be carefully monitored so as not to result in a policy lapse which could cause adverse income tax consequences as well as loss of the policy death benefit. <hr> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 72(e)(5). <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 72(e). <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 72(v). <a href="#_ftnref4" name="_ftn4">4</a>.     Atwood v. Commissioner, TC Memo 1999-61. </div></div>

March 13, 2024

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

<div class="Section1">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.<a href="#_ftn1" name="_ftnref1">1</a></div> <div></div> <div class="Section1">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.<a href="#_ftn2" name="_ftnref2">2</a>Generally, 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.<a href="#_ftn3" name="_ftnref3">3</a>Interest 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).<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 264(e)(1). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 264(e)(3). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 264(e)(5)(A). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 264(e)(2). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 264(e)(2)(B)(ii). <a href="#_ftnref6" name="_ftn6">6</a>. HIPAA ’96, § 501(d)(1). </div>

March 13, 2024

33 / Are there any exceptions to the general rule of nondeductibility of policy loan interest for unborrowed policy cash values?

<div class="Section1"> There is an exception to the general rule of nondeductibility of policy loan interest expense that is allocable to unborrowed policy cash values. The exception applies to any policy or contract owned by an entity engaged in a trade or business if the policy or contract covers only one individual who, at the time first covered by the policy or contract, is: (1) a 20 percent owner of the entity, or (2) an individual who is not a 20 percent owner but who is an officer, director, or employee of the trade or business. (A 20 percent owner is defined in IRC Section 264(e)(4)). A policy or contract covering a 20 percent owner will not fail to come within this exception simply because it covers both the owner and the owner’s spouse. Apparently, however, the policy will not qualify for this exception if spouses of officers, directors, or employees who are not also 20 percent owners are covered. For purposes of this rule, if coverage for each insured under a master contract (that is not a group life insurance contract) is treated as a separate contract for certain purposes, the coverage for each insured is treated as a separate contract.<a href="#_ftn1" name="_ftnref1">1</a> The exception is effective generally for contracts issued after June 8, 1997, in taxable years ending after this date. For purposes of this effective date, any material increase in the death benefit or other material change in the contract will be treated as a new contract. However, in the case of a master contract, the addition of covered lives is treated as a new contract only with respect to the additional covered lives.<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>. IRC § 264(f)(4)(E). <a href="#_ftnref2" name="_ftn2">2</a>. TRA ’97 § 1084(d), as amended by IRSRRA ’98 § 6010(o)(3)(B). See IRC § 264(f)(4)(E) for the definition of “master contract.” </div>

March 13, 2024

30 / Can a life insurance policy owner take an income tax deduction for the interest paid on a policy loan?

<div class="Section1"> To be deductible, interest paid by a policy owner on a policy loan must meet the rules discussed below and, if applicable, the rules discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4">4</a>. However, even if the interest is deductible under those rules, the amount of the deduction may be limited depending on whether the interest is classified as personal interest, trade or business interest, investment interest, or interest taken into account in computing income or loss from passive activities. Generally, the determination is made by tracing the use to which the loan proceeds are put.<a href="#_ftn1" name="_ftnref1">1</a> Thus, interest on a loan used to pay premiums on personal life insurance may come within an exception explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4">4</a>, but the deduction may not be available because personal interest is not deductible. There is little guidance as to whether interest on a loan used to buy life insurance can be considered investment interest. Borrowing to finance business life insurance generally has not been considered incurred in connection with the borrower’s trade or business. General Rule of Nondeductibility for Policy Loan Interest (Contracts Issued After June 8, 1997) Generally, no deduction is allowed for any interest paid or accrued on any indebtedness with respect to life insurance policies owned by a taxpayer covering the life of any individual, or any endowment or annuity contracts owned by the taxpayer covering any individual.<a href="#_ftn2" name="_ftnref2">2</a> This provision generally is effective for contracts issued after June 8, 1997, in taxable years ending after this date. For purposes of this effective date, any material increase in the death benefit or other material change in the contract will be treated as a new contract. However, in the case of a master contract, the addition of covered lives is treated as a new contract only with respect to the additional covered lives.<a href="#_ftn3" name="_ftnref3">3</a> The IRS has ruled that disallowed interest under IRC Section 264(a)(4) reduces earnings and profits for the taxable year in which the interest would have been allowable as a deduction but for its disallowance under that section. It does not further reduce earnings and profits when the death benefit is received under a life insurance contract.<a href="#_ftn4" name="_ftnref4">4</a> General Rule of Nondeductibility for Policy Loan Interest (Contracts Issued Prior to June 9, 1997) For contracts issued prior to June 9, 1997, the general rule under IRC Section 264(a)(4) states that no deduction is allowed for any interest paid or accrued on any indebtedness with respect to life insurance policies owned by a taxpayer that covered the life of any individual who is an officer or employee of, or who is financially interested in, any trade or business carried on by the taxpayer. The same rule applies to any endowment or annuity contracts owned by a taxpayer that cover any individual.<a href="#_ftn5" name="_ftnref5">5</a> Prior to legislation enacted in 1996, there was an exception to this general rule for policies with less than $50,000 of indebtedness. However, effective for interest paid or accrued after October 13, 1995, the ability to deduct policy loan interest paid on company-owned life insurance policies with loans of less than $50,000 was eliminated.<a href="#_ftn6" name="_ftnref6">6</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     Temp. Treas. Reg. § 1.163-8T. <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 264(a)(4). <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 264(f)(4)(E) for the definition of “master contract.” TRA ’97 § 1084(d), as amended by IRSRRA ’98 § 6010(o)(3)(B). <a href="#_ftnref4" name="_ftn4">4</a>.     Rev. Rul. 2009-25, 2009-38 IRB 365. <a href="#_ftnref5" name="_ftn5">5</a>.     IRC § 264(a)(4), prior to amendment by TRA ’97 § 1084(b)(1). <a href="#_ftnref6" name="_ftn6">6</a>.     IRC § 264(a)(4), as amended by HIPAA ’96 § 501(a) but before amendment by TRA ’97 § 1084. </div></div>

