G—Tax Treatment Of Policy
Loan Interest
With regard to interest on policy loans, because of a series
of changes in the Code, a variety of rules are applicable, depending upon the
identity of the policy owner, the tax year involved and the date of issue of the
policy. In all cases, interest which is accrued and added onto the principal of
a policy loan, and not currently paid in cash, is not deductible by a cash
basis taxpayer when accrued. If deductible at all, it would only be as of
the date the loan (including the accrued interest) is repaid.
Insurance Policies Owned By Individuals
In general, three rules are applicable for insurance policies
owned by individuals. As mentioned above, interest which is accrued and added
onto the principal of a policy loan, and not currently paid in cash, is not
deductible by a cash basis taxpayer when accrued. If deductible at all,
it would only be as of the date the loan (including the accrued interest) is
repaid. However, interest is not deductible in any event if the underlying
loan is for personal purposes, as opposed to investment or business purposes
(in the case of an investment or business purpose the investment interest
expense limitation and passive activity limitation are applicable). And
finally, even if otherwise deductible, interest paid on indebtedness incurred
or continued to pay annual premiums on a life, endowment or annuity contract is
not deductible if paid pursuant to a plan of purchase which contemplates a
systematic direct or indirect borrowing of part or all of the increases in cash
value; or, where a taxpayer incurs or continues indebtedness in order to
finance a single-premium life insurance, endowment, or annuity contract.
Deductibility Of
Policy Loan Interest For Business Owned Policies—Tax Years After 1996
As part of the Health Insurance Portability and
Accountability Act of 1996, I.R.C. §264 was amended to disallow any deduction
for interest on business-owned life insurance policy loans, with a limited
exception for certain defined "key person" policies. (The
change from prior law was subject to a transitional phase-in period under which
prior law may remain applicable to certain interest incurred after October 13,
1995 and prior to 1999.) If the insured falls within the definition of
"key person" interest is deductible to the extent that the
indebtedness on policies covering such person does not exceed $50,000. A
"key person" is defined as an officer or 20 percent owner of the
taxpayer/employer. There is a limitation on the number of individuals who
may qualify as key persons, as spelled out in more detail in Code §264(e)(3).
The Taxpayer Relief Act of 1997 imposed another, indirect,
limitation upon the deductibility of interest in general by a company which, owns a cash value life insurance contract. I.R.C.
§264(f) generally requires corporations which own
cash value insurance contracts issued after June 8, 1997 (with certain
exceptions) to reduce their otherwise deductible aggregate interest expense
(whether or not related to the insurance contract(s)) by applying a ratio keyed
to "unborrowed policy cash value." The
Internal Revenue Service Restructuring and Reform Act of 1998 added an
exception to this rule that excludes certain key persons from its application.
[See I.R.C. §264(f)(4)(E)].
Deductibility Of Policy Loan Interest
For Business Owned Policies—Tax Years Prior To 1997
Under the version of §264(a) which applied to tax years prior
to 1997, where the business-owned policy is on the life of an officer, employee
or other person financially interested in a business conducted by the taxpayer,
interest on a policy loan is generally deductible if the policy was issued on
or before June 20, 1986. For policies issued after
If a cash-basis policyholder does not pay his loan interest
in cash, but has interest discounted from the amount he receives, or has it
added to principal, he cannot deduct it then. He must make an actual payment to
the insurance company before he can take the deduction [Keith v. Comm`r, 139 F.2d 596; Nina Cornelia Prime, 39 B.T.A. 487;
Albert J. Alsberg, 42 B.T.A. 61; Rev. Rul. 73-482, 1973-2 C.B. 44]. The deduction will be allowed
where payment is made by a lending institution acting as agent for a
policyholder [Murray Kay, 44 T.C. 660]. If he pays such interest in a later
year, he deducts it at that time [Rev. Rul. 73-482,
supra].
Where a cash-basis policyholder has his interest added to
principal, and later surrenders the policy, he may deduct this interest in the
year of surrender. If the policy matures as an endowment, he may deduct such
interest at maturity. In these cases the interest is actually paid at surrender
or maturity when the same insurance company subtracts the loan (including this
interest) from the cash value or maturity proceeds.
Similarly, interest added to principal becomes deductible
when the policyholder dies. Here the company collects the loan (including such
interest) from the death proceeds [Est. of Pat E. Hooks, supra].
The Tax Court, in the Hooks case, did not decide whether this
interest is deductible in the decedent`s final return
or in the beneficiary`s return.
