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CRS REPORTS ON CORPORATE-OWNED LIFE INSURANCE TAX ISSUES.

SEP. 22, 1995

95-990E

DATED SEP. 22, 1995
DOCUMENT ATTRIBUTES
  • Authors
    Taylor, Jack
  • Institutional Authors
    Congressional Research Service
  • Subject Area/Tax Topics
  • Index Terms
    insurance, life
    interest deduction
    corporations
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 95-10117 (2 original pages)
  • Tax Analysts Electronic Citation
    95 TNT 219-19
Citations: 95-990E

             CORPORATE-OWNED LIFE INSURANCE: TAX ISSUES

 

 

                             Jack Taylor

 

                    Specialist in Public Finance

 

                         Economics Division

 

 

                               SUMMARY

 

 

Corporations can take advantage of the tax-free accumulation of interest income in life insurance policies by buying policies on the lives of their employees, with the company as the owner and beneficiary of the policy, using borrowed money, the interest on which is tax deductible. Thus the corporation is able to profit by the difference between its AFTERTAX borrowing rate and the TAX-FREE earnings rate on the life insurance policy. This practice was restricted in the Tax Reform Act of 1986 by denying an interest deduction for any loan in connection with a life insurance policy with a face value of more than $50,000. The Ways and Means Committee has approved a proposal to extend the ban on deducting interest to any policy owned by a business, phased in over five years.

BACKGROUND AND PROPOSED CHANGE

Since businesses may suffer financial losses due to the deaths of their employees, they have a legitimate reason to insure employees' lives, with benefits payable to the business. But life insurance policies also confer a tax advantage to the owner, because they allow tax-free accumulation of income ("inside build-up"), tax- free distributions in the form of loans, and finally tax-free payment of benefits on the death of the insured. So some businesses have purchased policies not for the protection against financial loss but for the tax benefits.

The return on life insurance policies is generally not high enough to make them a good investment for most businesses, unless life insurance protection against financial loss is needed. Businesses are not allowed to deduct the premiums they pay on policies they own; but if they borrow to pay the premiums or borrow the inside build-up from their own policies, they can deduct the interest they pay from other income (within limits). Thus they receive tax-free income accumulating in the policy financed by tax- deductible interest payments (which is not allowed for other nontaxable investments). It is this "arbitrage" that makes the policies an attractive investment. (Some companies subject to the alternative minimum tax may have this advantage greatly restricted because they must include a portion of the annual increase in a policy's cash value in the alternative minimum taxable income calculation. Internal Revenue Code section 56(g)(4)(B)(ii).)

The Tax Reform Act of 1986 (P.L. 99-514) limited the deduction for interest on loans "in connection with" a business-owned life insurance policy to policies of $50,000 or less if issued after June 20, 1986. 1 The Ways and Means Committee has approved a proposal to phase out the exception for policies under $50,000 over five years, beginning in 1996. 2 The Joint Committee on Taxation estimates that the change will raise $7 billion over seven years. 3

This proposal is the same as one made in President Bush's 1992 budget and by the Treasury Department in its 1990 report on the taxation of life insurance products. 4 The justification was that this change would discourage a growing problem of tax arbitrage but still allow companies to carry insurance on their employees.

One objection that might be made to this proposal is its retroactivity; it will apply to interest deductions for policies purchased under the old rules, not just those purchased after it goes into effect. The life insurance industry also argues that these policy loans encourage small, closely held corporations to provide for the continuation of the business after the death of the owners. This type of borrowing has also been promoted as a means of tax-free funding for retiree health benefits (which would not otherwise qualify for current tax deductions), but the Treasury Department has objected to this approach because it circumvents the antidiscrimination rules and funding restrictions imposed on fringe benefits elsewhere in the law. 5

 

FOOTNOTES

 

 

1 U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. JCS-10-87, May 4, 1987. U.S. Gov. Print. Off., Washington: 1987. P. 580.

2 U.S. Congress. Joint Committee on Taxation. Description of an Amendment in the Nature of a Substitute to the Chairman's Mark Relating to Corporate and Other Tax Reforms. JCX-39-95, Sept. 18, 1995. P. 7.

3 U.S. Congress. Joint Committee on Taxation. Estimated Revenue Effects. JCX-42-45 R, Sept. 18, 1995. P. 14. Earlier this year, the JCT had estimated that complete repeal would raise only $2.8 billion over five years. See Congressional Budget Office. Reducing the Deficit: Spending and Revenue Options. Washington, 1995. P. 383.

4 U.S. Department of the Treasury. General Explanation of the President's Budget Proposals Affecting Receipts. January 1992. P. 93; Report to the Congress on the Taxation of Life Insurance Company Products. March 1990. P. 53.

5 See, e.g., Saunders, Laura. A Price on Your Head. Forbes, Sept. 4, 1989. P. 80. 1990 Treasury report, P. 53.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Taylor, Jack
  • Institutional Authors
    Congressional Research Service
  • Subject Area/Tax Topics
  • Index Terms
    insurance, life
    interest deduction
    corporations
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 95-10117 (2 original pages)
  • Tax Analysts Electronic Citation
    95 TNT 219-19
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