Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question:  I have a customer who purchased a non-MEC participating whole life policy several years ago.  The policy has a loan against it, and the owner has chosen to have the policy dividends repay the loan.  How will the dividends used to repay the loan affect the client’s basis in the contract?

Answer:  Dividends used to repay the loan are treated as taxable distributions, and will reduce basis to zero, then will be taxable.

Code Section 72(e) deals with this question.  That Code Section provides that a dividend, when declared, reduces the policy owner’s basis in the life contract.

If the policy owner uses a dividend to buy PUAs, the basis in the contract is increased by the amount equal to the distribution.  Thus, there is no net effect on basis.

However, if the dividend is used to pay a debt of the policy owner—the policy loan—it would not increase the basis in the contract.  That makes sense, because the loan itself did not reduce the policy owner’s basis—so a repayment of the same loan should not increase basis.

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