Interest expense deductions on COLI loans after TRA '97.

Since the Tax Reform Act of 1986 (TRA '86), Congress has increasingly reduced the amount of interest that can be deducted on debt incurred with respect to company-owned life insurance (COLI) policies in which the taxpayer has an insurable interest. The Taxpayer Relief Act of 1997 (TRA '97) added yet another layer of reduction to what started with the TRA '86 and continued with the Health Insurance Portability and Accountability Act of 1996 (HIPAA).

The reason for these reductions appears to be that life insurance contracts receive preferential treatment under Sec. 264, which generally provides that no Federal income tax is imposed on the "inside buildup" on the earnings under the contract, unless it is cashed before the insured's death. In addition, an exclusion from Federal income tax is provided on payment of the proceeds after the insured's death.

Because of these preferences, Congress apparently has concluded that there is an inherent unfairness if a company is able, in simplest terms, to use these rules to its advantage, by borrowing funds against the untaxed "inside build up" while simultaneously being able to deduct the loan interest.

History of Deductibility of Interest on COLI Debt

Pre-TRA '86: Interest paid on loan proceeds on borrowing against a COLI policy was, in general, fully deductible to the extent of the rules governing interest deductions, even though the specific limitations on single-premium contracts have been in effect since 1942 (Sec. 264(a)(2)).

TRA '86: This act imposed the first genera imitation on certain insurance contracts purchased by a taxpayer on the lives of its officers, employees or individuals financially interested in any trade or business carried on by the taxpayer. Interest on loan proceeds from these contracts purchased after June 20, 1986 became nondeductible to the extent the loan exceeded $50,000, even if the proceeds were used for good business purposes (Sec. 264 b)).

HIPAA: This act repealed the limited deduction allowed by the TRA '86, denying any interest deduction, regardless of the loan amount. The 1996 rules apply to contracts purchased after June 20, 1986 by a business on the insured lives specified above. The HIPAA added an exception for debt up to $50,000 on "key-person" contracts; officers and 20% owners are considered "key persons." There is an overall limit on the number of key persons, as follows: the lesser of (a) 20 individuals or (b) 5% of the total officers and employees of the taxpayer. In addition, an interest rate cap on both "key-person" and pre-1986 contracts was added; the cap is based on the Moody's Corporate Bond Yield Average and is effective for interest paid after Dec. 31, 1995 (Sec. 264(a)(4) and (d)).

TRA '97: The current act expands the general repeal of the interest deduction to contracts purchased on the lives of all taxpayers, thereby nullifying the 1986 restriction that limited the interest expense denial to contracts purchased on the lives of a related group of persons (i.e., officers or employees of the taxpayer) or those financially interested in the trade or business. Congress believed businesses such as mortgage lenders were abusing insurance policies that they legitimately purchased on the lives of borrowers by using the policies as a way to borrow money and deduct interest (and premiums) as a business expense. The debt proceeds are then used for other purposes and the insurance policies are retained by the mortgage lender after the borrower has repaid the loan in full or the loan has been transferred to another lender. The TRA '97 retains the key-person exception and the interest rate caps.

Application of the COLI Interest Deduction Rules

To apply the COLI interest deduction rules, a taxpayer must pay careful attention to both the issue date of the insurance contract and the relationship of the insured to the taxpayer.

Example: Company X owns a life insurance policy with a face value of $500,000, issued May 1, 1982. X has outstanding loans of $40,000, which were taken out in 1984 and 1985 against the policy's cash value. X is considering borrowing an additional $40,000 to use for business purposes.

Because this is a pre-1986 insurance contract, it does not matter who the insured is or what his relationship is to the taxpayer; both the interest on the original $40,000 borrowed and the additional $40,000 of loan proceeds will be deductible if the interest is deductible under Sec. 163. The only limitation on the interest deduction wi be the interest rate cap imitations specified in Sec. 264(e)(2) B).

However, if the if e insurance po icy had been issued after June 20, 1986, but before June 8, 1997, it would matter who the insured is. The deductible interest would be limited by the $50,000 rule if the insured is an officer, employee or other person financially interested in the business. In addition, the amount of interest expense would be subject to the interest rate caps based on Moody averages.

If a similar policy was owned by a mortgage company on the life of the same individual and the policy was issued before June 8, 1997, the mortgage company would be able to claim interest expense deductions even if the debt was repaid in full or disposed of in some other way (i.e., by a sale to another broker). In addition, the $50,000 loan proceeds limitation would not apply to the mortgage company; prior to the TRA '97, the mortgage company would not be subject to the limits imposed in 1996. However, if the insurance policy was issued after dune 8, 1997, the mortgage company would not be able to claim any of the interest expense related to policy loans, even up to proceeds of $50,000 (Sec. 264(a)(4), as revised by the TRA '97).

Effective Date Issues and Related Changes

The 1997 revisions to Sec. 264 apply to contracts issued after June 8, 1997. A material increase in the death benefit or a material change in the contract will cause the contract to be treated as a new contract.

The TRA '97 made additional revisions and additions to Sec. 264 that should be noted. Sec. 264(a)(1) denies in full for all taxpayers deductions for premiums on any life insurance policy, endowment or annuity contract if the taxpayer is directly or indirectly a beneficiary thereof. This provision expands the nondeductibility of premiums to all taxpayers in the same manner as the expansion of the nondeductibility of interest to all taxpayers. There are two notable exceptions to the denial: premiums related to qualified pension plans and annuity contracts subject to Sec. 72(u) (i.e., annuity contracts held by other-than-natural persons, which are taxed on the "inside buildup" before it is withdrawn).

Sec. 264(f) contains a complex pro rata interest disallowance rule for taxpayers other than natural persons who have unborrowed policy cash values. Taxpayers subject to the disallowance rule must calculate a ratio to determine how much insurance loan interest is deductible. The ratio requires that taxpayers use the adjusted bases of not only the life insurance and/or annuity or endowment contracts owned, but; the adjusted bases of all other assets as the bottom portion of the ratio (Sec. 264(f)(2)(B)(ii)). This provision is similar to the disallowance of interest expense under Sec. 265. There is an exception to this pro rata interest disallowance for policies covering 20% owners, officers, directors and employees (Sec. 264(f)(4)(A))