Death benefits paid under a life insurance policy due to the death of the insured are usually excluded from the taxable income of the beneficiary under the Internal Revenue Code ("IRC"). Because of the tax-free nature of death benefits, the IRC prohibits the deduction of the premiums paid for life insurance when the premium payor is also the owner of the insurance. In addition, loans from insurers secured by policy values are not income and earnings credited to an owner's policy values (known as "inside buildup") by the insurance company are not currently taxed (and may escape taxation altogether if such earnings are not distributed other than as part of the death benefits paid upon the death of the insured). Interest incurred on indebtedness has historically be deductible,(although the deduction of "personal" interest was largely eliminated in 1986), however, and so in the 1950s a type of "leveraged insurance" transaction began being marketed that permitted an insurance owner to in effect deduct the cost of paying for insurance by (1) paying large premiums to create cash values, (2) "borrowing" against the cash value to in effect strip out the large premiums, and (3) paying deductible "interest" back to the insurer that was in turn credited to the policy's cash value as tax-deferred earnings on the policy that could fund the insurer's legitimate charges against policy value for cost of insurance, etc.
The Internal Revenue Service ("IRS") had early success in challenging the bona fides of these types of arrangements as creating legitimate debt and interest eligible to be deducted under the IRC provision permitting interest deductions in the Supreme Court case known as Knetsch v. U.S. Subsequent court losses and amendments to the relevant provisions of the IRC had the effect, however, of appearing to permit tax-deductible borrowing to provide funds to pay insurance premiums so long as such borrowing did not account for more than three of the first seven annual premiums on the policy (the "4 out of 7" test). Another IRC amendment limited the amount that could be borrowed (and yet yield deductible interest payments) with respect to any one insured to $50,000.
The advantage of being able to deduct interest, on the one hand, and yet not include in income the interest credited to the policy's cash value is a form of "tax arbitrage." Although the 4 out of 7 test was exploited in the 1980s by businesses seeking to in effect pay for insurance on employees/shareholders, e.g., on a deductible basis, the introduction of the $50,000 cap/insured in 1986 in turn led to the creation of broad-based leveraged COLI transactions, i.e., those in which the employer would purchase life insurance on hundreds or thousands of (usually low-level) employees, that would produce tax savings on interest deductions in excess of the actual cost to the employer of engaging in the transaction. These transactions were deemed by the IRS to be "tax shelters."
In a typical broad-based leveraged COLI transaction, a corporate employer would purchase policies on masses of lower-level employees, sometimes without the employees' knowledge or consent. When an insured employee died, the company received the death benefits, and the employee's family typically received either a small portion of the proceeds or nothing. These policies could remain in place even after the employee quits or retires. This practice of taking out life insurance policies on large numbers of rank-and-file employees, with or without their knowledge or consent, with the corporation making itself the beneficiary became known derisively as "janitor insurance" or "dead peasant insurance." Often the real purpose of the transaction was to obtain the benefits of the tax arbitrage and not to acquire insurance.
Ultimately, the IRS won court cases against several leveraged COLI investors, including Camelot Music, Winn-Dixie, American Electric Power, and Dow Chemical. Other similar investors settled their tax cases with the IRS on a basis mostly favorable to the IRS. In the meanwhile, Congress amended the IRC several times again to both ensure that the prohibition on borrowing (on a deductible basis) to fund insurance acquisitions was clear and to deny the tax-free nature of death benefits to corporate employer in some situations (e.g., if the insured was not provided with adequate advance notice and an opportunity to block the insurance acquisition or if the insured was not an employee of the corporation within a year of his or her death). So long as the employer complies with the new rules (adopted in 2006 and characterized as the "COLI Best Practices Act"), however, the tax free nature of the death benefits and the tax deferral on earnings credited to policy value remain (although the opportunity for tax arbitrage no longer exists).
The COLI Best Practices Provision, within The Pension Protection Act of 2006, was signed into law on August 17, 2006. This provision is designed to codify industry "best practices" regarding employer owned life insurance and amend the Internal Revenue Code of 1986 to exclude from gross income the proceeds from certain company-owned life insurance. The Act amends Section 101 of the Internal Revenue Code by adding subsection (j), “treatment of Certain Employer Owned Life insurance Contracts,” and adds Section 60391, “Returns and Records with respect to Employer-Owned Life Insurance Contracts.” Under Section 101(j), the employer owned death benefit proceeds will be considered eligible for exclusion from the employers’ income provided all the following Notice and Consent Requirements and one of the Specified Exceptions are met prior to the issuance of the insurance contract.
Notice and Consent Requirements
The Employee must :
1. Be notified in writing that the employer intends to insure the employee’s life and the maximum face amount for which the employee could be insured at the time the contract is issued. 2. Provide written consent to be insured under the contract during and after active employment. 3. Be informed in writing that the employer will be the beneficiary of any death benefits.
Specified Exception : Directors and Highly Compensated Employees: At time of contract issue, the insured employee; was a director, or a 5% or greater owner of the business at any time during the preceding year, or received compensation in excess of $95,000, adjusted for future inflation, in the preceding year, or was one of the five highest-paid officers, or was among the highest-paid 35% of all employees.
Accordingly, corporate-owned life insurance is still a viable and useful financial product for many businesses. According to one source, Hartford Life Insurance estimated that one-quarter of all Fortune 500 companies have COLI policies, which cover the lives of about 5 million employees.
Executive COLI is sometimes humorously and derisively referred to as "E. COLI", a reference to the disease-causing bacteria, e. coli.