It is reasonable to assume that discounted interest becomes
deductible for a cash-basis taxpayer in the same manner as unpaid interest
added to principal in the surrender, death and maturity situations.
Where a policyholder makes unspecified payments for both
premiums and loan interest, the remittances are applied first to premiums and
then to interest. Keeping the policy in force is of primary importance [Hiram
W. Evans, 5 T.C.M. 336]. Payments specified and applied as interest will be
treated as such [Murray Kay, supra].
An accrual-basis taxpayer deducts his interest each year as
it accrues, regardless of whether he pays it in cash
[M.G. Corlett, 5 T.C.M. 94].
A taxpayer cannot deduct interest he pays on another`s debt. Hence, only the policy owner can deduct
policy loan interest. If someone else pays it, no deduction is allowable.
Further Limitation On
Deductibility Of Policy Loan Interest— Financed Single Premium Policy
Even if otherwise deductible, where a taxpayer incurs or
continues indebtedness in order to finance a single-premium life insurance,
endowment, or annuity contract, his interest payments are nondeductible [I.R.C.
§264(a)(2)]. For purposes of this rule, a single-premium contract includes an
annual-premium policy on which substantially all the premiums were paid within
four years after issuance [I.R.C. §264(b)(1)]. A single-premium contract also
includes an annual-premium policy if the taxpayer deposited with the insurer a
sum to cover a substantial number of its future premiums [I.R.C. §264(b)(2)].
A face amount certificate, within the meaning of the
Investment Company Act of 1940 is defined as being an "endowment
contract" for purposes of Code §72, but is not considered an endowment
contract for purposes of Code §264 [Rev. Rul. 74-349,
1974-2 C.B. 91].
The payment of 73 percent of the total annual premiums under
a limited-payment life insurance policy within four years from the date of
purchase has been held not to constitute payment of "substantially
all" of the premiums within the meaning of Code §264(b) [Frederick A. Dudderan, 44 T.C. 632]. Similarly, a whole life policy was
not considered a single-premium policy where eight premiums were paid within
the first 4 years of a minimum deposit plan, with 4 discounted premiums kept
deposited with the insurer [Cen-Tex, Inc. v.
Campbell, Jr., 377 F.2d 688 (CA-5, 1967)].
Further
Limitation On Deductibility Of Policy Loan Interest—
Plan Of Purchase Rule
Even if otherwise deductible, interest paid on indebtedness
incurred or continued to pay annual premiums on a life, endowment or annuity
contract purchased after August 6, 1963, is not deductible if paid pursuant to
a plan of purchase which contemplates a systematic direct or indirect borrowing
of part or all of the increases in cash value. The deduction is denied whether
such borrowing is from the insurance company, a bank, or other lender, and
whether or not the policy is security for the loan [I.R.C. §264(a)(3)].
The general rule applies whether or not the taxpayer is the
insured, payee, or annuitant under the contract [Reg. §1.264-4(a)]. There are,
however, four exceptions to the general rule. These exceptions are discussed
below. It is important to remember, however, that these exceptions do not avoid
the limits on deductibility imposed by the Tax Reform Act of 1986, discussed
above. If, for example, an individual takes a loan on a personal policy, the
interest deduction will be denied even if one of the exceptions to Code §264
might otherwise apply.
Determination Of Amount Not Deductible
The interest paid by a taxpayer that is not allowed as a
deduction under the foregoing general rule is computed from the entire amount
that is borrowed to purchase or carry the contract. Thus, the interest not
allowed as a deduction is not limited just to the amount computed from the
increases in the contract`s cash value [Reg.
§1.264-4(b)].
Presumption Of A Systematic Borrowing
Plan
Whether a taxpayer`s indebtedness
is incurred or continued pursuant to a plan of purchase which contemplates the
direct or indirect borrowing of part or all of the increases in the contract`s cash value will depend upon all the facts and
circumstances in each case. In the case of borrowing in connection with
premiums for more than three years, a rebuttable
presumption arises that a systematic plan exists. That the premium in a
particular year was not borrowed does not preclude the existence of a plan
[Reg. §1.264-4(c)(1)].
A plan of indirect borrowing will subject the taxpayer to the
nondeductible interest rule. The rule applies whether the lender is an
insurance company, bank or any other person and regardless of whether there is
a pledge of the contract [Reg. §1.264-4(c)(2)].
