Breaking Down 'Company-Owned Life Insurance - COLI'
Company-owned life insurance (COLI), or corporate-owned life insurance, is typically taken out on a group of critical employees and pays a benefit when any one of those employees dies. Unlike typical life-insurance policies, COLI policies pay the death benefit to the same entity that pays the premiums.
COLI policies are a way for a corporation to minimize its tax burden, increase after-tax net income, finance employee benefits and cover the expense of replacing an insured employee upon that employee’s death. COLI policies typically continue to cover employees up to the year after they leave the company.
Because corporations have historically used COLI policies to exploit tax loopholes, the Internal Revenue Service requires the company to meet certain conditions to receive a tax-free death benefit. First, the company can only purchase COLI policies on the top 33 percent of employees ranked by compensation. Secondly, it must notify the employee or employees in writing of the terms of the policy before purchasing.
The History of Company-Owned Life Insurance (COLI)
COLI first appeared as a way for corporations to insure against the death of a key employee, such as an executive. Tax loopholes made COLI very appealing to many companies that began purchasing such policies on lower-ranking employees without notifying them, and continuing to pay premiums even after they left the company.
The practice reached its peak in the 1980s, when decreasing regulation prompted companies to insure a majority of employees, borrow against the cash value of the policies and deduct the interest on the loans. In the 1990s, Congress responded by passing laws that require employee consent and an insurable interest on the part of the company, meaning the company had to show the potential for loss due to an employee’s death to justify its purchase of a COLI policy. At the same time, the IRS reduced the ability of a company to deduct interest payments when borrowing against the policies. Companies would often claim that they spent the payouts on employee benefits, however, there was no requirement to do so. The companies didn’t even need to disclose how they spent them.
In the first decade of the 2000s, large corporations paid millions of dollars to settle lawsuits from family members of deceased employees who argued that the practice was unlawful. Later, Congress passed the COLI Best Practices Provision, as part of the Pension Protection Act of 2006, which introduced conditions for tax-free benefits. Consequently, while COLI policies still offer financial advantages to corporations, they are subject to greater regulation.