There are many different types of life insurance available that can offer financial protection in various ways, but perhaps one of the more complex areas of life insurance is corporate-owned life insurance. How does this type of insurance work, and who is the ultimate beneficiary? Here’s what you need to know about corporate-owned life insurance.
Who Benefits From Corporate-Owned Life Insurance?
Corporate-owned life insurance, also known as COLI, is a specific form of life insurance that a corporation can purchase for its own use. The insured will typically be an employee or a group of employees, the corporate owner, or one of the company’s debtors.
It differs from the life insurance policies that businesses offer their employees because the beneficiary of a COLI is the corporation itself. With general life insurance policies, in contrast, the family members of the employees receive the death benefits when the insured employee dies. Therefore, general life insurance benefits employees because it gives them peace of mind that their family will have financial protection if they pass away.
How Does COLI Benefit Corporations?
There are many ways to structure COLI depending on the business’s objectives. The most common approach is using these policies for funding nonqualified deferred compensation (NQDC) plans.
Some COLIs will contain key person life insurance that provides a death benefit to the business should a key employee pass away.
It may also be used to cover the buyout of an owner or partner of a business upon their death in the form of a buy-sell agreement or to buy shares of company stock that the deceased owned, such as in a closely held business. COLI is also used as a financial strategy to recover the costs of funding employee benefits.
In all of these scenarios, the corporation is the ultimate beneficiary.
How Does COLI Function?
A corporation will usually buy a cash-value life insurance policy for a particular employee or a group of employees and pay the policy’s premiums. This makes the business both the beneficiary and the owner of the policy and allows them to retain all rights to benefits such as the buildup of cash value as well as the death proceeds. It is important to note that the employee does not have any interest in the policy beyond being named as the insured.
When these policies are structured appropriately, the cash value they accumulate will not be subjected to federal income tax. In addition, the corporation may borrow against these policies and use the funds to pay for the policy’s premiums or nonqualified plans. Corporations may also elect to deduct some or all of the interest they paid on a policy loan.
How Do Corporations Benefit From Funding a NQDC Plan With A COLI?
Business can benefit by using a COLI to fund their NQDC plans. First, it has the potential to offer a tax-free cash value buildup. It also allows the company to recover some or all of the NQDC plan’s costs.
In addition, it allows a business to match its assets to its liabilities, reducing cash flow problems when distribution occurs. Finally, it offers reassurance to plan participants that the corporation’s cash flow will not impact their benefits.
There are a few risks involved, however. For example, if the insurance company encounters serious financial difficulties, the corporation may have trouble accessing the cash value of the policy to pay for its plan benefits. Therefore, it is essential to consider the financial stability and earnings history of an insurance company prior to buying COLI from them.
Can Companies Purchase COLI For All Their Employees?
In the past, some companies purchased COLI policies as a way to take advantage of certain tax loopholes. These days, however, such policies are regulated more carefully, and the IRS requires certain conditions to be met in order for corporations to receive the tax-free death benefit.
For example, corporations may now only buy COLI policies for their top 35 percent of employees in terms of compensation. They are also required to provide those employees with written notice of their intent to purchase the policy as well as its terms, and they must obtain their consent prior to purchasing it. These rules are aimed at preventing the practice of purchasing policies on lower-ranking employees without their knowledge and paying premiums on them long after they have left the company.
In addition, the company must show that they have an insurable interest in terms of potential for loss in the event that a specific employee dies in order to justify their COLI policy purchase.
Learn More About Corporate-Owned Life Insurance Policies With Vector Benefits
To find out more about how your company can take advantage of corporate-owned life insurance policies to reduce financial risk, reach out to the experienced benefits specialists at Vector Benefits today.