The Internal Revenue Service has issued advice on how a life settlement investor should handle interest costs when computing earnings and profits.

The IRS gives the guidance in IRS Revenue Ruling 09-25.

The IRS considers the situation of a life settlement company that pays $100 for a paid-up life insurance policy with a $500 death benefit. The company pays for the policy using a loan that carries an interest rate of 7%. The interest on the loan and the initial purchase price are the policy buyer’s only costs in connection with the contract.

When computing taxable earnings on the policy, Internal Revenue Code Section 264(a)(4) appears to disallow the policy buyer from deducting the interest costs from gains on the policy, officials write.

Officials ask in the ruling whether the policy buyer can deduct interest costs from the death benefit proceeds, anyway.

“Disallowed interest under 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 Section 264(a)(4),” IRS officials hold in the revenue ruling. “It does not further reduce earnings and profits when the death benefit is received under a life insurance contract.”

A copy of the ruling is available here.