rr-11-09.pdf

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Part I

Section 264.--Certain Amounts Paid in Connection with Insurance Contracts

(Also § 1035.)

Rev. Rul. 2011-9

ISSUE

Does the pro rata interest expense disallowance rule of § 264(f)(1) of the Internal
Revenue Code apply to Old Policy and to New Policy in the situations described below?
FACTS
Situation 1
. Taxpayer is a corporation engaged in a trade or business that has
substantial indebtedness on which it incurs interest expense. On January 3, 2000,
Taxpayer purchased a life insurance policy (“Old Policy”) covering the life of A
, an
employee of Taxpayer, as of that date. A was not a 20-percent owner, officer, or
director of Taxpayer, and was the only individual covered by Old Policy. On January 3,
2011, Taxpayer received a new life insurance policy (“New Policy”) covering the life of A

as of January 3, 2011, in exchange for Old Policy in a transaction that qualified for non-
recognition of gain or loss under § 1035. New Policy also covers only the life of A
and
has the same death benefit as Old Policy. A
remained an employee of Taxpayer as of

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January 3, 2011. Both Old Policy and New Policy are life insurance contracts as
defined in § 7702.
Situation 2
. The facts are the same as in Situation 1, except that on January 4,
2010, A
terminated employment with Taxpayer.
LAW
Under § 264(f)(1), no deduction is allowed for that portion of the taxpayer’s
interest expense that is allocable to unborrowed policy cash values.
Section 264(f)(7) defines “interest expense” as the aggregate amount allowable
to the taxpayer as a deduction for interest (within the meaning of § 265(b)(4)) for the
taxable year (determined without regard to §§ 264(f), 265(b) and 291).
Section 264(f)(3) defines “unborrowed policy cash value” as, with respect to any
life insurance policy or annuity or endowment contract, the excess of (A) the cash
surrender value of the policy or contract determined without regard to any surrender
charge, over (B) the amount of any loan with respect to the policy or contract. If the
amount described in (A) with respect to any policy or contract does not reasonably
approximate its actual value, the amount taken into account under (A) is the greater of
the amount of the insurance company liability or the insurance company reserve with
respect to the policy or contract (as determined for purposes of the annual statement
approved by the National Association of Insurance Commissioners) or is another
amount as determined by the Secretary.
Section 264(f)(2) states that, for purposes of § 264(f)(1), the portion of the
taxpayer’s interest expense that is allocable to unborrowed policy cash values is an

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amount that bears the same ratio to that interest expense as the taxpayer’s average
unborrowed policy cash values of life insurance policies, and annuity and endowment
contracts, issued after June 8, 1997, bears to the sum of (i) in the case of assets of the
taxpayer that are life insurance policies or annuity or endowment contracts, the average
unborrowed policy cash values of those policies and contracts, and (ii) in the case of
any other assets of the taxpayer, the average adjusted bases (within the meaning of
§ 1016) of those assets.
Section 264(f)(4) provides an exception to the pro rata interest expense
disallowance rule of § 264(f)(1) for certain policies and contracts. Under § 264(f)(4),
§ 264(f)(1) does not apply to any policy or contract owned by an entity engaged in a
trade or business if the policy or contract covers only one individual and if that individual
is (at the time first covered by the policy or contract) (i) a 20-percent owner of the entity,
or (ii) an individual (not described in (i)) who is an officer, director, or employee of the
trade or business.
Section 264(f) applies to contracts issued after June 8, 1997, in taxable years
ending after that date. For this purpose, any material increase in the death benefit or
other material change in the contract is treated as a new contract. Taxpayer Relief Act
of 1997, Pub. L. No. 105-34, § 1084.
Section 1035(a)(1) provides that no gain or loss is recognized on the exchange
of a life insurance contract for another life insurance contract, or for an endowment or
annuity contract or for a qualified long-term care insurance contract. The legislative
history of § 1035 explains that § 1035 provides non-recognition treatment for taxpayers

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who have "merely exchanged one insurance policy for another better suited to their
needs and who have not actually realized gain." H. Rep. 1337, 83d Cong., 2d Sess. 81
(1954). Under § 1.1035-1, the contracts exchanged must relate to the same insured.
ANALYSIS
Old Policy

