Company-Owned Life Insurance (COLI): Definition, Purpose, Taxes

What Is Company-Owned Life Insurance (COLI)?

Company-owned life insurance (COLI) is a life insurance policy that pays a benefit to the company if an insured employee dies.

Understanding Company-Owned Life Insurance (COLI)

Company-owned life insurance (COLI), also referred to as corporate-owned life insurance, is a policy taken out on one or more critical employees. The company pays the insurance premiums and receives the death benefit if a covered employee dies.

COLI policies are a way for a company to minimize its tax burden, increase after-tax net income, finance employee benefits, and help cover the expenses associated with replacing an insured employee upon that employee’s death. COLI policies typically continue to cover employees up to the year after they leave the company.

COLI Requirements

Because some insurance companies used COLI policies to exploit tax loopholes, the Internal Revenue Service (IRS) now requires that they meet certain conditions to receive a tax-free death benefit. For example, the company can only purchase COLI policies for the top 35% of employees, ranked according to their compensation. In addition, it must notify the employee in writing of the terms of the policy and obtain their written consent before purchasing.

History of COLI

COLI first appeared as a way for companies to insure against the death of a key employee, such as a top-level executive. However, tax loopholes made COLI very appealing to many companies. Companies attempting to exploit those loopholes began purchasing policies on lower-ranking employees without telling them and continued to pay premiums even after they left the company.

The practice reached its peak in the 1980s when decreasing regulation prompted some companies to insure a majority of their employees, borrow against the cash value of the policies, and deduct the interest on the loans.

In the late 1980s and 1990s, Congress responded by passing laws that require employee consent and an "insurable interest" on the part of the company. This meant that companies had to show the potential for loss due to an employee’s death to justify the purchase of a COLI policy. At the same time, the IRS reduced the ability of a company to deduct interest payments when borrowing against the policies.

Companies would often claim that they spent the payouts on employee benefits; however, there was no requirement to do so. The companies didn’t even need to disclose how they spent the money.

In the first decade of the 2000s, large corporations paid millions of dollars to settle lawsuits from family members of deceased employees who argued that the practice was unlawful. Later, Congress passed the COLI Best Practices Provision, as part of the Pension Protection Act of 2006, which introduced conditions for tax-free benefits. Consequently, while COLI policies still offer financial advantages to employers, they are subject to greater regulation.