If you spend any time on farm forums or social media, you’ve probably seen the pitch: “Become your own bank.” Promoters of the Infinite Banking Concept (IBC) tell a compelling story. They suggest that, instead of going to the local Co-op or an ag lender for operating loans, you should buy a high-cash-value whole life insurance policy. By “overfunding” this policy, you create a pool of cash. When it’s time to buy seed, fertilizer, or a new tractor, you simply borrow against your policy, pay yourself back with interest, and keep the money “in the family.”
On a spreadsheet, it looks like the ultimate way to harvest extra profit. But in the eyes of the IRS, this “tax-free” bank can quickly turn into a field full of weeds.
The “Tax Wash” That Doesn’t Wash Out
The primary goal for most farmers using an S-Corporation is to create a “tax wash.” You take a loan from your personal insurance policy, lend that money to your farm S-Corp, and have the S-Corp pay you interest. You hope to deduct that interest as a business expense on the farm side while the money grows tax-deferred in the insurance policy.
However, I.R.C. §264 stands directly in the way. The law says you cannot deduct interest on debt used to “purchase or carry” life insurance if it’s part of a systematic plan to borrow.
A Farmer’s Example: The “Lending” Trap
Let’s say “Farmer Joe” owns a grain operation as an S-Corp. He pays a $50,000 annual premium into a policy. In Year 3, he needs $45,000 for diesel and fertilizer.
- The Policy Loan: Joe borrows $45,000 from his policy at 6% interest.
- The Farm Loan: Joe lends that $45,000 to his Farm S-Corp at 10% interest.
- The Goal: Joe wants his farm to deduct $4,500 in interest to lower his taxable farm income.
During an audit, the IRS agent will look at the substance of the deal, not just Joe’s promissory note. Because Joe has a pattern of borrowing to fund the farm, the IRS will apply the “Economic Substance Doctrine” (I.R.C. §7701(o)). Since Joe and his S-Corp are essentially the same economic unit, moving money in a circle to manufacture a deduction is viewed as a “sham.”
The result? The IRS disallows the farm’s $4,500 deduction. Joe still has to report the $4,500 he received as personal income. Joe ends up paying taxes on his own money moving in a circle, with no tax relief for the interest he actually paid to the insurance company.
The “Golsen Rule” and Legal Red Flag
The courts have been clear for decades. In the famous case of Golsen v. Comm’r., the Tax Court ruled that when a loan’s only real purpose is to turn insurance premiums into “deductible interest,” it’s a sham.
Furthermore, the “Nexus Test” from the Wiscons in Cheeseman case allows the IRS to argue that if you borrow money for the farm because your capital is tied up in a life insurance policy, those loans are “indirectly” carrying that insurance. That makes the interest non-deductible.
The Risk of “Constructive Distributions”
If your S-Corp is paying your personal policy interest, the IRS may call that a “constructive distribution.” This is a disaster for a farmer:
- Your farm loses the interest deduction.
- Your “basis” in the farm is reduced.
- If you don’t have enough basis, you could suddenly owe capital gains taxes on the money you thought you were just “moving around.”
Better Ways to Fund the Farm
If you need liquidity or want to build wealth without an audit hanging over your head, consider these IRS-compliant alternatives:
- I.R.C. §162 Executive Bonus: The farm pays your premiums as a bonus. It’s a clean, undisputed deduction for the farm and builds your personal cash value without the circular loan headache.
- Traditional Commercial Financing: Ag lenders specialize in the “business necessity” of farming. Their interest is clearly deductible under I.R.C. §163 and usually carries lower rates than the “gross” rates of insurance companies.
- Qualified Retirement Plans: Defined benefit or cash balance plans allow farmers to put away over $200,000 a year in fully deductible contributions.
The Bottom Line
The Infinite Banking Concept offers a great story of autonomy, but the Tax Court cares about substance over labels. If your “private bank” is just a conduit to manufacture deductions, the IRS has a massive arsenal of cases to shut it down.
Protect your family farm by choosing strategies that grow your wealth in the sunshine, not in the shadows of a tax mirage.