Of course, policy loans are not the only systematic plan of
borrowing available. A policyholder may obtain a loan from a bank or other
lending institution to pay premiums and pledge his policy as collateral for the
loan. In one case a taxpayer entered into a ten-year program to purchase mutual
fund shares and a whole life insurance policy. The payment of the first year`s premium was financed by borrowing the full amount of
the premium from the issuing company, and pledging the mutual fund shares as
collateral for the loan. On the expiration of the one-year loan period, the taxpayer`s note was replaced with a new note which included
the second year`s premium, the first year`s premium and accrued but unpaid interest. This
procedure was repeated each year, and additional mutual fund purchases secured
each new note. The IRS ruled that this constituted a systematic plan of
borrowing the cash values, and disallowed a deduction for the interest on the
loans [Rev. Rul. 74-500, 1974-2 C.B. 91].
Exceptions To The General Rule
The Code and regulations provide four exceptions to the
general rule. If any of these exceptions apply, all or a portion of interest
paid on indebtedness will be allowed.
1. The Seven-Year
Exception - Even though a systematic plan of borrowing exists, an interest
deduction will be allowed if no part of four of the annual premiums is paid by
means of indebtedness during the seven-year period beginning on the date the
first premium was paid on the contract [Rev. Rul.
72-609, 1972-2 C.B. 199]. However, if within the seven-year period there is an
amount borrowed by the taxpayer that exceeds the current year`s
premium, the excess will be attributable to the most recent prior policy year
and then to each succeeding prior year. Thus, even though the taxpayer pays the
first four annual premiums by means other than borrowing, subsequent loans
within the next three years, depending on the amount, may cause the excess over
that year`s premium to relate back to such four years
and nullify the exception [Reg. §1.264-4(d)(1)].
2. The $100 Exception-
Where the interest paid on any indebtedness that would constitute a plan
subject to the general rule does not exceed $100 in the taxable year, such
interest will not be disallowed. If the amount of interest exceeds $100,
however, the entire amount is disallowed [Reg. §1.264-4(d)(2)].
3. The Unforeseen Events
Exception- If a taxpayer incurs an indebtedness due to an unforeseen
substantial loss of his income or increase in his financial obligations, such
event will constitute an exception to the general rule [Reg. §1.264-4(d)(3)].
4. The Trade or Business
Exception- Where a taxpayer incurs indebtedness to finance business obligations
rather than cash value life insurance, the interest on such indebtedness will
not be disallowed. The determination of whether borrowing is in connection with
the taxpayer`s trade or business rather than to
finance cash value life insurance will be made upon all the facts and
circumstances in each case. Borrowing to finance key-man, split-dollar or stock
retirement plans is not considered to come within this exception [Rev. Rul. 81-255, 1981-2 C.B. 79]. As noted supra, however, it
is permissible to deduct interest for policy loans with respect to such
contracts that do not exceed $50,000 in coverage for an employee or someone who
"is financially interested in any trade or business carried on by the
taxpayer" [I.R.C. §264(a)(4)]. The pledging of policies as part of the
collateral of a loan to finance inventory expansion or capital improvements is
also permissible [Reg. §1.264-4(d)(4)].
Plan Of Purchase Rule Applied To
Disallow COLI Interest Deductions
In TAM 9812005 the Service was presented with a set of facts
involving the deductibility of COLI ("Corporate Owned Life
Insurance") loan interest under the pre-1997 rules outlined above. The
taxpayer acquired life insurance policies on a large group of employees as a
funding resource for health care benefits. The taxpayer engaged in a
"plan-of-purchase" systematic borrowing against cash values to fund
premium payments during the first three years that the contracts were in force,
but did not continue the borrowing after the third year. Instead,
premiums thereafter (as well as portions of the loan interest) were paid with
cash value withdrawals and "load dividends," which effectively represented
refunds by the insurance company of portions of the policy premiums.
Thus, at no point during the tax years at issue did the policy cash values,
after taking into account the loans, cash value withdrawals, accrued interest
and load dividends, exceed eight-tenths of one percent of the year-end policy
value.
The IRS Disallowed the Interest Deductions Based on the
Following Conclusions
Based upon all of the circumstances of the arrangement
involved, "the loading dividend mechanism, partial withdrawals and
artificial premium structure of Taxpayer`s COLI
policies served no economic purpose other than to provide the circular flow of
cash necessary to produce the expected tax benefits with a minimum cash outlay
by Taxpayer. . . . As Taxpayer did not acquire, and Insurer did not forego, the
use of any funds as a result of the loans . . . the purported policy loans in
this case did not produce `indebtedness` for tax purposes."