In both Situation 1 and Situation 2, A was an employee of Taxpayer on January
3, 2000, which was the date as of which A was first covered by Old Policy. A was the
only individual covered by Old Policy. Under the exception provided by § 264(f)(4)(A),
the pro rata interest expense disallowance rule of § 264(f)(1) did not apply to Old Policy
in either situation.
New Policy

In general, a contract that is received in exchange for an existing contract is
treated as a new contract issued on the date of the exchange for purposes of testing the
contract's qualification as a life insurance contract under § 7702. See
1 Staff of Senate
Comm. on Finance, 98th Cong., 2d Sess., Deficit Reduction Act of 1984, Explanation of
Provisions Approved by the Committee on March 21, 1984, at 579 (Comm. Print 1984);
Notice 2006-95, 2006-2 C.B. 848, section 5.01. Consistently, the exchange of a life
insurance contract for another life insurance contract is treated as a material change,
and the contract received in the exchange is treated as a new contract, for purposes of
applying the 7-pay test of § 7702A(b) to determine whether the contract is a modified
endowment contract (MEC). 2 H.R. Conf. Rep. No. 1104, 100th Cong., 2d Sess. II-98
(1988), 1988-3 C.B. 588. Cf.
1 Staff of Senate Comm. on Finance, 98th Cong., 2d

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Sess., Deficit Reduction Act of 1984, Explanation of Provisions Approved by the
Committee on March 21, 1984, at 540 (Comm. Print 1984) (date of issuance of a life
insurance contract for purposes of determining the tax reserve method applicable to the
contract under § 807(d)(2) is the date shown on the policy form).
In some circumstances, the issue date or other attributes of a contract carry over
in a § 1035 exchange pursuant to an explicit rule. For example, in the case of § 101(j)
Congress grandfathered an employer-owned life insurance contract that is received
after August 17, 2006, in a § 1035 exchange for a contract that was issued on or before
that date. Pension Protection Act of 2006, § 863(a), Pub. L. No. 109-280. See also

Rev. Rul. 92-95, 1992-2 C.B. 43 (for purposes of § 72(q)(2)(I) and 72(u)(4), the "date of
purchase" of an annuity contract acquired in a § 1035 exchange for another annuity
contract is the date of purchase of the annuity contract that was exchanged for the new
contract). Congress did not provide a rule under which the status of the insured as an
employee "at the time first covered" for purposes of § 264(f)(4)(A) would carry over from
a contract given up in a § 1035 tax-free exchange to a contract received in such an
exchange, even though the status of the insured as an employee is material to the
purpose and application of the exception provided by § 264(f)(4).
In Situation 1
, A was an employee of Taxpayer on January 3, 2011, which was
the date as of which A was first covered by New Policy. A
was the only individual
covered by New Policy. Under the exception provided by § 264(f)(4)(A), the pro rata
interest expense disallowance rule of § 264(f)(1) did not apply to New Policy in
Situation 1.

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In Situation 2, A was not an employee of Taxpayer on January 3, 2011, which
was the date as of which A was first covered by New Policy, nor was A a 20-percent
owner, officer, or director of Taxpayer. Accordingly, New Policy does not qualify for the
exception provided by § 264(f)(4)(A). The fact that A
was an employee of Taxpayer at
the time first covered by Old Policy (January 3, 2000) does not change this result.
HOLDINGS
In both Situation 1 and Situation 2, Old Policy qualified for the exception provided
by § 264(f)(4). Therefore, the pro rata interest expense disallowance rule of § 264(f)(1)
did not apply to Old Policy.
In Situation 1
, New Policy qualifies for the exception provided by § 264(f)(4).
Therefore, the pro rata interest expense disallowance rule of § 264(f)(1) does not apply
to New Policy.
In Situation 2
, New Policy does not qualify for the exception provided by
§ 264(f)(4). Therefore, the pro rata interest expense disallowance rule of § 264(f)(1)
applies to New Policy.
DRAFTING INFORMATION
The principal author of this revenue ruling is Rebecca L. Baxter of the Office of
Associate Chief Counsel (Financial Institutions & Products). For further information
regarding this revenue ruling, contact Ms. Baxter at (202) 622-3970 (not a toll-free call).