Life insurance provides financial protection for millions of people in America and around the world. Not all life policies are purchased by individuals; many companies and other institutions also use life insurance for various purposes, such as to provide liquidity. But the rules that pertain to corporate ownership of life insurance are somewhat more complex than for individual or group policies. This article examines the history, purpose and taxation of corporate-owned life insurance (COLI) in America.
Nature and Purpose of COLI
As the name states, COLI refers to life insurance that is purchased by a corporation for its own use. The corporation is either the total or partial beneficiary on the policy, and an employee or group of employees, owner or debtor is listed as the insured(s). Fundamentally, COLI differs from group life insurance policies that are typically offered to most or all of the employees in a company, because this type of insurance is designed to protect the employees and their families and not the company itself. COLI can be structured in many different ways to accomplish many different objectives. One of the most common is to fund certain types of nonqualified plans, such as a split-dollar life insurance policy that allows the company to recoup its premium outlay into the policy by naming itself as the beneficiary for the amount of premium paid, with the remainder going to the employee who is the insured on the policy. Other forms of COLI include key person life insurance that pays the company a death benefit upon the death of a key employee, and buy-sell agreements that fund the buyout of a deceased partner or owner of a business. In many cases, the death benefit is used to buy some or all of the shares of company stock owned by the deceased (such as with a closely-held business). COLI is also frequently used as a means of recovering the cost of funding various types of employee benefits.
History of COLI
COLI has existed in one form or another for well over 100 years; its nickname as "dead peasant" insurance originates in 19th century Russia, where feudal serfs were bought and sold as property by the rich. Members of the ruling class could "buy" dead serfs that had been counted in previous censes from their former owners in a morbid effort to acquire collateral to obtain loans. Companies used COLI in America 100 years later to exploit a loophole in the Internal Revenue Code that permitted a form of tax arbitrage, where the owner of a life insurance policy could take out large loans from the cash value of the policy and then pay deductible interest on the payments back into the policy, which was in turn not counted as income to the policy owner. The Internal Revenue Service (IRS) eventually limited this loophole to $50,000 of cash value per policy, but the use of COLI as a tax shelter continued into the 1980s, when many firms would buy policies on large numbers of their lowest tier employees (often without their knowledge and/or consent) and then take loans out of the cash values of these policies. The tax deductions that companies received were often greater than the actual cost of the premiums paid. Furthermore, the company would collect the death benefit from the policy if the employee died, leaving little or nothing for the employee's family or estate. The 1990s saw the demise of much of this activity as the IRS cracked down on these practices in tax courts and won mostly favorable rulings.
Current Tax Law for COLI
The tax rules pertaining to COLI are fairly complex and also vary somewhat from one state to another, in some cases. Life insurance is one of the most tax-advantaged vehicles in existence; the death benefit from any life policy is always tax-free for individual and group policies. However, this is not always true for policies owned by corporations. In an effort to limit corporate tax evasion through the use of COLI, these policies must now meet several criteria in order to retain their tax-advantaged status:
- COLI policies can only be purchased on the highest-compensated third of employees.
- Any employee named as the insured on a COLI policy must receive written notification before purchase of the policy of the company's intent to insure the employee and also the amount of coverage.
- The employee must also receive written notification if the company is a partial or total beneficiary of the policy.
There are two instances where these notifications are not necessary in order for the company to receive a tax-free death benefit. The first is when an insured employee dies who worked for the employer at any time during the previous year. (This rule prevents companies from continuing to hold policies indefinitely on former workers who are no longer employed by the company.) The other applies to directors and highly-compensated employees; any death benefit paid upon the death of this type of employee is also exempt from taxation. But money that is placed inside cash value policies by corporations grows tax-deferred just as for individuals. However, the issue of whether the insured's families or other beneficiaries of some types of COLI policies could receive tax-free death benefits has also been the subject of litigation. Initially, the IRS disallowed the tax-free status of this benefit, it eventually recanted and permitted the policies to be paid without taxation to families and other heirs, although it stated that it felt that the death benefit in this case should be taxable according to its interpretation of the tax laws.
Corporate-owned life insurance is used by companies to accomplish many types of objectives, and its rules and taxation are complex topics that are somewhat subject to interpretation in some cases. For more information on this topic, consult your financial advisor.