"The amounts denominated as `interest` by Taxpayer and
Insurer did not, in substance, represent compensation for the use or
forbearance of money." Instead, theses amounts "were paid to
support an interdependent and circular structure of charges and credits, the
purpose of which was to increase Taxpayer`s tax
deductions (while simultaneously increasing the amounts credited to the COLI
policies` tax deferred inside buildup)." In the IRS view the
Taxpayer did not have a sufficient non-tax business purpose for the financing
transaction used to acquire the COLI policies.
The taxpayer argued that the four-out-of-seven safe harbor
rule should be applied since the systematic borrowing ceased after the third
year (and therefore after seven years, the four-out-of-seven test would have
been complied with). As discussed above, the four-out-of-seven rule is
keyed to the payment of at least four of the first seven annual premiums
without utilization of indebtedness. With respect to the premium payments
for policy years after the first three years, the issue became what is meant by
the term "annual premiums due." Even after the first three
years, the taxpayer was not actually paying the stated policy premium amounts,
but rather those amounts systematically reduced by the "loading
dividends." The taxpayer contended that the payment of this net
amount for four of the first seven years, as long as there were
no indebtedness involved in those payments, would satisfy the safe harbor rule.
The TAM concludes, however, that application of the safe
harbor provision must be interpreted in this case as based upon payments of the
actual gross stated premium amounts, not the net amounts after application of
the loading dividends. In effect, the loading dividends after the third
year were treated the same as policy loans, which of course, made the
four-out-of-seven safe harbor inapplicable. The Service concluded that
the loading dividends were not true policy dividends in the usual sense (based
upon the insurer`s experience, the discretion of
management or any usual source of dividends), but rather "it was
contemplated from the outset that these contractually pre-arranged loading
dividends would reduce the premiums actually required to be paid."
In effect, the IRS view is that the dividends were funded directly from premium
allocation to an intentionally overstated charge.
As a result of the 1996 amendments to I.R.C. §264, broad
based leveraged COLI is no longer viable, since even the limited deduction for
interest on COLI policy loans was effectively eliminated (except for certain
key person policies). Thus, the holding in TAM 9812005 is important only
with respect to open tax years prior to 1997.
With respect to these years, however, the TAM is of considerable importance,
since it goes to some length to analyze the economics and substance of a
leveraged COLI arrangement--with an unfavorable conclusion.
After TAM 9812005: Dow Chemical v.
Some commentators have estimated that the type of leveraged
COLI arrangement analyzed in the TAM typifies three-quarters of the leveraged
COLI programs in existence. The effect of the TAM has already been quite
significant with respect to the leveraged COLI variation sometimes derided as
“janitor insurance.” Corporate CFOs and their advisors realized that
under the pre-1996 rules, the more employees whose lives they insured, the more
premiums they could finance through policy loans and the more interest on those
loans they could deduct.
Large corporations could potentially save millions in taxes
through leveraged coverage of hundreds of employees. Winn-Dixie Stores, Inc., a
large public corporation, took such a course in 1993, insuring more than 30,000
employees! CM Holdings (a holding company for Camelot Music, Inc., a
national music store chain) insured 1,430 of its employees. American Electric
Power (AEP), a major Midwestern public utility, insured 20,000 employees.
The Service denied these three taxpayers’ claimed deductions and won in the
courts in three consecutive major cases (American Electric Power, Inc. v.
The main point of the three cases before Dow was the courts’
application of the “sham transaction” doctrine, invoked by the IRS when
necessary to combat abusive manipulation of Code provisions and accepted by
courts in appropriate circumstances through most of the history of the Internal
Revenue Code. In Winn-Dixie, for example, the court examined projections
which revealed that over a 60-year period, each year’s projected total of policy
premiums, fees and loan interest exceeded the projected total of death
benefits, loans and other withdrawals for the year. Thus, before income
tax effect, the arrangement could be expected to have a negative impact on cash
flow each year. However, after taking into account the income tax
deduction for the interest expense, the savings in corporate income taxes more
than offset the negative cash flow from the transactions themselves. From
this the court had no trouble concluding that the transactions were a sham,
having no legitimate business purpose and no economic substance apart from the
intended reduction of income taxes, the taxpayer’s arguments to the contrary
notwithstanding. (For example, it argued that the program had a
legitimate business purpose as a vehicle to fund its employee benefit program,
but the only way funds could have been generated was through reduction of
income taxes.)
The Service advanced essentially the same arguments in Dow
that it had in its earlier successes: specifically that Dow’s plan had no
economic substance or business purpose in reality (a sham in substance) and
that the plan was a sham in fact. A third argument was that the plan
violated the “four-of-seven” rule mentioned above (I.R.C. §264(d)(1)) and therefore was not entitled to the claimed
deduction.
