Is the interest paid on a policy loan tax deductible?

The answer to this question depends on the classification of the policy loan and on whether the policy is a single premium contract.

1. Personal policy loan interest
   1. The deduction for personal loan interest was eliminated by the Tax Reform Act of 1986. As a result, a deduction for personal policy loan interest is not allowed, regardless of when the policy was issued or the loan made [IRC §163(h)(1)].
   2. Retrieve: IRC §163
2. Company-owned life insurance
   1. The ability of a taxpayer to deduct policy loan interest on company-owned life insurance policies has changed over the years with different pieces of tax legislation:
      1. Prior to 1986, policy loan interest on company-owned life insurance was fully deductible, subject to the single premium contract and the systematic borrowing restrictions discussed in IV. and V. below.
      2. The Tax Reform Act of 1986 amended IRC §264(a)(4) so that, for policies issued after June 20, 1986, a taxpayer could deduct policy loan interest on company-owned life insurance covering the life of an officer, employee or any other person with a financial interest in the business only to the extent that total indebtedness did not exceed $50,000.
      3. The Health Insurance Portability and Accountability Act of 1996 amended IRC §264(a)(4) yet again, eliminating the deductibility of policy loan interest on company-owned life insurance with loans of less than $50,000, but introducing yet another exception. While not disturbing the deductibility of policy loan interest on company-owned life insurance policies issued before June 21, 1986, this legislation did introduce an interest rate cap that applies to those policies, as well as to policies issued after June 20, 1986.
      4. The end result is that the deductibility of policy loan interest on company-owned life insurance policies depends on when the policy was issued.
   2. Policies issued before 6/21/1986:
      1. Policy loan interest on company-owned life insurance that falls within an interest rate cap continues to be fully deductible, subject to the single premium contract and the systematic borrowing restrictions discussed in IV. and V. below.
      2. Interest rate cap—No deduction is allowed for interest paid or accrued after December 31, 1995 to the extent such interest exceeds the amount of interest that would have been due if the applicable rate of interest were used [IRC §264(d)(2)(A)].
         1. Applicable rate of interest/fixed interest rate contracts—The rate described in Moody’s Corporate Bond Yield Average-Monthly Average Corporates as published by Moody’s Investors Services, Inc. for the month in which the contract was issued [IRC §264(d)(2)(b)(ii)(I)].
         2. Applicable rate of interest/variable interest rate contracts—The taxpayer must elect an “applicable period” for such contract, which can be for any number of months not exceeding 12; the applicable rate of interest is then equal to the Moody’s rate for the third month preceding the first month in such period [IRC §264(d)(2)(b)(ii)(II)].
         3. What this means is that, if the interest rate charged by the insurance policy exceeds an interest rate cap (i.e., the applicable rate of interest), the difference between the amount of interest payable under the policy’s interest rate and the amount of interest payable under the applicable interest rate cannot be deducted.
      3. Such interest is deductible only to the extent that it is actually paid in cash or cash equivalent in the tax year [IRC §163; Reg. §1.163-1].
   3. Policies issued after 6/20/1986:
      1. With the passage of the Health Insurance Portability and Accountability Act of 1996, loan interest paid or accrued by a taxpayer after October 13, 1995 on company- owned life insurance policies generally is not deductible, regardless of the amount of the outstanding loan [IRC §264(a)(4) as amended].
      2. Key person exception—There is, however, an exception that allows loan interest on a company-owned life insurance policy covering a “key person” to be deducted, up to a maximum of $50,000 of aggregated policy loans on contracts covering such key person [IRC §264(d)(1)], subject to an interest rate cap.
      3. Interest rate cap—No deduction is allowed for interest paid or accrued after December 31, 1995 to the extent such interest exceeds the amount of interest that would have been due if the applicable rate of interest were used [IRC §264(d)(2)(A)].
         1. The applicable rate of interest for any month is the rate described in Moody’s Corporate Bond Yield Average-Monthly Average Corporates as published by Moody’s Investors Service, Inc. for such month [IRC §264(d)(2)(B)(i)].
         2. Policy loan interest paid or accrued in excess of the interest that would have been due if the applicable rate of interest were used cannot be deducted.
      4. Key person limitation—For purposes of policy loan interest deductibility described in 2. above, a “key person” is an officer or 20% owner of the taxpayer, and the number of individuals who can be treated as a key person for this purpose is limited to the greater of:
         1. five individuals; or
         2. the lesser of 5% of the total officers and employees or 20 individuals [IRC §264(d)(3)].
         3. This effectively limits “key person” treatment to a maximum of 20 individuals.
      5. Policy loan interest that qualifies for the key person exception is deductible only to the extent that it is actually paid in cash or cash equivalent in the tax year [IRC §163; Reg. §1.163-1].
      6. The deductibility of policy loan interest is also subject to the single premium contract and systematic borrowing restrictions discussed in IV. and V. below.
      7. Transition rule—If the interest on existing company-owned life insurance policy loans is no longer deductible due to the changes put into effect by the Health Insurance Portability and Accountability Act of 1996, there is a transition period during which at least a portion of the policy loan interest may remain deductible.
         1. If the policy loan was either taken before January 1, 1996 or, for policies issued in 1994 or 1995, before January 1, 1997, qualified interest paid or accrued after October 13, 1995 and before January 1, 1999 may remain at least partially deductible during this transition period.
