By Guy Baker and Stanley Mountford
|The insurance industry is one of the most creative and adaptive group of marketers and agents ever assembled. But they must adhere to the tax laws and respect the intent of the law. A popular strategy has been circulated recently that flies in the face of legal precedence and common sense. This article looks at the merits of the argument for tax deducting interest on policy loans greater than $50,000. Not only is there no legal authority, the tax law clearly speaks against this strategy. Tax practitioners and financial advisors would be wise to familiarize themselves with IRC Section 264 and the reasons why the limitation exists and why there is no special class of employee who is exempt from this limitation.|
Financial advisors, attorneys and accountants should be on the alert for a life insurance strategy being promoted which claims an interest expense related to life insurance premium financed loans are 100% tax deductible under IRC §264 for key persons. Specifically, this strategy claims a “key person policy”, as defined in IRC §264(e)(3), that is owned by a company (company owned life insurance “COLI”) is exempt from the $50,000 loan limitation. A carefully drafted whitepaper has been circulating claiming, under IRC §264, the interest expense for a premium financed life insurance policy on a key person COLI is in a separate (special) category and is not subject to the interest deduction limitation of $50,000 loan specified in IRC §264(a)(4),(e). To the uninformed eye, the whitepaper may appear to have some legal authority for this claim, but in fact, there is no authority under §264 (or any other code section or regulation) that remotely suggests premium financed life insurance can be considered a separate category that bypasses the $50,000 loan limitation, §264(e)(1).
Is an interest expense for a loan to finance premiums for a COLI on the life of a key person tax deductible under current law? Yes, if the policy qualifies under the “safe harbor” exception §264(d)(1), the 4 out of 7 rule, but only up to a $50,000 loan, §264(e)(1).
IRC §264 evolved over time responding to the evolution of COLI programs designed to create tax arbitrage for the policyholder. To fully understand §264 you need a basic understanding of the history behind it.
There are two primary tax benefits arising from the ownership of life insurance policies: (1) taxpayers may defer tax on their policy’s inside buildup; and (2) taxpayers exclude from income any death benefit received pursuant to §101(a). In addition, pre-1964, policyholders could deduct interest incurred on policy loans with minimal limitations. This combination of deferral of taxation of inside buildup, the exemption of taxation of death benefits, and the deductibility of interest on policy loans created the opportunity for significant life insurance sales for two decades. The tax arbitrage by policyholders was a cost effective way to fund deferred compensation benefits for key employees. By using an asset that produces tax-deferred income as security for a loan, a taxpayer was able to deduct interest incurred on the loan while the secured asset increases in value tax free. Because some life insurance companies were marketing life insurance products as a tax saving devise, in 1964 Congress enacted limitations on the deductibility of policy loan interest.
In 1964 Congress amended §264 to provide that “no deduction is allowed for amounts paid or accrued on indebtedness incurred or continued to purchase or carry a life insurance contract pursuant to a plan of purchase which contemplates the systematic borrowing of part or all of the increase in the cash values of such contract. §264(a)(3)”. Congress also enacted an exception to this general disallowance rule with respect to “interest paid or accrued on policy loans incurred or continued as part of plan whereby no part of 4 out of the first 7 annual premiums are due on the contract is paid by means of indebtedness. §264(d)(1).” This safe harbor is commonly referred to as the “four out of seven” safe harbor.
Amendments to §264 did not end the use of tax arbitrage associated with life insurance. Fortune 500 corporations began purchasing COLI on the lives of their executives as a means of generating large policy loans, substantial interest deductions, and significant tax savings. In an attempt to stop this abuse, in 1986 Congress eliminated the interest deduction on policy loans to the extent that the aggregate indebtedness exceeded $50,000 per employee. §264(a)(4),(e).
Skilled life insurance marketers, to get around the $50,000 loan limitations, sold “broad-based” COLI programs wherein a corporation purchased insurance on thousands of its non-executive employees, regardless of the value of the employees’ services to the corporation. By increasing the number of policies issued to the COLI plan, the corporation could increase aggregate policy loans and loan interest deductions while remaining within the $50,000 per policy loan limitation. In addition, some insurance companies offered polices with artificially high policy loan interest rates with a small spread between interest charged and interest credited to the policy. By increasing the policy loan interest rate, this had the effect of increasing the tax deduction, and increasing the tax free interest credited on the inside buildup to the policy.
Until 1996 “broad-based” COLI programs were used extensively by large corporations. For example, public records document that Winn-Dixie purchased guaranteed issue COLI on 36,000 employees and Dow Chemical insured over 20,000 employees, just to name two companies. Once again Congress took action and amended §264 by entirely eliminating the availability of policy loan interest deductions generated by COLI programs, except for certain key person insurance programs §264(a)(4),(e)(3),(5). The 1996 amendment established two employee categories: (1) Key person, meaning an officer or 20-percent owner §264(e)(3); and 2) A Controlled Group, meaning all other employees are aggregated and treated as a single person for the $50,000 loan limitation §264(5)(A),(B).
In addition, Congress added subsection (f), Pro Rata Allocation of Interest Expense to Policy Cash Values. This subsection eliminated artificially high policy loan interest rates which increased the tax deduction and the tax free crediting rate on the inside buildup of the policy. Again, there is an exception to this rule for a “key person” §264(f)(4)(A).
In summary, IRC §264 is clear in its intent to limit COLI interest deductions for any and all types of policy loans with respect to aggregated policies on a single life to the $50,000 loan limitation, providing the policy first qualifies for the “safe harbor” exception under §264(a)(3),(d)(1). Any claim the interest expense is tax deductible without limits for policy loans on a key person COLI with respect to premium financing is erroneous and indefensible to an IRS challenge.