In America and around the world, millions of people have access to life insurance as a form of financial security. A lot of businesses and other institutions also purchase life insurance for a variety of reasons, including providing liquidity. Individuals do not always obtain life insurance.
However, the regulations governing corporate ownership of life insurance are a little more intricate than those governing individual or group plans. The history, function, and taxes of corporate-owned life insurance (COLI) in America are all examined in this article.
Nature and Purpose of COLI
COLI, as the name suggests, refers to life insurance that is bought by a business for internal usage. An individual employee or group of individuals, an owner, or a debtor are designated as the insured(s) on the policy, which designates the corporation as either the full or partial beneficiary.
COLI fundamentally differs from group life insurance policies that are normally provided to the majority or all of an organization’s employees in that it is intended to safeguard the employees and their families rather than the firm. COLI can be organized in a variety of ways to achieve a variety of goals.
One of the most popular is funding specific kinds of nonqualified plans, like split-dollar life insurance policies that enable the business to recover its premium investment by naming itself as the beneficiary for the amount of premium paid and the employee who is the policy’s insured as the recipient of the remaining benefits.
Other types of COLI include buy-sell agreements that finance the buyout of a deceased partner or business owner and key person life insurance that pays the company a death benefit following the passing of a key employee.
The death benefit is frequently used to purchase all or part of the shares of stock that the dead owns in the company (such as in the case of a closely held business). Additionally, COLI is frequently utilized to recoup the expense of providing various employee benefits.
Origin of COLI
COLI has been around for well over a century in one kind or another; its moniker, “dead peasant” insurance, comes from 19th-century Russia, where feudal serfs were purchased and sold as property by the wealthy.
In a morbid attempt to gather collateral for loans, members of the ruling elite might “buy” deceased serfs from their former owners who had been counted in the earlier census.
100 year later, businesses in America used COLI to take advantage of an Internal Revenue Code loophole that allowed for a type of tax arbitrage where the owner of a life insurance policy could take out sizable loans against the policy’s cash value and then pay deductible interest on the payments back into the policy, which was then not considered income to the policy owner.
The Internal Revenue Service (IRS) eventually set a cap on this loophole at $50,000 of cash value per policy, but COLI’s use as a tax shelter persisted into the 1980s.
At that time, many businesses would purchase policies on a significant portion of their lowest-tier employees (often without their knowledge or consent) and then take loans against the cash values of those policies.
Companies frequently claimed tax deductions that were higher than the real cost of the premiums they had to pay. Additionally, if the employee passed away, the firm would receive the death benefit from the policy, leaving little to nothing for the individual’s heirs or estate.
The IRS cracked down on these activities in tax courts and won largely favorable rulings, which led to the end of much of this activity in the 1990s.
How Does Corporate-Owned Life Insurance (COLI) Work?
In contrast to typical life insurance, corporate-owned life insurance (COLI) is purchased, owned, and paid for by the employer, who also receives the death benefit upon the employee’s passing.
The fact that neither the employee nor their heirs receive benefits from the policy sets it apart from group life insurance. The firm, however, can, in rare cases, consent to split the settlement with the insured’s family.
Businesses can purchase COLIs to receive considerable tax advantages, recover the cost of funding employee benefit programs, assist in covering income lost and hiring expenses after the insured passes away, and help cover lost revenue.
Key person insurance is a sort of COLI designed to protect important workers, such as CEOs, business owners, partners, or people in specialized roles.
As cash-value insurance plans, COLIs are bought. A portion of the premium payment made by the company is added to a cash value account, where it can be invested or earn interest at a set rate. Investments made using the cash value of the policy continue to be tax-free as long as they are not relinquished before the covered person passes away.
Loans or premium payments may be made using money taken out of COLI’s cash value.
Requirements of Corporate-Owned Life Insurance (COLI)
A corporate-owned life insurance (COLI) contract cannot be formed without the employer demonstrating a significant economic interest—or an insurable interest—in the employee’s life. In other words, the employer must demonstrate that the insured employee’s death would result in a loss of revenue or some other type of financial damage.
The insured employee must provide their approval to have their life insured before a COLI may be put into effect. They should:
- Obtain formal confirmation from the company that it will be the policy’s beneficiary and that the amount of coverage has been disclosed.
- Provide the business with written authorization.
The employer cannot punish the employee for exercising their right of refusal.
Additionally, each year that the COLI contract is in effect, businesses must provide Form 8925 with their tax returns. Additionally, the business must maintain sufficient documents to back up the data on Form 8925.
Corporate-Owned Life Insurance (COLI) and Tax Implications
Corporate-owned life insurance (COLI) is primarily used by businesses for tax reasons. For instance, if the covered employee passes away, the company will receive a tax-free death benefit and have access to a tax-deferred or tax-free cash value account.
The accrued cash value funds, in contrast to usual investments, are only taxed if the life insurance policy is relinquished before the insured’s demise. Additionally, businesses are permitted to borrow money against the policy’s cash value and deduct any applicable interest from their taxable income.
However, the sector is now very tightly regulated because COLIs can be used for tax purposes. For instance, businesses are unable to pay premiums using cash-value loans and then deduct the corresponding loan interest.
Additionally, the payout of the policy will only be tax-free provided the following conditions are satisfied and the company has obtained the required written notification and permission forms:
- The covered worker belonged to the top 35% of paid employees at the business or was a director.
- Within a year of their death, the injured worker had a job with the company.
- The covered employee’s family, estate, or trust might obtain a share of the company through the death benefit.
- The family of the insured employee receives the death benefit.
Current COLI Tax Law
The tax regulations governing COLI are fairly intricate and, in some situations, differ slightly from state to state. One of the most advantageous tax planning tools available is life insurance; both individual and group policies’ death benefits are always tax-free.
However, this isn’t always the case with corporate-owned insurance coverage. These plans must now fulfill a number of requirements in order to maintain their tax-advantaged status in an effort to reduce corporate tax evasion through the use of COLI:
- The highest-paid third of employees are the only ones who can purchase COLI coverage.
- Any employee listed as the insured on a COLI policy must be informed in writing of the company’s intention to insure them, along with the scope of the coverage, prior to the acquisition of the policy.
- If the employer is either a full or partial beneficiary of the policy, it must also notify the employee in writing.
There are two situations in which the corporation may get a tax-free death benefit without the need for these notifications.
The first occurs when a deceased insured employee who had employment with the business at some point in the preceding year passes away. (This regulation forbids businesses from keeping policies on former employees who are no longer employed by the company indefinitely.)
The second one pertains to directors and highly compensated workers; any death benefits provided upon the passing of this group of workers are also not subject to taxation. However, corporate investments in cash value policies grow tax-deferred, just like personal investments.
However, there has also been legal debate over the possibility of tax-free death benefits being paid out to the insured’s relatives or other beneficiaries under certain types of COLI policies.
The tax-free status of this benefit was initially denied by the IRS, but it later withdrew its opposition and allowed the policies to be paid tax-free to families and other heirs, despite the fact that it maintained that the death benefit in this particular case should be taxable in accordance with its interpretation of the tax laws.
Conclusion
Companies employ corporate-owned life insurance to achieve a variety of goals, and the regulations and taxation governing it are intricate subjects that can occasionally be open to interpretation. Consult your financial counselor for further details on this.
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