Depending on the disbursements of the loan to specific expenditures, the IRS will classify interest incurred on a loan as: (1) trade or business interest; (2) investment or passive activity interest; or (3) personal interest.
- Trade or business situations – Contracts purchased before June 21, 1986 are not subject to any limit on deductibility of interest. Severe limitations on interest deductions apply in all other policy loan situations making it almost impossible to obtain an interest deduction.
After 1996 legislation, the general rule of nondeductibility for policy loan interest on company owned policies does not apply to policy loan interest paid on policies insuring a key person up to $50,000 of indebtedness. A key person is an officer or 20 percent owner of the taxpayer. The number of persons who may be treated as a key person is limited to the greater of: (1) five persons; or (2) the lesser of 5 percent of the total officers and employees or 20 individuals. Generally, this rule of nondeductibility is applicable to interest paid or accrued after October 13, 1995, but there are several transitional provisions.
Additionally, the Internal Revenue Code imposes an interest rate cap for interest paid or accrued after December 31, 1995. Interest in excess of that which would have been paid had the applicable rate of interest been used cannot be deducted. The applicable rate of interest is that rate described in Moody’s Corporate Bond Yield Average – Monthly Average Corporates as published by Moody’s Investors Service. The Code also specifies a manner in which to determine the applicable rate of interest for pre-1996 contracts.
After 1997, the rule concerning the deduction of policy loan interest states that no deduction shall be allowed for “… any interest paid or accrued on any indebtedness with respect to 1 or more life insurance policies owned by the taxpayer covering the life of any individual.”
Although the exception from the general disallowance rule for policies on key employees and the interest rate caps put in place by 1996 legislation remain unchanged, 1997 legislation added a new provision30 which generally provides that no deduction will be allowed for the part of the taxpayer’s interest expense that is “allocable to unborrowed policy cash values.” This 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 bears to the sum of: (1) in the case of assets that are life policies or annuity or endowment contracts, the average unborrowed policy cash values; and (2) in the case of assets of the taxpayer that do not fall into this category, the average adjusted bases of such assets.
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 the loan with respect to the policy or contract.
Finally, there is an exception to the general rule of nondeductibility of interest expense allocable to unborrowed policy cash values. The exception applies to policies and contracts owned by entities if the policy covers only one individual who, at the time first covered by the policy, is: (1) a 20 percent owner of the entity; or (2) an individual who is an officer, director or employee of the trade or business. A policy or contract will not fail to come within this exception simply because it covers both the owner and the owner’s spouse. Apparently, spouses of officers, directors, or employees who are not also 20 percent owners cannot be covered and still have the policy or contract qualify for this exception.
- Investment or passive activity situations – In the authors’ opinion, where the policyowner can document that the proceeds of a policy loan were used to purchase an investment or expended on a passive activity, the interest should be considered investment interest or passive activity interest. For instance, if a policy loan was used to help the policyowner purchase land to be used for development, the loan interest should be deductible subject to investment interest limitations.
- Personal situations – In personal situations, the rule is simple and absolute. Interest on a policy loan is not deductible if it is neither trade or business nor investment interest.
Single Premium Contracts
Even if a deduction is otherwise allowable, no deduction is allowed for interest paid or accrued on indebtedness incurred to purchase or continue in effect a single premium life insurance contract. The term single premium is defined broadly. Essentially it is a policy on which substantially all the premiums are paid within four years of the date the policy was purchased or a policy on which an amount is deposited with the insurer for the payment of a substantial number of premiums.
The interest deduction prohibition applies to existing as well as to newly-issued policies. If an existing policy which falls into the definition of single premium is pledged as collateral for a loan, it is likely that interest on that loan will not be deductible.
