Corporate-Owned Life Insurance Coverage

Corporate-owned life insurance, known as COLI, is taken out by the company on the life of an employee where the company is the beneficiary of the policy proceeds. COLI policies are attractive to companies not just because they provide tax-free liquidity on the death of an employee, but also because of additional favorable tax treatment and financial benefits they can provide if structured properly.

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Lauren Blair has been practicing law for more than 25 years. Lauren has been a licensed member in good standing of the Illinois bar since 1994, the year she graduated from Illinois Institute of Technology’s Chicago-Kent College of Law. Prior to law school, Lauren obtained a Bachelor of Arts in government from Cornell University. For the first 20 years of her practice, she worked in mid-size l...

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UPDATED: Mar 30, 2021

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Overview

  • Corporate-owned life insurance is a way for a business to offset the expenses of losing a valuable upper-tier employee
  • Businesses must adhere to specific guidelines in order to buy life insurance on employees
  • In addition to being required to notify employees, companies are also subject to a number of IRS policies regarding the premiums and financial repercussions of corporate-owned life insurance

Did you know that companies can buy life insurance policies on the lives of their employees where the death benefit goes to the company rather than the insured employee’s beneficiaries? The theoretical reason behind corporate-owned life insurance is to protect the company when a key employee dies by allowing the company to use the death benefit to help find a successor or to buy back the deceased’s ownership interest in the company. However, corporate-owned life insurance policies are also attractive to companies because of the favorable tax treatment they receive and the additional financial benefits they can provide if structured properly.

The rules governing life insurance policies where the company is the owner and the beneficiary are unique, and while some are discussed in this article, it is important to always consult with a professional for tax advice on life insurance policies.

If you’re considering corporate-owned life insurance for the financial benefits it can provide for your business, put your ZIP code into our search tool to connect with a knowledgeable insurance provider in your area who will walk you through the pros and cons of this unique coverage.

What is corporate-owned life insurance?

Corporate-owned life insurance, abbreviated as COLI, is life insurance purchased by a company on the life of its employees and/or owners. The company is not just the owner of a COLI policy, it is also the named beneficiary of the policy proceeds. Although in some cases, a COLI policy might allow the employee to designate a beneficiary to receive a portion of the death benefit proceeds, most often the employee has no rights or interest in the life insurance proceeds.

The concept of a business taking life insurance on its workers originated in Russia hundreds of years ago when it was known as dead peasant insurance. Back then, feudal peasants were treated as property and were listed as such on census records. Landowning gentry often engaged in the practice of buying and selling dead serfs to increase the collateral on their books to obtain loans.

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What is the purpose of corporate-owned life insurance?

Today, COLI policies serve a variety of purposes.

One of the main objectives of a COLI is typically to provide a source of assets to finance employee benefit programs. For example, a company can take out a COLI policy on executives and other key employees and then use the life insurance proceeds to fund its nonqualified deferred compensation or retirement savings plans for highly-compensated employees.

COLI policies are also used to recoup the cost of group insurance by naming the company as the beneficiary of a portion of the life insurance proceeds up to the amount of premiums paid.

Another common purpose of COLI is to provide assets, through the death benefit, to buy back a deceased owner’s shares of stock or other equity interest in the business. 

Are there tax advantages to corporate-owned life insurance?

Life insurance is often viewed as one of the most tax-advantaged assets because life insurance proceeds are tax-free for individual and group policies. If a COLI policy is structured properly, the allowable cash value that accumulates under the policy will not be subject to federal income tax as it accumulates.

What’s more, the company is allowed to borrow against the policy and use the borrowed funds to pay the corporate-owned life insurance premiums and/or fund nonqualified plans. On top of that, even though a business cannot deduct premiums paid on a COLI policy, companies may be able to deduct all or part of the interest on borrowed funds.

Many companies have used COLI to game the system and evade tax liability. As a result, the IRS enacted the Pension Protection Act of 2006, which sets forth specific rules that limit the amount an employer can receive from a COLI policy as a tax-free death benefit. In general, unless an exception applies, the amount a company can exclude as income from a COLI death benefit cannot exceed the premiums and any other amounts paid for the policy.

What are the tax rules for corporate-owned life insurance?

Corporations have certainly used COLI policies for tax evasion purposes. In an effort to prevent companies from using COLI policies to evade tax obligations, the IRS implemented several requirements that companies must follow in order for it to maintain tax-free status. Below is a general explanation of some of the rules that govern corporate-owned life insurance taxation, but you should always consult a tax professional for legal advice.

Restrictions Relating to the Insured

COLI policies can only be purchased on the highest-compensated third of employees. Additionally, in most cases except for directors and certain highly-compensated employees, any employee named as the insured on a COLI policy must receive written notification before purchase of the policy, not just of the company’s intent to take out life insurance on the employee’s life, but also of the amount of coverage and whether the company is a partial or total beneficiary of the policy.

Deductions for Nonqualified Plan Payments

Companies can deduct amounts paid to an employee under a nonqualified deferred compensation plan that is funded by COLI, including any earnings on the contributions. The company receives the deduction in the year the employee actually receives the nonqualified plan benefits. 

Deductions of Premiums

An employer cannot deduct the premiums of a COLI policy because of the general rule that premiums are not deductible on any life insurance policy where the company is the policyholder and the insured is an officer or employee of the company.

Deduction of Interest Paid on Loans

Depending on the particular circumstances, companies may be able to deduct the interest of a loan taken against the accumulated cash value in a COLI. However, for policies purchased after June 20, 1986, the IRS does not allow a deduction for interest on loans that total more than $50,000 per insured.

Taxation of Cash Value, Policy Withdrawals, and Loan Proceeds

The accumulated cash value of a COLI generally is not taxed. If the accumulated cash value is withdrawn, the IRS treats the withdrawal as a nontaxable recovery of investment in the contract so long as the withdrawals do not exceed your investment in the contract (i.e., premiums paid minus dividends and prior cash distributions).

On the other hand, withdrawals that exceed the company’s investment in the contract will be treated as income to the company. With regard to loan proceeds that are borrowed against the COLI accumulated cash value, they are not subject to taxation because they are not treated as distributions under the policy.

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Get Help

As discussed above, corporate-owned life insurance can be used by companies to achieve many financial benefits. However, because COLI policies have been used in the past to evade tax obligations, the IRS enacted specific taxation rules to govern the use of COLI.

As with all tax issues, it is important to get professional advice. For more information on corporate-owned life insurance, enter your ZIP code in our search tool to find an insurance provider who can answer your questions about whether a COLI policy is right for your business.

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