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 June 20, 1986 the deduction (for pre-1997 tax years) with respect to policies on any single individual is limited to the interest attributable to an aggregate of $50,000 of indebtedness.

Delayed Deduction

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].

By Whom Deductible

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. United States

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. U.S., 136 F. Supp. 2d. 762 (S.D. Ohio 2001), In re CM Holdings, Inc., 254 B.R. 570 (D. Del. 2000), aff`d 301 F. 3d. 96 (3d. Cir. 2002), and Winn Dixie Stores, Inc. v. Commissioner, 113 T.C. 254 (1999), aff`d 254 F.3d. 1313 (10th Cir. 2001), cert. denied, __ U.S. __ (2002)).  The issue of interest deductability for pre-1997 leveraged COLI schemes appeared “relatively settled” until the District Court for the Eastern District of Michigan tossed a firecracker into the situation by handing the IRS its first defeat in Dow Chemical v. U.S., __ F. Supp. 2d. __ (E.D. Mich., No. 00-10331-BC, March 31, 2003). 

Litigation Before Dow

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 Decision in Dow

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.

Dow’s Policy Withdrawals as Shams in Fact

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.

The Four-in-Seven Rule Comes to Dow’s Rescue

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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