What is Corporate-Owned Life Insurance (“COLI”)?
COLI differs from group life insurance policies that are offered to employees of a corporation because COLI benefits the corporation itself, whereas general life insurance policies are designed to protect the corporation’s employees and their families.
COLI can be structured in many different ways to accomplish a wide variety of business objectives. One of the most common objectives of COLI is to informally fund certain types of nonqualified deferred compensation (“NQDC”) plans. Other forms of COLI include key person life insurance that pays the corporation a death benefit upon the death of a key employee and buy-sell agreements that fund the buyout of a deceased partner or owner of the business.
In many cases, the death benefit is used to buy some or all of the shares of company stock owned by the deceased (such as with a closely-held business). COLI is also frequently used as a means of recovering the cost of funding various types of employee benefits.
How Does COLI Work?
Typically, the corporation purchases a cash-value life insurance policy on an individual employee (or employees) and pays the related policy premiums. The corporation is the owner and beneficiary of the COLI policy. Thus, the corporation retains all rights to the benefits under the policy, including the cash value buildup and the death proceeds. The employee has no interest in the policy (other than being named as the insured).
If structured properly, the cash value that accumulates under the policy will not be subject to federal income tax as it accumulates. The corporation can also borrow against the policy. The borrowed funds can then be used to pay the policy premiums and/or to fund nonqualified plans. In addition, the corporation may be able to deduct all or part of the interest it pays on a policy loan.
Note that in general, the corporation must have an insurable interest in its employee in order to purchase life insurance on his or her life.
Why Should a Corporation Consider COLI to Informally Fund a NQDC Plan?
There are many reasons why an employer might wish to purchase COLI to informally fund a NQDC plan. COLI is attractive because it does the following:
- Provides psychological assurance to NQDC plan participants that their benefits will not be endangered by the corporation’s cash flow demands.
- Enables the corporation to match assets to liabilities, thereby reducing or eliminating any cash flow issues when it is time for distributions to occur.
- Provides potentially tax-free buildup of cash value.
- Enables the corporation to recover all or part of the cost of the NQDC plan.
Are There Risks Associated with Using COLI to Informally Fund a NQDC Plan?
As with many business endeavors, there are several risks that are associated with using COLI to informally fund a NQDC plan. First, if the insurance company experiences severe financial difficulties, the corporation may be unable to access the policy’s cash value to pay the plan benefits. In addition, the disparity between the estimated earnings (earnings projected when the policy is issued) and the actual earnings may leave the corporation with insufficient cash value to pay plan benefits when due. Accordingly, the corporation should evaluate an insurance company’s financial stability and earnings history before purchasing COLI.
Corporations should also be aware of the alternate minimum tax (“AMT”). If a corporate employer is the owner of a life insurance policy, the annual inside buildup (cash value) and death proceeds are among the factors that may subject the employer to the AMT.
Will Use of a COLI Policy to Informally Fund a NQDC Plan Cause the Plan to be Subject to ERISA?
No. If properly structured, the use of a COLI policy to informally fund a NQDC plan will not subject the plan to extensive Employee Retirement Income Security Act of 1974 (“ERISA”) provisions. ERISA imposes participation, vesting, funding, distribution, fiduciary, and reporting rules on employer qualified plans and other funded plans. For the most part, these rules do not apply to unfunded NQDC plans.
Using COLI to informally fund a NQDC plan will not cause the plan to be funded for ERISA purposes. More specifically, if the corporate employer is the owner and beneficiary of the policy, and the NQDC plan benefits are paid directly out of the corporation’s general assets, and the employee participants do not have any contractual rights under the policy, the plan should be considered unfunded for ERISA purposes.
How is COLI Treated for Federal Income Tax Purposes?