Financing the Policy through Policy Loans
Generally, even if a deduction is otherwise allowable, when premium payments are financed through policy loans, no deduction is allowed for interest payments. There are four exceptions to this general rule:
- Four-out-of-seven premiums paid without borrowing (the “four-out-of-seven” rule) – As its name implies, if no part of four of the first seven years’ annual premium, measured after the date of issue (or after the last substantial increase in premiums if later) are paid through a loan, the interest deduction will be allowed (if otherwise deductible). Stated in the reverse manner, if more than three premiums are borrowed during the first seven policy years (or during the first seven years after the last substantial increase in premiums), even if the interest would otherwise be deductible, it may not be deducted. Once the four-out-of-seven test is failed, not only are prior interest deductions lost but all future deductions are barred as well.
Repayment of the loans during or after the seven-year period will not wash the taint. Once the four-out-of-seven rule is violated by the payment of more than three premiums by loans, interest can never qualify for a deduction. Nor can the taint be removed by a gift or even a sale of the policy. The new owner carries over both payments by loan and payments by debt from the prior owner. So if the old owner borrowed two years’ premiums, the new owner can borrow only one more without jeopardizing the interest deduction. Conversely, if the old owner had paid four premiums without borrowing, the new owner can borrow all of the next three years’ premiums. The bottom line is that a new seven-year period does not begin merely because of a change of ownership.
If the seven-year rule is met during the first seven years, there is no limit to the amount that can be borrowed in subsequent years (assuming no substantial increase) in premiums. This means the policyowner could borrow the policy’s entire cash value for any purpose whatsoever every year starting in the eighth policy year. Assuming the interest was otherwise deductible, it would not be barred by the tax prohibition regarding financing of premiums through loans.
Most experts feel that the IRS would not bar interest deductions on loans from universal life contracts merely because there is no specified premium that must be paid during each of the first seven years. Some say that the safest course of action is for the policyowner to pay four out of the first seven of the lowest premiums necessary to sustain the policy. Others say that no borrowing is permissible in a universal life policy.
- The $100 exception – Even if there is found to be a systematic plan of borrowing to pay premiums, the interest deduction will not be disallowed if the interest does not exceed $100 for the policyowner’s taxable year. This is an “all or nothing” exception. The entire deduction, not merely the excess, will be disallowed if the interest incurred in a year is more than $100. So, for most business-owned policies, this exception is a minor one.
- The unforeseen events exception – A deduction is not disallowed even if there is a loan and even if that loan is used to pay premiums if the reason for the systematic plan of borrowing was either that: (a) there was an unforeseen substantial increase in the policyowner’s financial liability; or (b) the policyowner suffered an unforeseen substantial loss in income.
The interest deduction will be disallowed if the economic shock was foreseeable at the time the policy was purchased. For instance, college education or retirement expenses are both foreseeable events. On the other hand, a layoff or firing is not.
- Trade or business exception – An otherwise allowable interest deduction will not be disallowed if the loan was incurred in connection with the taxpayer’s trade or business. But this requires that the policyowner prove that the amounts borrowed against the life insurance contract were actually used for business purposes. Business purposes, however, do not include outlays for key employee, buy-sell coverage, split dollar agreements, or retirement plans. Thus, the policyowner must be able to document (perhaps by a tracing of cash flows showing how the funds were used) not only indebtedness, but also a business purpose other than the purchase of cash value life insurance. The IRS will look at all the facts and circumstances of each case. If it finds that other business loans increase annually by the same amount as the premiums on a new policy, it will probably disallow the interest deduction. But probably the interest deduction on regular business loans (for instance indebtedness to purchase new equipment) will not be disallowed merely because the business used money in a year to buy life insurance instead of paying off or paying down the loan.
Interest Paid on Conversion of a Term Policy
Where a term policy is converted into a permanent contract, in some cases that conversion is made on an original age basis. This means the new contract is issued as though the policy were originally permanent coverage. The advantage is that premiums will be much lower than if the new policy were issued on an attained age basis. But to restore the insurer to where it would have been had the policy really been issued at the insured’s original age, the policyowner must pay back premiums plus interest (the difference between the premiums that have actually been paid on the term policy and the premiums that would have been paid on the permanent policy had it been issued instead of the term contract plus interest on that difference at a specified annual rate). This interest is not deductible.
