rr-09-25.pdf

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Part I

Section 312.—Effect on Earnings and Profits

26 CFR 1.312-6: Earnings and profits.
(Also §§ 101, 264).

Rev. Rul. 2009-25

ISSUE

When is interest that is disallowed as a deduction under § 264(a)(4) of the
Internal Revenue Code (“Disallowed Interest”) taken into account in determining
earnings and profits?
FACTS
A
, an individual, holds a paid-up life insurance contract on his own life. Upon the
death of A
, the death benefit under the contract ($500) is payable to the beneficiary
named in the contract.
X
is a calendar year subchapter C corporation unrelated to A. On the first day of
Year 1, X
purchases A’s life insurance contract for $100 in a transaction that is not
described in § 101(a)(2)(A) or (B), and names itself the beneficiary under the contract.

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On the first day of Year 1, X borrows $100 at seven percent simple interest per
annum to purchase the life insurance contract. The interest on the loan is
unconditionally payable at the end of Year 1 and Year 2 and the interest was in fact paid
at the end of Year 1 and Year 2. But for its disallowance under § 264(a)(4), X
could
deduct seven dollars of interest on the loan in both Year 1 and Year 2 under § 163.
Other than the initial purchase price, the interest on the loan is the only amount X incurs
in connection with the contract.
A
dies on the first day of Year 3, and X receives the $500 death benefit under the
life insurance contract. Pursuant to § 101(a)(2), X includes $386 in gross income ($500
(death benefit) - ($100 (amount paid for the contract) + $14 (Disallowed Interest
deductions in Year 1 and Year 2))).
LAW AND ANALYSIS
Section 101(a)(1) provides that except as otherwise provided in §§ 101(a)(2),
101(d), 101(f), and 101(j), gross income does not include amounts received (whether in
a single sum or otherwise) under a life insurance contract, if such amounts are paid by
reason of the death of the insured.
Section 101(a)(2) generally provides that in the case of a transfer for valuable
consideration, by assignment or otherwise, of a life insurance contract or any interest
therein, the amount excluded from gross income by § 101(a)(1) shall not exceed an
amount equal to the sum of the actual value of such consideration and the premiums
and “other amounts” subsequently paid by the transferee. The term "other amounts"
includes interest paid or accrued by the transferee on indebtedness with respect to the

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contract or any interest therein if such interest paid or accrued is not allowable as a
deduction by reason of § 264(a)(4).
Section 163(a) generally provides that a deduction is allowed for all interest paid
or accrued within the taxable year on indebtedness.
Section 264(a)(4) generally provides that no deduction shall be allowed for any
interest paid or accrued on any indebtedness with respect to 1 or more life insurance
policies owned by the taxpayer covering the life of any individual, or any endowment or
annuity contracts owned by the taxpayer covering any individual.
Earnings and profits are a measure of economic income, or a corporation's
capacity to pay dividends. See
e.g., S. Rep. No. 169, Vol. 1, 98th Cong., 2d Sess., 198
(1984). “In general, the computation of earnings and profits of a corporation . . . is
based upon reasonable accounting concepts that take into account the economic
realities of corporate transactions as well as those resulting from the application of tax
law. Thus, losses and expenses that are disallowed as a deduction for Federal income
tax purposes, charitable contributions in excess of the limitation provided therefore [sic],
and other items that have actually depleted the assets of the corporation, even though
not reflected in the income computations, are allowed as deductions in computing
earnings and profits.” Rev. Rul. 75-515, 1975-2 C.B. 117, obsoleted
by Rev. Rul. 2003-
99, 2003-2 C.B. 388 (holding codified in § 312(l)). See
also Rev. Rul. 71-165, 1971-1
C.B. 111 (“An expense of an accrual basis corporation that under the Code is never an
allowable deduction in computing taxable income usually is reflected in earnings and
profits in the year to which it is attributable, except where the Code specifically provides
that the corporation’s earnings and profits shall not be reduced by any amount which is

4
not allowable as a deduction in computing its taxable income.”); Rev. Rul. 77-442,1977-
2 C.B. 264 (quoting Rev. Rul. 71-165 and Rev. Rul. 75-515). Because Disallowed
Interest depletes the assets of a corporation at the time the interest would be allowed as
a deduction but for its disallowance under § 264(a)(4), earnings and profits are also
reduced in that year. Accordingly, X
in both Year 1 and Year 2 reduces its earnings and
profits by the seven dollars of Disallowed Interest.
In Year 3, X receives the $500 death benefit under the life insurance contract
purchased from A
and, under § 101(a)(2), excludes from gross income an amount
representing the $14 of Disallowed Interest.
Items excluded from gross income generally increase earnings and profits. See
§ 1.312-6(b). Furthermore, even though the Disallowed Interest in Year 1 and Year 2
actually depletes the amount of earnings available for distribution, X
previously reduced
its earnings and profits by the Disallowed Interest in each of those years. Section
1.312-6(d) (“A loss sustained for a year before the taxable year does not affect the
earnings and profits of the taxable year.”); Rev. Rul. 76-299, 1976-2 C.B. 211 (“A capital
loss carryover does not affect the earnings and profits of the taxable year in which it is
used because the loss giving rise to the carryover is reflected in the accumulated
earnings and profits at the beginning of the taxable year of the carryover”). Reducing
earnings and profits in Year 3 by the amount of Disallowed Interest taken into account
under § 101(a)(2) would cause an unwarranted double reduction of earnings and profits
and, therefore, is not permitted. See
, e.g., Bangor & Aroostook Railroad Co. v.
Commissioner, 16 T.C. 578, 586 (1951), aff’d 193 F.2d 827 (1
st
Cir. 1951).

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Although X
in Year 3 includes in its gross income only $386 of the $500 death
benefit because of the applicable offsets under § 101(a)(2) (including the $14 of
Disallowed Interest), X
includes $400 ($500 (the death benefit) less $100 (the amount X
pays for the contract)) in its earnings and profits in Year 3.
HOLDING
Disallowed Interest under § 264(a)(4) reduces earnings and profits for the
taxable year in which the interest would have been allowable as a deduction but for its
disallowance under § 264(a)(4). It does not further reduce earnings and profits when
the death benefit is received under a life insurance contract.
DRAFTING INFORMATION
The principal author of this revenue ruling is Russell P. Subin of the Office of
Associate Chief Counsel (Corporate). For further information regarding this revenue
ruling, contact Russell P. Subin at (202) 622-7790 (not a toll-free call).