Deductions for Payments Made Under a NQDC Plan
The corporation can deduct amounts paid to an employee under a NQDC plan that is informally funded by COLI. In general, the corporation receives the deduction in the taxable year that its contribution is included in the employee’s gross income. This means that the corporation will receive the deduction in the year the employee actually receives the NQDC plan benefits. The corporation can deduct the total amount paid to the employee, including any earnings on the corporation’s contributions. The fact that the source of the funds used to pay the deferred compensation is indirectly a COLI policy does not change the deductibility of the payments.
Deduction of Premiums Paid
Premiums are not deductible when they are paid on any life insurance policy that covers any officer or employee of the corporation when the corporation is a direct or indirect beneficiary under the policy. Because the corporation is the direct beneficiary of a COLI policy, the corporation cannot claim a deduction for the premiums paid.
Deduction of Interest Paid on Loans
If the corporation borrows against the cash value that accumulates in a COLI, the corporation may be able to deduct the loan interest. If four of the first seven years’ policy premiums have been paid without borrowing from the policy, any interest the corporation pays on the loans is ― to a certain extent ― deductible. However, if a policy was purchased after June 20, 1986, no deduction is allowed for interest on loans that total more than $50,000 per insured individual under policies covering the lives of officers, employees, and other financially interested parties. In essence, the corporation can purchase separate COLI policies on any number of employees and deduct the interest on a loan of up to $50,000 from each policy.
Treatment of Cash Value Buildup
Generally, the COLI policy’s accumulated cash value is not currently taxed. The corporation, as policyholder, can accumulate cash value in the policy tax-free as long as the corporation allows the cash value to accumulate inside the contract. Note that the accumulation of cash value in the policy may be subject to the AMT.
Treatment of Policy Withdrawals and Loan Proceeds
If the corporation withdraws the cash value that accumulates within a COLI policy, the Internal Revenue Service (“IRS”) treats the withdrawal as a nontaxable recovery of investment in the contract (i.e., premiums paid minus dividends and prior cash distributions). However, withdrawals that exceed the corporation’s investment in the contract will be treated as income to the corporation, as the employer. Loan proceeds borrowed against the cash value that accumulates within the COLI policy are not treated as distributions under the policy and therefore are not subject to taxation.
It is important to note that it is sometimes possible for a COLI policy to be treated as a modified endowment contract. If a COLI is treated as a modified endowment contract, it does not receive the tax benefits that usually are afforded to life insurance contracts. As a result, the corporation should try to avoid modified endowment contract status whenever possible.
In general, the death benefits received from a COLI policy are exempt from federal income tax. However, Internal Revenue Code Section 101(j), enacted as part of the Pension Protection Act of 2006, limits the amount a corporation can receive as a tax-free death benefit in certain circumstances. In general, unless an exception applies, the amount a corporation can exclude from income as a death benefit from a COLI policy cannot exceed the premiums and other amounts paid by the corporation under the policy. Any death benefit in excess of such amount is included in income.
What is the Bottom Line for COLI?
COLI is a savvy financial option that can be structured in many different ways to accomplish a wide variety of corporate objectives. One of the most common objectives of COLI is to informally fund certain types of NQDC plans. Other forms of COLI include key person life insurance that pays the corporation a death benefit upon the death of a key employee and buy-sell agreements that fund the buyout of a deceased partner or owner of the business.
As with many business endeavors, there are risks associated with using COLI to informally fund a NQDC plan. However, if properly structured, the use of a COLI policy to informally fund a NQDC plan will keep the plan exempt from most ERISA provisions and provide substantial tax advantages and cash flow benefits for the corporation.
By working with an experienced employee benefits attorney to establish the COLI and related NQDC plan, the corporation can be sure to establish a customized plan that best meets its needs and also complies with applicable law.
Author: Emily Langdon
This article has been prepared for general information purposes and (1) does not create or constitute an attorney-client relationship, (2) is not intended as a solicitation, (3) is not intended to convey or constitute legal advice, and (4) is not a substitute for obtaining legal advice from a qualified attorney. Always seek professional counsel prior to taking action.