Policy Loan to Purchase Tax-Exempt Securities
No deduction is allowed for interest on a loan incurred or continued to purchase or carry tax exempt securities. If the loan is taken out to finance the purchase of any type of tax exempt asset, an interest deduction is barred. On the other hand, if the deduction is otherwise allowable, it will not be blocked merely because the policyowner also held tax exempt securities.
Timing of Interest Deduction
In those rare cases where policy loan interest is allowable as a deduction, the timing of the deduction becomes important. Some of the basic rules concerning the timing of the interest deduction and the party who can take it:
- Accrual basis policyowners take the deduction in the year interest -accrues even if payment of the interest has not been made in that year.
- Cash basis policyowners take the deduction only in the year that the interest is paid.
- Only the policyowner may take a deduction and only if the policyholder has paid the interest. A father, for example, cannot pay and deduct interest on a policy owned by his son nor can a shareholder pay and deduct interest on a policy owned by his corporation. But interest otherwise deductible will not be disallowed if the loan (including interest) reduces the benefit paid at an insured’s death. The IRS will treat the situation as though interest were paid at the time of the insured’s death. An assignee cannot deduct interest that accrued before the policy was transferred to him.
Taxation of Policyowner or Insured in Business Situations
If the employer is directly or indirectly a beneficiary of the insurance contract, then the insured-employee is not taxed on the corporation’s payment of policy premiums.
The policyowner may be subject to income tax in a number of situations. These include:
- where an insured’s employer pays premiums on a policy owned by employee (or employee’s third party assignee) and proceeds are paid to employee’s named beneficiary or estate;
- where the proceeds of a policy owned by the corporation are payable to the personal beneficiary or estate of an employee.
- Where a corporate owned policy will be used to fund a stock redemption agreement in which the corporation will use the proceeds to buy back its own stock, premiums the corporation pays will not be taxed to any shareholder.
- Where a policy to fund a buy-sell agreement is personally owned by a shareholder and the shareholder has named a personal beneficiary or designated his or her estate as recipient of policy proceeds, premium payments by the corporation may be considered a distribution of dividends.
Likewise, where a policy on one person’s life (e.g., another shareholder) is owned by a coshareholder (for instance to fund a buy-sell agreement), premium payments made by the corporation will be considered dividends or compensation paid on a shareholder-employee’s behalf.
For life insurance contracts entered into after August 17, 2006, certain requirements must be met for the death proceeds of an employer-owned life insurance contract to be received income-tax free. One set of requirements is that before an employer-owned life insurance contract is issued, the employer must meet certain notice and consent requirements. The insured employee must be notified in writing that the employer intends to insure the employee’s life, and the maximum face amount the employee’s life could be insured for at the time the contract is issued. The notice must also state that the policy owner will be the beneficiary of the death proceeds of the policy. The insured must also give written consent to be the insured under the contract and consent to coverage continuing after the insured terminates employment.
Another set of requirements regards the insured’s status with the employer. The insured must have either been an employee at any time during the twelve-month period before his death, or, at the time the contract was issued, a director or highly compensated employee.
Alternatively, the death proceeds of employer-owned life insurance will not be included in the employer’s income (assuming the notice and consent requirements are met) if the amount is paid to a member of the insured’s family (defined as a sibling, spouse, ancestor, or lineal descendent), any individual who is the designated beneficiary of the insured under the contract (other than the policy owner), a trust that benefits a member of the family or designated beneficiary, or the estate of the insured. If the death proceeds are used to purchase an equity interest from a family member, beneficiary, trust, or estate, the proceeds will not be included in the employer’s income.
An employer-owned life insurance contract is defined as a life insurance contract owned by a person or entity engaged in a trade or business and that person or entity (or certain related persons) is a beneficiary under the contract, and the contract covers the life of an insured who is an employee when the contract is issued.