March 13, 2024

34 / What are the general interest deduction rules?

<div class="Section1"> As a general tax principle, interest is deductible by a cash basis taxpayer only to the extent the taxpayer actually pays it in cash or cash equivalent in the tax year.<a href="#_ftn1" name="_ftnref1">1</a> Thus, if the interest due on a policy loan is not paid but is merely deducted [withdrawn] by the insurer from principal at the time of making the loan or merely added to loan principal, it is not currently deductible by a cash basis taxpayer.<a href="#_ftn2" name="_ftnref2">2</a> Likewise, a cash basis taxpayer cannot deduct interest owing on a policy loan that is deducted by the insurer from the proceeds of a new loan with the balance being remitted to the policyholder.<a href="#_ftn3" name="_ftnref3">3</a> But if interest that has been deducted from or added to the principal amount of the policy loan is later paid, it is deductible by the cash basis taxpayer when paid.<a href="#_ftn4" name="_ftnref4">4</a> If the interest has been added to the loan principal, a deduction is allowable when, on maturity or surrender of the policy or on the death of the insured, the insurer deducts the accumulated interest from the proceeds.<a href="#_ftn5" name="_ftnref5">5</a> Cash basis taxpayers deduct prepaid interest over the period to which it relates, not in the year it is prepaid.<a href="#_ftn6" name="_ftnref6">6</a> An accrual basis taxpayer can deduct interest in the year it accrues, regardless of whether the interest is actually paid in that year.<a href="#_ftn7" name="_ftnref7">7</a> Only the person who owns a policy when the interest accrues is entitled to the deduction. A policy owner who takes out a policy loan and later makes an absolute assignment of the policy subject to the loan is not entitled to deduct interest that accrues after the assignment. For example, if a father continues to pay interest on policy loans after giving the policy to his children, he cannot deduct payments of interest accruing after the transfer.<a href="#_ftn8" name="_ftnref8">8</a> Nor can a husband deduct on a separate return the interest he pays on a policy loan when the policy is owned by his spouse.<a href="#_ftn9" name="_ftnref9">9</a> Similarly, a person to whom the policy has been assigned cannot pay and deduct interest that has accrued before the assignment.<a href="#_ftn10" name="_ftnref10">10</a> When a policyholder makes unspecified installment payments covering both premiums and interest, payments will be applied first toward premiums, and only the balance will be considered deductible interest.<a href="#_ftn11" name="_ftnref11">11</a> Payments specified and applied as interest, however, will be treated as such.<a href="#_ftn12" name="_ftnref12">12</a> IRC Section 265(a)(2) forbids the deduction of interest on loans to purchase or carry tax-exempt investments. Borrowing to enable an insured to buy a key person policy on the insured from the insured’s employer was held sufficiently unrelated to the insured’s investment in tax-exempt bonds so that interest on the loan was deductible to the extent that the tax-exempt bonds were not used as collateral for the loan.<a href="#_ftn13" name="_ftnref13">13</a> Several cases have disallowed the deduction of interest on loans that were considered “sham” transactions – that is, transactions that offered the taxpayer nothing of economic substance other than a hoped-for deduction.<a href="#_ftn14" name="_ftnref14">14</a> Annual loans against cash value to pay current premiums were not considered “sham” in Coors v. U.S.,<a href="#_ftn15" name="_ftnref15">15</a> Lee v. U.S.,<a href="#_ftn16" name="_ftnref16">16</a> and Golsen v. U.S.