The Taxation of Life Insurance Policy Loans

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.

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.

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).

The Internal Revenue Code 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.

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.

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

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.

“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.

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

There is an exception to this 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.

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.

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