For many Americans, individual life insurance policies offer a valuable layer of financial protection. However, companies are increasingly purchasing life insurance with the aim of providing liquidity or other purposes. There are many advantages to using life insurance in this way, but there is a complex web of rules and tax laws governing corporate ownership of life insurance that must be understood if organizations want to get the most out of this approach.
What Is Corporate-Owned Life Insurance?
Corporate-owned life insurance, or COLI, is life insurance that a corporation purchases for its own use. The beneficiary of a COLI policy may be the corporation, either in part or in full, while the insured is usually an employee or group of employees, debtor or owner.
COLI should not be confused with the type of group life insurance policies that are often offered to the employees of a company. Group life insurance protects employees and their families rather than the company itself and is not the same as COLI.
The Objectives Of COLI
To understand the tax laws that apply to COLI, it is important to consider the reason that COLI is being used. COLI policies can be structured in different manners depending on the business’s objectives. Many times, it will be used to fund non-qualified plans. For example, a split-dollar policy may allow a business to recoup the premium investment into the policy by naming themselves as the beneficiary for the premium paid, with the rest going to the worker who was insured.
Another type of COLI is a key person life insurance policy that will pay a death benefit to the organization should a key employee pass away. COLI may also be used for buy-sell agreements that will fund the buyout of a partner or owner of the business when they pass away. The death benefit could be used to buy all or just some of the shares of stock in the business that the deceased owned. It can also be used to help recover the costs of funding different types of employee benefits.
COLI Tax Considerations
In the past, companies used these types of policies to take advantage of a loophole in the Internal Revenue Code that enabled a type of tax arbitrage wherein owners of life insurance policies could receive significant loans for the cash value of their policy and pay a tax-deductible interest on their payments back into the policy. At the time, this would not be considered income for the policy owner.
Eventually, the Internal Revenue Service reduced this loophole to just $50,000 in cash value per policy. However, firms found other ways to use COLI as a tax shelter, such as by purchasing policies on large numbers of low-tier employees without their knowledge and getting loans for the cash values of these policies. The tax deductions they received were often higher than the actual cost of the premiums they paid. Then, if the employee died, the company would collect their death benefits, which left nothing for the employee’s estate. The IRS started to take measures against these practices in the 1990s.
Current Tax Law For COLI
Although the tax rules that apply to COLI do vary slightly from state to state, life insurance remains one of the most tax-advantaged instruments available. However, while the death benefits from life policies are always tax-free for group and individual policies, policies owned by corporations face additional regulations aimed at limiting corporate tax evasion through COLI.
For example, corporate-owned life insurance policies may only be purchased for the top third of a corporation’s employees in terms of compensation.
Any employee who has been named as the insured on a corporate-owned insurance policy must be given written notification prior to purchasing the policy outlining the company’s intent to do so as well as the amount of coverage they plan to obtain.
Employees must also be informed in writing if the company is a total or partial beneficiary of a policy that names them as the insured.
However, there are two cases where these types of notifications may not be necessary for the company to get tax-free death benefits. One occurs when an insured employee passes away who worked for the company at some point in the past year. The goal of this rule is to stop companies from keeping policies indefinitely on workers who are no longer employed by them.
The other case involves highly-compensated employees and directors, whose death benefits are not subject to taxation.
Discuss Corporate-Owned Life Insurance Policies With The Benefits Specialists
Corporate-owned life insurance can be an effective way for corporations to reduce financial risk, but it must be approached carefully to maximize the benefits. Contact the experienced associates at Vector Benefits today for assistance with all of your life insurance needs and help starting a COLI policy.