<a href="#_ftn17" name="_ftnref17">17</a> The important factors in these cases were the following: <blockquote>There was no prepayment of interest or premiums; The owner needed liquidity to meet premium payments; Death benefits were at all times substantial; Policies were standard policies; and The loans were straightforward, ordinary, and available to any policyholder.<a href="#_ftn18" name="_ftnref18">18</a></blockquote> The deduction of interest on a policy loan in each of the first three policy years and the subsequent surrender of the policy in the fourth year was not considered a sham when a change in the tax law eliminated the insured’s need for the policy death benefit.<a href="#_ftn19" name="_ftnref19">19</a> In a case involving corporate owned life insurance policies, the Tax Court held that payments from the corporation to the insurance companies were not “interest” paid on policy loans but were, in fact, constructive dividends to the insured shareholders. The court noted that payment of these amounts by the corporation conferred an economic benefit on the shareholders by increasing both the policy cash values and the death benefits.<a href="#_ftn20" name="_ftnref20">20</a> Deduction of interest paid on a policy loan by a grantor trust is discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="152">152</a>; the deductibility of interest on a loan under a tax-sheltered annuity is discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4068">4068</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.       IRC § 163; Treas. Reg. § 1.163-1. <a href="#_ftnref2" name="_ftn2">2</a>.       Rev. Rul. 73-482, 1973-2 CB 44. <a href="#_ftnref3" name="_ftn3">3</a>.       Keith v. Commissioner, 139 F.2d 596 (2d Cir. 1944). <a href="#_ftnref4" name="_ftn4">4</a>.       Rev. Rul. 73-482, 1973-2 CB 44. <a href="#_ftnref5" name="_ftn5">5</a>.       Estate of Hooks v. Commissioner, 22 TC 502 (1954), acq. 1955-1 CB 5. <a href="#_ftnref6" name="_ftn6">6</a>.       IRC § 461(g). <a href="#_ftnref7" name="_ftn7">7</a>.       IRC § 461(h). <a href="#_ftnref8" name="_ftn8">8</a>.       Dean v. Commissioner, 35 TC 1083 (1961). <a href="#_ftnref9" name="_ftn9">9</a>.       Colston v. Burnet, 59 F.2d 867 (DC Cir. 1932); see also Sherman v. Commissioner, 18 TC 746 (1952), nonacq. 1964-2 CB 9. <a href="#_ftnref10" name="_ftn10">10</a>.     Fox v. Commissioner, 43 BTA 895 (1941); Orange Securities Corp. v. Commissioner, 45 BTA 24 (1941). <a href="#_ftnref11" name="_ftn11">11</a>.     Evans v. Commissioner, 5 TCM (CCH) 438 (1946). <a href="#_ftnref12" name="_ftn12">12</a>.     Kay v. Commissioner, 44 TC 660 (1965). <a href="#_ftnref13" name="_ftn13">13</a>.     Levitt v. U.S., 517 F.2d 1339 (8th Cir. 1975). <a href="#_ftnref14" name="_ftn14">14</a>.     American Elec. Power Co. v. U.S., 2003-1 USTC ¶ 50,416 (6th Cir. 2003); IRS v. CM Holdings, Inc., 2002-2 USTC ¶ 50,596, 301 F.3d 96 (3d Cir. 2002); Winn-Dixie Stores, Inc. v. Commissioner, 254 F. 3d 1313, 2001-2 USTC ¶ 50,495 (11th Cir. 2001). <a href="#_ftnref15" name="_ftn15">15</a>.     215 Ct. Cl. 840 (1978). <a href="#_ftnref16" name="_ftn16">16</a>.     215 Ct. Cl. 831 (1978). <a href="#_ftnref17" name="_ftn17">17</a>.     80-2 USTC 9741. <a href="#_ftnref18" name="_ftn18">18</a>.     Coors v. U.S., 215 Ct. Cl. 840 (1978). <a href="#_ftnref19" name="_ftn19">19</a>.     Shirar v. Commissioner, TC Memo 1987-492, rev’d, 916 F.2d 1414 (9th Cir. 1990). <a href="#_ftnref20" name="_ftn20">20</a>.    Young v. Commissioner, TC Memo 1995-379. </div></div>