Taxation of Policyowner in Creditor Situation
If a creditor receives life insurance proceeds as payment of the debt, the IRS may claim that the proceeds should not be considered tax-free life insurance proceeds. For instance, in a collateral assignment (nonsplit dollar) case where a creditor must prove the existence and amount of debt in order to collect the proceeds, proceeds are received because of the indebtedness rather than because of the insured’s death. Of course, the creditor could still receive the proceeds income tax free as a recovery of basis (the sum of any unpaid debt and premiums paid but not deducted) except to the extent the creditor already enjoyed a bad debt deduction.
Taxation of Policyowner in Alimony Situations
Where the insured pays premiums on a life insurance policy pursuant to a divorce or separation agreement signed after 1984, payments are taxable as alimony to the noninsured spouse owner.
Taxation of Advance Premium Deposits
A discount is allowed to a policyowner who pays premiums more than one year before they fall due. The IRS taxes the interest increment earned on those prepaid premiums.
This makes the fund, set aside by the policyowner and placed in the insurer’s hands, taxable before it is applied to pay premiums. Each year, as the interest on the remaining discounted fund is applied toward the payment of a new year’s premium (or when it becomes available to be withdrawn by the policyowner without substantial restrictions or limitations); it is considered constructively received and therefore taxable. If the interest cannot be taken by the policyowner, it becomes taxable each year when it is applied toward the payment of the next due annual premium. If the policyowner cashes in a policy or it matures, the policyowner can lower taxable gain by any advance premiums paid and any interest increments that were already taxed. In other words, the policyowner can include in his basis the sum of discounted premiums plus interest upon which he paid tax.
Taxation of Accelerated Death Benefits
Amounts received under a life insurance contract on the life of a terminally ill insured will be treated as an amount paid by reason of the death of the insured and are therefore not includable in the insured’s gross income.
Amounts paid on behalf of a chronically ill individual are subject to the same limitations applying to long-term care benefits. They are treated as tax-free amounts paid by reason of the death of the insured as long as they don’t exceed the greater of the actual costs incurred for qualified long-term care services provided for the insured or the $330 per day limitation in effect for 2015 (as indexed for inflation).
There are several special rules that apply to chronically ill insureds. Generally, the favorable tax treatment outlined above will not apply to any payment received for any period unless such payment is for costs incurred by the payee (who has not been compensated by insurance or otherwise) for qualified long-term care services provided to the insured for the period (note that with an indemnity type of chronic illness rider, as opposed to a reimbursement rider, the benefits may be used for any purpose). Additionally, the terms of the contract under which such payments are made must comply with the requirements of Code section 7702B plus several other requirements.
Terminally ill is defined as an illness or physical condition that can reasonably be expected to result in death within twenty-four months following certification by a doctor. A chronically ill individual is a person who is not terminally ill and who has been certified by a physician as being unable to perform, without substantial assistance, at least two activities of daily living for at least ninety days or a person with a similar level of disability. Further, a person may be considered chronically ill if he requires substantial supervision to protect himself from threats to his health and safety due to severe cognitive impairment and this condition has been certified by a health care practitioner within the previous twelve months.
There is one exception to this general rule of nonincludability for accelerated death benefits. The rules outlined above do not apply to any amount paid to any taxpayer other than the insured if the taxpayer has an insurable interest in the life of the insured because the insured is a director, officer or employee of the taxpayer or if the insured is financially interested in any trade or business of the taxpayer.
Sale of a Life Insurance Policy
Prior to 2009 the general rule was that gain on the sale of a life insurance contract was taxable as ordinary income. Gain was determined as if the contract had been surrendered by the policyowner. So the excess of the sales proceeds over the net premium cost (premiums paid less tax free dividends received) was taxable.
