26 U.S.C. § 264 — Certain amounts paid in connection with insurance contracts

(a) General rule. You may not deduct: premiums on any life insurance policy, or endowment or annuity contract, if you are directly or indirectly a beneficiary under it; interest paid or accrued on debt taken out to buy or keep a single-premium life insurance, endowment, or annuity contract; except as allowed under part (d), interest on debt taken out under a plan that involves systematically borrowing — directly or indirectly, from the insurer or elsewhere — against part or all of the contract's rising cash value, unless it's a single-premium contract (which is already covered above); and, except as allowed under part (e), interest on debt tied to any life insurance policy, or annuity or endowment contract, that you own and that covers any individual's life. The single-premium-annuity rule only applies to contracts bought after March 1, 1954. The systematic-borrowing rule only applies to contracts bought after August 6, 1963. The "any policy you own" rule only applies to contracts bought after June 20, 1986. (b) Exceptions to the beneficiary-premium rule. The ban on deducting premiums when you're the beneficiary does not apply to an annuity contract described in section 72(s)(5), or to an annuity contract covered by section 72(u). (c) What counts as a "single premium" contract. For the single-premium-interest rule in (a), a contract counts as single-premium if either almost all its premiums are paid within the first 4 years after it's purchased, or a lump sum is deposited after March 1, 1954 with the insurer to cover a substantial number of future premiums. (d) Exceptions to the systematic-borrowing rule. The systematic-borrowing ban in (a) doesn't apply to interest someone pays or accrues in a tax year if: at least 4 of the annual premiums due in the first 7 years after the plan's first premium was paid were not paid using borrowed money; the total amount that would otherwise lose its deduction under this rule for that tax year is $100 or less; the debt was taken on because of an unexpected big drop in income or an unexpected big rise in financial obligations; or the debt is tied to the person's trade or business. If premiums on a contract rise substantially, a new 7-year period starts running from the date of the first increased premium. (e) Special rules for the "any policy you own" ban. The ban in (a) on deducting interest tied to any policy you own doesn't apply to interest on debt covering an individual who is a "key person," as long as the total such debt tied to that person is $50,000 or less. Even for that key-person debt (and for the pre-1986-contract rule in the last sentence of (a)), starting with interest for months after December 31, 1995, you can't deduct more interest than you would get using an "applicable rate of interest." Work it out this way: first, find the applicable rate for the month, which is Moody's Corporate Bond Yield Average — Monthly Average Corporates (or whatever succeeds it) for that month. For a contract bought on or before June 20, 1986: if it has a fixed interest rate, use the Moody's rate from the month the contract was purchased, for every later month too; if it has a variable rate, use the Moody's rate from the third month before the start of each 12-month "applicable period" — normally the year beginning on the policy's issue date, though the taxpayer could elect (within 90 days of this rule taking effect) a different period of up to 12 months. Then compare your actual interest for the month to what you'd get at the applicable rate; you can only deduct up to the applicable-rate amount. A "key person" is an officer or a "20-percent owner" (defined below), but no more than the greater of 5 people, or the smaller of 5% of a taxpayer's officers and employees or 20 people, can count as key persons for that taxpayer at once. A "20-percent owner" is, for a corporation, anyone who directly owns 20% or more of its stock or voting power, and for any other taxpayer, anyone who owns 20% or more of the capital or profits interest. For the 20-percent-owner test and the $50,000 key-person cap, all members of one "controlled group" — companies treated as a single employer under the tax code sections named in the statute — are treated as a single taxpayer, and the Secretary decides how to divide the $50,000 limit among them. (f) Spreading interest expense across policy cash values. You may not deduct the part of your interest expense that's tied to cash value you haven't borrowed against — your "unborrowed policy cash value." To find that non-deductible part: take the ratio of (1) your average unborrowed cash value, for the year, of life insurance policies and annuity or endowment contracts bought after June 8, 1997, to (2) that same figure plus the average adjusted basis (under section 1016) of all your other assets — then apply that ratio to your total interest expense for the year. "Unborrowed policy cash value" means a contract's cash surrender value, ignoring any surrender charge, minus any loan against it; if that cash surrender value doesn't reasonably reflect the contract's real value, use instead the larger of the insurance company's stated liability or reserve for the contract, or another amount the Secretary sets. This cash-value rule does not apply to: a policy or contract covering only one person who, when first covered, was a 20-percent owner, officer, director, or employee of the business that owns the policy — a policy covering a 20-percent owner and their spouse jointly still qualifies; or an annuity contract covered by section 72(u). A policy excepted this way is also left out of the ratio calculation above. Where the tax code treats each insured person's coverage under a "master contract" as a separate contract for certain other purposes, that same treatment applies here — except a group life insurance contract, as defined elsewhere in the code, is not a "master contract" for this purpose. This cash-value rule normally does not apply to a policy held by an individual person — but if a trade or business is directly or indirectly the beneficiary, the policy is treated as held by that business instead, unless the business is a sole proprietorship or is really just someone working as an employee; even then, only the cash value up to the benefit the business is actually entitled to is counted, and the Secretary can require policyholders and insurers to report information needed to enforce this. For partnerships and S corporations, this rule is applied at both the entity and the owner level. If interest is already disallowed under (a) or under section 265, it isn't counted again here, and the amount otherwise counted is reduced by that disallowed debt; this subsection is applied before section 263A's rules on capitalizing certain costs. "Interest expense" here means your total interest deduction for the year (as defined in section 265(b)(4)), figured without regard to this subsection, section 265(b), or section 291. All members of a "controlled group" (as defined above) are treated as one taxpayer for this subsection too — except that insurance companies taxed under subchapter L are left out when combining an affiliated group this way.