Economic Substance
Unlike its predecessors, Dow persuaded the court that its
COLI plan was not a “sham in substance”—that it had a real business purpose, that of defraying the future cost of unfunded employee
benefits. The reason is that it carefully documented that it obtained
expert advice on legal issues and most importantly was able to show a
projection of a positive pre-tax cash flow after 18 years (contrast
Winn-Dixie’s negative cash flow in year 60, mentioned above).
This is the most important lesson of Dow for future
litigants: a taxpayer that took pains over its plan selection and design,
sought outside expert advice, and documented the entire process stands a good
chance of demonstrating a real economic purpose.
However, Dow did not defeat the argument that its policy
withdrawals were shams in fact—fictional transactions. The withdrawals
took place in years 4 through 7, and were implemented through a circular series
of nettig transactions. In policy years 4 through 7
(when premium payments were to be made with unborrowed
funds), Dow would send a premium to the insurer, and within a matter of days
Dow would request a withdrawal from the policy, and the withdrawal would be
applied by the insurer to "pay" roughly 90 percent of the premium and
accrued loan interest. This occurred, even though, at the end of each policy
year, cash values were fully encumbered with prior policy loans. Only 10 percent
of the premiums described above did not come from the partial withdrawals.
The circularity wasn’t the problem per se. The problem
is that the contracts limited partial withdrawals to the unencumbered cash
value in the policy. With the policy totally encumbered by loans, Dow
could not make its withdrawal and could not apply that 90% to the premium;
therefore the insurer could not deem the premium paid (except for the 10% that
was paid in cash). In short, the 90% came from nothing, and the
withdrawal - premium paying mechanism, as the court found, was a sham in fact.
In the prior cases, this finding would have been enough to
disallow the deduction. The Dow court, however, found that the Service’s
third argument, based on the four-in-seven rule, carried the day. As
mentioned, the rule provides a safe harbor under the plan-of-purchase rule “if
no part of 4 of the annual premiums due during the 7-year period (beginning
with the date the first premium . . . was paid) is paid under such plan by
means of indebtedness.” [I.R.C. §264(d)(1)]
Dow’s argument was that because it did not pay the premiums by means of
“indebtedness,” but by a combination of cash and partial withdrawals, it gains
the shelter of the safe harbor.
The Service argued, as in earlier cases, was that §264(d)(1)
implicitly imposes a level premium requirement. Since the only legitimate
premium Dow paid in years 4 through 7 was the 10% it paid in cash, the premium
was not level and therefore Dow is shut out of the safe harbor.
The court’s response was a rather pedestrian exercise in
statutory construction, which issued in the conclusion that the statute has no
level premium requirement. This analysis is not very sophisticated, but
even assuming it is correct it does not go to the heart of the
matter. Assuming that there is no level premium requirement in §264(d)(1), all this shows is that the parties are free to write
their contract with uneven premiums. On this assumption, Dow and its
insurer could agree that the premium for years 1-3 will be $10 million per
year, and for years 4-7 $10 per year, and this will
not offend the statute. (Since it’s an elementary principle of statutory
construction that Congress does not intend absurdities, this could be a
compelling argument against uneven premiums.) But this was not the case
here. The uneven premiums resulted from the sham character of the partial
withdrawals. Under the sham transaction doctrine, this by itself should
have been enough to invalidate the deductions, four-of-seven rule or not.
Since the court has already found that the partial withdrawals were shams, why
was this not sufficient to disallow Dow’s claim? This is certainly the
most curious aspect of the decision.
Charge For
Non-Annual Premium Payments
The extra charge included in life insurance premiums is not
deductible as interest where an insurance company offers optional modes of
payment of gross premiums and the policyowner chooses
to pay other than on an annual basis [Rev. Rul.
79-187, 1979-1 C.B. 95].
"Interest" Paid On Policy
Reinstatement
When a lapsed life insurance policy is reinstated, the
overdue premiums plus "interest" must be paid, and any policy loan
must also be repaid or reinstated together with "interest" thereon.
Such "interest" is nondeductible under Code §163 since it was not
paid on an indebtedness [Williams v. Comm`r, 409 F.2d
1361 (CA-6, 1968)].
"Interest" Paid In Original Age
Policy Conversion
Interest paid as a result of converting a term policy to a
higher premium type of contract is always nondeductible. For interest payments
to be deductible they must arise from an indebtedness,
and there is no indebtedness in connection with interest payments when the
policy owner must pay the "back" premiums plus "interest"
in an original age policy conversion.
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