Each year, millions of Americans utilize life insurance as a financial safeguard, providing their families and other beneficiaries a multitude of protections, most importantly ensuring the continuation of their legacy. What you may be unaware is that many corporations and other institutions also utilize life insurance for numerous purposes. However, the regulations that apply to corporate ownership of life insurance can be slightly more complicated than individual policies. Below, we explore the history, the intent, and the taxation for corporate-owned life insurance (or COLI) and hopefully elucidate some helpful strategies should you decide to explore this fantastic investment opportunity.
Here is COLI in a Nutshell
Just as the name implies, the often bandied term ‘COLI’ refers to a life insurance policy that has been purchased by or for a corporation. In this scenario, the corporation is often listed as either the total (or partial) beneficiary, and a single employee or employee group, a debtor or possibly even the corporate owner will be listed as the insured(s). So, what is the significance or difference from a typical group life insurance policy that would be offered by most companies? COLI policies differ in one fundamental way: they are designed to offer protection to employees and their families, as opposed to protecting the corporation itself. It accomplishes this through myriad structured methods that can be determined by the policyholder. For instance the policy can be used to fund specific types of nonqualified plans including split-dollar life insurance, a complex arrangement which permits the company to recoup the initial premiums by naming itself the beneficiary for the amount of the premium already paid, thereby allowing for the remainder to be paid out to the employee(s) named on the policy.
Another type of COLI might utilize ‘key-person life insurance’ or life insurance that only pays out a life-insurance payment upon the death of a key individual within the company. Other forms include buy-sell agreements that can possibly fund buyouts of deceased partners or board members. In some situations the death benefit can even be used to purchase all or some of the remaining corporate stock owned by an individual, thereby securing the value of that stock to fund various benefits for remaining employees.
COLI Has Been With Us for A Long Time
Policies such as COLI have been used in various forms for well over 100 years. In fact, so-called ‘dead peasant’ insurance found its genesis in nineteenth-century Russia where feudal plebs were bought and sold as capital by rich overlords. These lords frequently bought dead serfs that had been enumerated in censuses by their previous owners. They then used these dead serfs to establish collateral for loans. Later, corporations in America sought to exploit loopholes in the tax policy by using such insurance to once again obtain large cash loans based on the value of the policy and then, in turn, use that cash to pay back tax-free deductible interest payments on said loans. The fledgling IRS eventually caught on, limiting such loans to only $50,000 of cash value per policy. Despite this, companies continued to use COLI as a tax shelter well into the 1980s when they purchased policies for large numbers of their low-level employees and then obtained loans on the cash values of those policies. This was often done without the employee’s knowledge or consent. The logic behind this was that the tax deductions the companies received were often far larger than the costs of paying the policy premiums. Better yet, if one of these employees actually died, the company could collect the death benefit, leaving nothing for the employee or their families. Thankfully under further scrutiny by the IRS, the practice came to end in the early 1990’s.
COLI in the Modern Day
Today, the tax regulations related to COLI policies are complex and varied, depending on which state you are in. Even so, life insurance can be considered one of the most tax-advantaged financial vehicles on earth. This is due to the fact that the death benefits in every state are guaranteed to be paid out to any beneficiary tax-free. However, these rules change when the policy is owned by a corporation. In an effort to combat corporate tax evasion, companies seeking to utilize COLI policies must now conform to a number of strict criteria in order to maintain their tax-advantaged position:
Companies can only purchase COLI policies for the top third of employees in terms of compensation.
The company must provide written notification to any employee who is listed as insured on a COLI policy. The notification must describe the company’s intent, as well as the amount of the coverage.
The company must also notify the employee in writing if they (the company) are also listed as a partial or total beneficiary.
In light of these regulations, there are two instances where these notifications are not necessary. The first instance would be when an employee who listed on the policy dies who has worked for the employer at any point during the past year. This ensures that companies don’t continue to attempt to hold policies indefinitely for former employees. The second instance would come into play upon the death of directors or other highly-compensated employees. In this scenario, the death benefit paid for this type of employee is tax exempt.
Despite this, money that is outlaid into certain cash-value policies by corporations continues to increase tax-deferred, just as it is for individual purchasers. However, recently the courts have continued to litigate regarding issues surrounding whether families or other types of beneficiaries can still receive tax-free benefits. The IRS has technically gone back and forth as to whether to grant tax-free status to such benefits but has recently decided that families and heirs can indeed receive such payouts. This ruling did, in fact, come with the added caveat that the issue would be handled on a case-by-case basis and that the IRS reserved the right to interpret the tax laws.
Corporate-owned life insurance is a highly useful financial instrument that is utilized by corporations and other groups to accomplish various objectives. The rules and regulations regarding such transactions are highly complex and can be subject to interpretation and locality. Our advice is to consult your local financial advisor to see if this type of insurance is best for you.