Corporate-Owned Life Insurance (COLI): What It Is and the Rules That Apply

Ownership, Premiums and Beneficiary in a COLI Contract

Each role carries its own federal rule.

Owner. The business owns the contract. When the business is also directly or indirectly a beneficiary and the insured is an employee on the issue date, that ownership brings the contract within section 101(j)(3).

Premium payer. The business pays the premiums. Section 264(a)(1) provides that "no deduction shall be allowed for... premiums on any life insurance policy... if the taxpayer is directly or indirectly a beneficiary under the policy." IRS Publication 334 adds that "the disallowance applies without regard to whom the policy covers."

Beneficiary. The business is the beneficiary. Proceeds flow to the business at the insured's death.

Policy loans. Section 264(a)(4) disallows interest on debt with respect to policies the taxpayer owns, for contracts purchased after June 20, 1986. Section 264(e) excepts interest on up to $50,000 of such debt per key person, subject to its conditions:

• A "key person" is an officer or a 20-percent owner.
• The number of key persons is capped at the greater of 5 individuals, or the lesser of 5 percent of officers and employees or 20 individuals.
• An interest-rate cap tied to a published monthly corporate bond yield average applies for months beginning after December 31, 1995.
• Controlled groups are treated as one taxpayer.

Split-dollar and executive bonus arrangements use different ownership and beneficiary structures. Split-dollar life insurance is treated separately.

Key Federal Rules: Section 101(j), Notice and Consent, and Form 8925

The baseline rule comes first. Section 101(a)(1) provides that "gross income does not include amounts received... under a life insurance contract, if such amounts are paid by reason of the death of the insured." That exclusion is subject to listed exceptions, including transfer for value under section 101(a)(2) and subsection (j).

The definition. Section 101(j)(3) defines an employer-owned life insurance contract as one "owned by a person engaged in a trade or business" that is "directly or indirectly a beneficiary," covering "an insured who is an employee... on the date the contract is issued." The "applicable policyholder" includes related persons and businesses under common control.

The cap. Section 101(j)(1) limits the exclusion to "the sum of the premiums and other amounts paid by the policyholder for the contract."

The exceptions. The cap is lifted only where the section 101(j)(4) notice and consent requirements are met and one of these exceptions applies:

• Exception (A), based on the insured's status. The insured was an employee at any time during the 12-month period before death. Alternatively, at issuance the insured was a director, a highly compensated employee, or a highly compensated individual as defined in the Code, with "35 percent" substituted for "25 percent" under section 101(j)(2)(A).
• Exception (B), amounts paid to heirs. The amount is paid to a family member, a designated beneficiary other than the policyholder, a trust for them, or the insured's estate. It also covers an amount used to buy an equity interest in the policyholder from any of those persons.

Notice and consent. Before issuance, the statute requires that the employee:

• be notified in writing of the intent to insure and of the maximum face amount,
• consent in writing to being insured, including coverage that may continue after employment ends, and
• be informed in writing that the policyholder will be a beneficiary.

Notice 2009-48, answer A-7, states that a wholly owned corporation and its employee-owner are not excused from these requirements. Its answer A-13 describes limited IRS relief for an inadvertent failure, subject to three conditions:

• the policyholder made a good faith effort,
• the failure was inadvertent, and
• the failure was discovered and corrected no later than the due date of the policyholder's tax return for the taxable year in which the contract was issued.

Answer A-13 also states that missing consent "cannot be corrected after the insured employee has died." This page describes that guidance as of its date.

Reporting. Section 6039I requires each applicable policyholder to file a return for each year it owns contracts issued after the section's enactment. The return shows:

• the number of employees,
• the number of employees insured,
• the total insurance in force,
• the policyholder's identifying details and type of business, and
• whether a valid consent exists for each insured employee.

Section 6039I also requires the policyholder to keep supporting records. Form 8925 is the IRS form for this return.

Notice-and-consent compliance and Form 8925 reporting depend on the facts of the contracts involved and need individual review by the insurers and a qualified tax professional.

Potential Advantages of a COLI Arrangement

The features businesses cite trace to specific rules and contract terms, and none of them is assured for any particular contract.

• Death benefit treatment. Where an exception applies and notice and consent preceded issuance, section 101(j)(2) lifts the cap. The section 101(a)(1) exclusion then governs the full amount, subject to its other limits.
• Cash value. Many permanent policies build cash value under their terms. How that value is taxed depends on the contract meeting the federal definition of life insurance and on how it is accessed.
• Matching a liability. For a deferred compensation promise, cash value can serve as a business asset informally held against a future obligation. It is not a pension or an investment, and nothing ensures it matches the liability.
• Direct payment. The insurer pays the death benefit to the named beneficiary under the contract. Rules on beneficiary designations and claims vary by state.

Important Considerations and Compliance Obligations

Several obligations attach to these arrangements.

• Premiums. Under section 264(a)(1), premiums are not deductible when the business is directly or indirectly a beneficiary, whatever its business purpose. Where the beneficiary relationship is indirect or unclear, the answer turns on the contract's facts.
• Failing section 101(j). The exclusion stops at premiums and other amounts paid, and the excess is included in gross income.
• Reporting. The section 6039I return is due for each year the contracts are owned. A failure to file can have its own consequences, which depend on the facts.
• Policy-loan interest. Section 264(a)(4) disallows the deduction, apart from the section 264(e) key-person exception.
• Transfers. Under section 101(a)(2), a transfer of a policy "for a valuable consideration" can limit the exclusion to the consideration paid plus later premiums, unless a statutory exception applies. That topic needs its own analysis of the contracts involved.
• Insurer practice. Insurers' forms, procedures, charges and timing vary from insurer to insurer and are confirmed with the insurers involved.

When to Review a COLI Arrangement

Business events tend to prompt a review of an existing arrangement. Common triggers include:

• the insured's termination, retirement or change in role, or the death of a different key person;
• new shareholders, an amended buy-sell agreement or an entity conversion;
• a change in deferred compensation obligations;
• changes in law affecting section 101(j), section 264 or section 6039I; and
• the yearly Form 8925 filing, which offers a built-in checkpoint for confirming consents and coverage counts.

A review of this kind typically involves qualified tax, legal and insurance professionals and the insurers involved.

Hypothetical Example: COLI in a Closely Held C Corporation

This example is hypothetical and uses round figures.

Assumptions:

• A C corporation owns a $1,000,000 policy on one key employee.
• The corporation pays $20,000 a year in premiums.
• The insured dies after 10 years.
• No "other amounts" were paid for the contract.
• The policy was never transferred for a valuable consideration.

Premiums paid: $20,000 × 10 = $200,000.

Scenario A (hypothetical): conditions met. Written notice and consent were obtained before issuance, and the insured was a highly compensated employee at issuance. Because both conditions are satisfied, section 101(j)(2) lifts the cap.

• Death benefit: $1,000,000.
• Excluded under section 101(a)(1): $1,000,000.
• Included in gross income: $1,000,000 − $1,000,000 = $0.

Scenario B (hypothetical): no notice and consent. No written notice and consent were obtained before issuance, so the section 101(j)(1) cap applies.

• Excluded: $200,000 (the premiums paid).
• Included in gross income: $1,000,000 − $200,000 = $800,000.

The example illustrates the mechanics only. It does not represent any reader's result, which depends on the contracts and the business's own facts.