Ours is an income tax system that taxes net income. But what if certain income is not subject to tax because it falls within an exception to the first of our three guiding principles? Logically, such expenses should not be deductible – and this is indeed a rule that the Code implements in at least two places.
Section 265 denies deductions for the costs of realizing tax exempt income. Section 264(a)(1) provides that a life insurance contract beneficiary’s premium payment is not deductible. Of course, the life insurance payment by reason of death is excluded from the beneficiary’s gross income. § 101(a)(1). This same principle generally applies to interest incurred to pay life insurance contract premiums. § 264(a)(4).