In 2009 the IRS issued guidance providing that the sale of a life insurance policy may produce both ordinary income and capital gains taxes. The amount of taxable income is the difference between the sale proceeds and the policyholder’s adjusted basis in the policy (aggregate premium payments minus cost of insurance charges). The portion of taxable income that will be considered ordinary income is the difference between the cash surrender value and the aggregate premiums (i.e., the taxable amount for an ordinary cash surrender). The portion of taxable income that will be considered capital gains is the difference between the sale price of the policy and the adjusted basis in the policy minus any amounts subject to ordinary income tax.
The facts of 2009 guidance involved a sale to an unrelated third party who had no insurable interest in the life of the insured (i.e., an investor or life settlement company). It is unclear whether the 2009 guidance would apply to a sale involving a related third party or a party that has an insurable interest in the life of the insured. In the authors’ opinion such a sale would be governed by the pre-2009 rules applicable to the sale of life insurance policy.
Generally, if a life insurance policy is sold for less than its basis, no loss deduction is allowed since most courts have characterized the portion of the policyowner’s premium going toward pure insurance protection as a current expense rather than an investment. The balance of the premium is directed toward policy reserves so to the extent that policy reserves and cash value are the same, no loss has been incurred.
If the policy is sold at less than its fair market value, the difference in this bargain sale may be taxable income to the buyer in certain situations. For instance, if a business sells a key employee policy to the insured employee, the excess of the policy’s fair market value over the price paid will be taxed to the buyer as additional compensation.
Suppose a corporation pays an annual premium today and then tomorrow sells a policy on an employee’s life to her in return for an amount equal to its cash value. The difference between the value received and the amount paid is treated as a bonus to the employee. Since the policy’s value will often exceed the cash surrender value, even a sale of a policy for its cash value on the last day of a policy year may result in taxable income to the employee.
These same rules apply where an employee or shareholder sells a policy to a corporation; ordinary income is realized by the seller to the extent that the value of the policy exceeds net premium cost.
Corporate Distribution of a Policy
In some situations, life insurance policies have been used by a corporation to pay for the purchase of stock or other assets. For instance, assume a corporation buys back its own stock or purchases land and in return pays for the purchase by distributing a life insurance policy on the life of the selling shareholder or landowner. Here, the transaction is considered an exchange of the policy for stock (or land). The seller of the stock would realize gain equal to the excess of: (1) the value of the policy over; (2) the seller’s basis in the stock (or land). That gain would be capital gain if the parties can prove that the policy was given in exchange for the property the corporation receives.
A more common scenario is that a business may distribute a policy on the life of an employee or shareholder. If this property transfer occurs in connection with the performance of services (i.e., a Section 83 transfer), then the value of the policy for distribution purposes is its Fair Market Value (FMV). IRS guidance provides that the safe harbor fair market value for life insurance is the greater of Interpolated Terminal Reserve (ITR) or PERC (premiums plus earnings minus reasonable charges – essentially the cash value without regard to surrender charges).
If the transferee is a shareholder of a C corporation, then the FMV of the policy transferred may constitute a taxable dividend. If the transferee is an owner of a pass-through entity (partnership, limited liability company (LLC) or S corporation), then the FMV value of the policy will serve to reduce the owner’s outside basis first. With LLC or partnerships, any excess FMV reduces the basis of the policy transferred. With S corporations, any excess FMV is taxed as capital gain. If the transferee is a nonowner employee, then the FMV of the policy will constitute taxable compensation (and the basis of the policy going forward will be the FMV of the policy at the time of the transfer plus any additional premiums paid into the policy).
From the business’ perspective, the transfer may also have income tax consequences. With S and C corporations, any gain in the policy at the time of transfer is taxable to the corporation. If the transfer constitutes taxable compensation to the transferee, then the corporation will receive a deduction that likely more than offsets its taxable income. With LLCs and partnerships, a transfer to an owner is disregarded for income tax purposes and no gain is triggered at the time of the transfer. However, if the transfer is to a nonowner employee, then gain should be triggered, but an offsetting deduction for the full FMV of the policy should be available.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM