One of the fundamental legal requirements for life insurance is that the policyholder have an “insurable interest” in the life of the would-be insured. Because businesses rely on the hard work and know-how of their personnel—particularly those with particular experience or training—companies have an insurable interest in their officers and employees.
In fact, corporate-owned life insurance (COLI) is a specialized form of life insurance designed to protect businesses against the risk of losing vital employees.
As it turns out, though, a COLI program can do a lot more than just provide cashflow when a key employee dies.
More than a few companies have discovered that, due to the tax advantages and long-term growth potential, COLI is also a financially efficient way to fund employee benefits and deferred compensation packages.
What is Corporate Owned Life Insurance (COLI)?
Corporate-owned life insurance is permanent life insurance purchased by a business to cover an employee, officer, partner or other key person.
Traditionally, COLI was primarily intended to insure against the financial risk of losing a vital employee (“key person insurance”)—such as costs associated with hiring replacements or decreased revenue resulting from lost clients or diminished productivity.
More recently, because COLI policies accrue cash value and earn tax-advantaged growth, many companies have extended COLI programs to a greater number of employees and use COLI earnings to fund long-term obligations like employee benefits and deferred compensation packages.
COLI is also frequently used as a source of liquidity for contractual stock buy-backs or to fund a buyout pursuant to a buy/sell agreement.
COLI is particularly popular with large corporations and financial institutions.
Over half of the largest American companies—and the vast majority of financial institutions—own life insurance policies covering their officers or key employees.
With that said, any business with long-term employee obligations and sufficient cash to cover the premiums can potentially benefit from COLI.
How Are COLI Policies Structured?
In most cases, COLI comes in the form of a whole life or universal life policy purchased by an employer to cover a newly hired or recently promoted high-ranking employee or officer.
The insured employee must consent to the coverage at the time of issuance.
Premium cost is almost always borne by the company, which is both policyholder and beneficiary under the COLI policy.
Premium payments are typically more front-loaded than with most consumer life insurance, though paying in too much too early can negatively affect the tax advantages.
Cash Value Growth
COLI cash surrender value builds with each premium payment and earns interest over time, and most COLI policies are structured to build value faster than ordinary consumer policies.
Growth rates are usually linked to the performance of the life insurance company’s investments or to market rates as a whole, depending on the specific policy and company.
COLI policies designed to fund deferred compensation often provide multiple investment options for the company (or sometimes covered employee) to select among.
Cash surrender value is treated as a company asset, and policy growth counts as company earnings, but with no corresponding current tax liability.
When policy proceeds are received by the company as a death benefit, the funds including policy growth are tax-free.
COLI is generally considered an illiquid asset; however, policy value can be accessed at any time through a surrender, partial withdrawal, or contractual policy loan.
To the extent policy growth is received via surrender or partial withdrawal (i.e., not as a death benefit), growth is taxable when received. Policies often impose surrender fees if cashed out within the first few years after issuance.
How Does a COLI Program Work?
Typically, a business will hold COLI policies covering multiple high-ranking employees and officers within a pool or trust earmarked to finance long-term benefits and deferred compensation obligations.
If a policy is triggered by the death of a covered employee, the policy proceeds are paid to the company, and the funds are then available for long-term obligations.
If a covered employee leaves the organization, the company can keep the policy in place or cash out—either way, when received the proceeds are applied toward funding long-term benefits and compensation.
COLI growth offsets some or all of the overhead costs of administering compensation and benefits packages.
Due to the tax advantages of COLI, returns often substantially outperform comparable low-risk investments a business might otherwise use to finance long-term obligations.
What are the Tax Advantages of COLI?
Growth earned on COLI cash value is either tax-deferred or tax-free, depending upon whether it is realized through a surrender or death-benefit payout.
No current tax liability is incurred for cash-value growth unless actually withdrawn from the policy.
And, if growth is received as a death benefit upon the insured employee’s death, the entire amount is non-taxed.
As a result, policy earnings grow and compound for as long as COLI remains in place, with no income or capital gains tax liability if growth is paid out as part of a death benefit.
In most cases, employees and their families don’t directly receive COLI proceeds.
Instead, policy payouts, including long-term, tax-free growth, increase cash available to meet long-term obligations.
However, if a portion of COLI policy proceeds is paid to an insured employee’s surviving family members, the policyholder business can deduct some or all of the payout.
Using COLI to Fund Non-Qualified Deferred Compensation.
A COLI program can provide a tax-advantaged, low-risk means of funding deferred compensation packages offered to attract high-value employees.
Technically, COLI policies are held as part of a business’s general assets, and proceeds are not formally restricted to funding deferred compensation.
Nevertheless, the long-term nature of COLI as a financial asset and its inherent tax and growth advantages, make it a natural fit as a deferred-compensation funding source.
By way of example, a company might implement a COLI program including universal life policies covering a dozen high-ranking officers eligible for deferred compensation.
Premiums paid toward the policies build up cash value, which earns tax-free returns and counts as an asset on the company’s books.
When a policy is triggered, the tax-free proceeds (including growth) are applied toward the funding pool for deferred compensation packages.
Or, if deferred compensation obligations are currently payable and death benefit proceeds have not yet sufficiently funded the pool, partial policy surrenders or policy loans can be used to cover the payments.