         2. Qualified interest—Several requirements must be met for policy loan interest paid during this transition period to be deductible as qualified interest. For interest paid or accrued after December 31, 1995:
            1. the indebtedness must not be with respect to more than 20,000 insured individuals; and
            2. the lesser of the following interest rates must be used in determining deductible interest:
               1. the interest rate stated in the contract that was in effect on October 13, 1995; or
               2. the applicable percentage of the rate of interest described in Moody’s Corporate Bond Yield Average-Monthly Average Corporates:
                  For 1996 the applicable percentage is 100%
                  For 1997 the applicable percentage is 90%
                  For 1998 the applicable percentage is 80%
               3. For example:
                  Policy loan: $40,000
                  Policy interest rate in effect on 10/13/95: 8.5%
                  Moody’s rate: 7.9%
                  Applicable percentage (1997): 90%
                  Qualified interest rate (90% of 7.9%): 7.1%b
                  1997 policy loan interest due ($40,000 × .085): $3,400
                  1997 deductible qualified interest ($40,000 × .071): $2,840
         3. Spread of income rule—There is also a spread of income provision designed to ease the transition for taxpayers impacted by these new rules on loan interest deductibility.
            1. Certain amounts received during 1996, 1997 or 1998 from an existing company-owned life insurance policy subject to the new rules on loan interest deductibility will be includable in gross income ratably over the four-year period beginning with the taxable year such amount would have been included in income (e.g., a $20,000 taxable amount received in 1997 is includable in gross income in 1997, 1998, 1999 and 2000 at the rate of $5,000 per year, rather than the full $20,000 being includable in 1997).
            2. The amounts received that are eligible for this spreading of income over four tax years include amounts received during 1996, 1997 or 1998:
               1. on the complete surrender, redemption or maturity of the policy; or
               2. in full discharge of the obligation under the policy which is in the nature of a premium refund.
   4. Retrieve:
      1. IRC §264
      2. IRC §163
3. Investment or passive activity policy loan interest
   1. No deduction is allowed for interest on a policy loan used to purchase or carry tax-exempt securities [IRC §265(a)(2)].
   2. There is no definite determination on whether a policyowner who uses the proceeds of a policy loan to purchase a taxable investment or expends the proceeds on a passive activity should be allowed a deduction on policy loan interest, subject to investment interest limitations.
   3. While some authorities feel such policy loan interest should be deductible, other authorities disagree.
   4. Retrieve: IRC §265
4. Single premium contracts
   1. No deduction is allowed for interest paid or accrued to purchase or continue a single premium life insurance, endowment or annuity contract purchased after 3/1/1954 [IRC §264(a)(2)].
   2. A single premium contract is defined as one for which:
      1. substantially all the premiums are paid within four years after the contract is purchased; or
      2. an amount is deposited with the insurer for the payment of a substantial number of future premiums [IRC §264(b)].
   3. No deduction is allowed, even if the deduction would otherwise be permitted.
   4. Retrieve: IRC §264
5. Systematic borrowing restrictions
   1. In general, even if a policy loan interest deduction is otherwise allowed, when premium payments are financed through a systematic plan of borrowing, no deduction for interest payments is allowed [IRC §264(a)(3)].
   2. There are, however, four exceptions to this general rule:
      1. “First four out of seven” exception:
         1. If no part of four of the first seven years’ annual premiums are paid through a loan, the interest deduction will be allowed, assuming the interest is otherwise deductible [IRC §264(c)(1)].
         2. The first seven years’ annual premiums are measured from the date of issue or after the last “substantial increase in premiums,” if later.
         3. If the “first four out of seven” test is failed, any prior interest deductions are lost, together with all future deductions.
         4. Once the “first four out of seven” test has been failed (i.e., more than three years’ annual premiums have been borrowed), the effect of disallowing the interest deduction cannot be undone by repaying the policy loan (Rev. Rul. 72-609, 1972-2 CB 199).
         5. If in any year during the seven-year period, the taxpayer borrows more than an amount needed to pay one annual premium, the excess is considered borrowed to pay premiums that were paid in prior years with non-borrowed funds.
         6. Once the “first four out of seven” exception is met, there does not appear to be a limit on the amount that can be borrowed.
      2. $100-a-year exception:
         1. Even if a systematic plan of borrowing exists, the interest deduction will not be disallowed for any tax year in which interest does not exceed $100 [IRC §264(c)(2)].
         2. If the policy loan interest exceeds $100, none of it can be deducted (Reg. §1.264- 4(d)(2)).
      3. Unforeseen event exception:
         1. A deduction paid for interest on a policy loan is not disallowed, even if a systematic plan of borrowing exists, if the reason for the borrowing was due to:
            1. an unforeseen substantial increase in the policyowner’s financial obligations; or
            2. an unforeseen substantial loss in the policyowner’s income [IRC §264(c)(3)].
         2. The deduction will be disallowed if the economic event was foreseeable at policy issue (e.g., retirement or college costs) (Reg. §1.264-4(d)(3)).
         3. An example of an unforeseeable event is job loss.
      4. Trade or business exception:
         1. If otherwise allowable, the interest deduction will not be disallowed if the loan is incurred in connection with the taxpayer’s trade or business [IRC §264(c)(4)].
         2. The taxpayer must be able to prove that the policy loan was actually used for business purposes.
         3. Business purposes do not include borrowing to finance the purchase of business life insurance (e.g., key employee coverage, buy-sell plan funding, retirement benefits, etc.) (Reg. §1.264-4(d)(4); American Body & Equipment Co. v. U.S., 511 F.2nd 647 (5th Cir. 1975)).
            1. This does not mean that the policy loan interest on business life insurance cannot be deductible under one of the other exceptions, such as the “first four out of seven” exception.
   3. Retrieve: