Corporate-owned life insurance
Encyclopedia
Corporate-owned life insurance (COLI), also known as dead peasant life insurance or janitors insurance, is life insurance
on employees' lives that is owned by the employer, with benefits payable to the employer. When the employer is a bank, it is known as a bank owned life insurance (BOLI).
COLI was originally purchased on the lives of key employees and executives by a company to hedge
against the financial cost of losing key employees to unexpected death, the risk of recruiting and training replacements of necessary or highly-trained personnel, or to fund corporate obligations to redeem stock
upon the death of an owner. This use is commonly known as "key man" or "key person" insurance. Although this article refers only to practice and policy in the United States
, key person insurance is used in other countries as well.
Primarily in the 1990s, some companies aggressively insured a broad base of employees, sometimes without the employee's knowledge and consent. Additionally, the premiums for this insurance were leveraged
and deducted, in essence creating a transaction with little or no economic substance – the company essentially put up none of their own money, and received minimal death benefits long term, but gathered significant interest deductions over time – the only "real" value to the transaction. In 2006, the U.S. Congress and the Internal Revenue Service
(IRS) set some guidelines and limits on this practice.
Today, COLI is most common for senior executives of a firm, but its use for general employees is still sometimes practiced, primarily as a real economic transaction for Voluntary Employee Benefit Associations (VEBAs).
("IRC") dealing with life insurance benefits paid due to the death of the insured, the benefits are usually excluded from the taxable income of the beneficiary.
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 beneficiary of the death benefit rather than the individual employee and their family. 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).
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, which 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 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
."
The Internal Revenue Service
(IRS), via the Supreme Court case Knetsch v. United States
(1947), had early success in challenging the bona fides of these types of arrangements as creating legitimate debt and interest eligible to be deducted. However, subsequent court losses and IRC amendments weakened their position, 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).
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.
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 by introducing conditions that must be met in order to exclude from gross income the proceeds from 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 employer's income provided all the following Notice and Consent Requirements and one of the Specified Exceptions are met.
Notice and Consent Requirements
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.
by the Russian novelist Nikolai Gogol
. Before the emancipation of the serfs in Russia in 1861
, they were regarded as chattel, and inventoried as "souls". These "souls" could be bought, sold and used as collateral for loans and mortgages. In the novel, the protagonist Chichikov travels Russia seeking to purchase "dead peasants", "souls" who had been reported in a previous census but who had since died. In purchasing the "dead souls", he will relieve the previous owner of the tax burden, while accumulating a number for himself that will allow him to obtain loans with them as collateral.
The term entered popular usage in America journalistic coverage of some court cases involving COLI in the mid- to late-1990s, and more prominently via Michael Moore
's 2009 movie Capitalism: A Love Story
, which had a segment criticizing COLI. In the court record of the IRS lawsuit decided in 1999 against Winn-Dixie for use of COLI for tax avoidance, several memos written by the insurance brokerage firm handling the policies between Winn-Dixie and AIG
had described the practice under the title of "Dead peasants".
When there is no "insurable interest" between the policy owner and the insured.
Life insurance
Life insurance is a contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger...
on employees' lives that is owned by the employer, with benefits payable to the employer. When the employer is a bank, it is known as a bank owned life insurance (BOLI).
COLI was originally purchased on the lives of key employees and executives by a company to hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
against the financial cost of losing key employees to unexpected death, the risk of recruiting and training replacements of necessary or highly-trained personnel, or to fund corporate obligations to redeem stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
upon the death of an owner. This use is commonly known as "key man" or "key person" insurance. Although this article refers only to practice and policy in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, key person insurance is used in other countries as well.
Primarily in the 1990s, some companies aggressively insured a broad base of employees, sometimes without the employee's knowledge and consent. Additionally, the premiums for this insurance were leveraged
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
and deducted, in essence creating a transaction with little or no economic substance – the company essentially put up none of their own money, and received minimal death benefits long term, but gathered significant interest deductions over time – the only "real" value to the transaction. In 2006, the U.S. Congress and the Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
(IRS) set some guidelines and limits on this practice.
Today, COLI is most common for senior executives of a firm, but its use for general employees is still sometimes practiced, primarily as a real economic transaction for Voluntary Employee Benefit Associations (VEBAs).
Tax law history
Under the Internal Revenue CodeInternal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
("IRC") dealing with life insurance benefits paid due to the death of the insured, the benefits are usually excluded from the taxable income of the beneficiary.
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 beneficiary of the death benefit rather than the individual employee and their family. 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).
1950s: Leveraged insurance
Interest incurred on indebtedness has historically been deductible, (although the deduction of "personal" interest was largely eliminated in 1986), and in the 1950s a type of "leveragedLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
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, which 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 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
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
."
The Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
(IRS), via the Supreme Court case Knetsch v. United States
Knetsch v. United States
Knetsch v. United States, 364 U.S. 361 , was a decision by the United States Supreme Court concerning taxation law.The taxpayer was a saver who was convinced to buy a deferred annuity because the inside buildup on such policies is tax-deferred. However, he wanted to claim a deduction on the money...
(1947), had early success in challenging the bona fides of these types of arrangements as creating legitimate debt and interest eligible to be deducted. However, subsequent court losses and IRC amendments weakened their position, 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).
1980s: Tax shelters
Another IRC amendment limited to $50,000 the amount that could be borrowed (and yet yield deductible interest payments) with respect to any one insured. 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 US$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.
1990s to present: Limited reform
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. 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
Pension Protection Act of 2006
The Pension Protection Act of 2006 , 120 Stat. 780, was signed into law by U.S. President George W. Bush on August 17, 2006.-Pension reform:...
, 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 by introducing conditions that must be met in order to exclude from gross income the proceeds from 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 employer's income provided all the following Notice and Consent Requirements and one of the Specified Exceptions are met.
Notice and Consent Requirements
- The Employee must, prior to the issuance of the insurance contract:
- 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.
- Provide written consent to be insured under the contract during and after active employment.
- Be informed in writing if the employer will be a sole or partial beneficiary of any death benefits.
- Specified Exception:
- The insured was an employee at any time during the 12-month period before the insured’s death.
- 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.
According to one source, Hartford Life Insurance estimated that one-quarter of all Fortune 500
Fortune 500
The Fortune 500 is an annual list compiled and published by Fortune magazine that ranks the top 500 U.S. closely held and public corporations as ranked by their gross revenue after adjustments made by Fortune to exclude the impact of excise taxes companies collect. The list includes publicly and...
companies have COLI policies, which cover the lives of about 5 million employees.
Origin of term "Dead peasant" to refer to COLI
COLI is sometimes referred to as "dead peasant" life insurance, by reference to the 1842 novel Dead SoulsDead Souls
Dead Souls is a novel by Nikolai Gogol, first published in 1842, and widely regarded as an exemplar of 19th-century Russian literature. Gogol himself saw it as an "epic poem in prose", and within the book as a "novel in verse". Despite supposedly completing the trilogy's second part, Gogol...
by the Russian novelist Nikolai Gogol
Nikolai Gogol
Nikolai Vasilievich Gogol was a Ukrainian-born Russian dramatist and novelist.Considered by his contemporaries one of the preeminent figures of the natural school of Russian literary realism, later critics have found in Gogol's work a fundamentally romantic sensibility, with strains of Surrealism...
. Before the emancipation of the serfs in Russia in 1861
Emancipation reform of 1861
The Emancipation Reform of 1861 in Russia was the first and most important of liberal reforms effected during the reign of Alexander II of Russia. The reform, together with a related reform in 1861, amounted to the liquidation of serf dependence previously suffered by peasants of the Russian Empire...
, they were regarded as chattel, and inventoried as "souls". These "souls" could be bought, sold and used as collateral for loans and mortgages. In the novel, the protagonist Chichikov travels Russia seeking to purchase "dead peasants", "souls" who had been reported in a previous census but who had since died. In purchasing the "dead souls", he will relieve the previous owner of the tax burden, while accumulating a number for himself that will allow him to obtain loans with them as collateral.
The term entered popular usage in America journalistic coverage of some court cases involving COLI in the mid- to late-1990s, and more prominently via Michael Moore
Michael Moore
Michael Francis Moore is an American filmmaker, author, social critic and activist. He is the director and producer of Fahrenheit 9/11, which is the highest-grossing documentary of all time. His films Bowling for Columbine and Sicko also place in the top ten highest-grossing documentaries...
's 2009 movie Capitalism: A Love Story
Capitalism: A Love Story
Capitalism: A Love Story is a 2009 American documentary film directed, written by and starring Michael Moore. The film centers on the late-2000s financial crisis and the recovery stimulus, while putting forward an indictment of the current economic order in the United States and capitalism in general...
, which had a segment criticizing COLI. In the court record of the IRS lawsuit decided in 1999 against Winn-Dixie for use of COLI for tax avoidance, several memos written by the insurance brokerage firm handling the policies between Winn-Dixie and AIG
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
had described the practice under the title of "Dead peasants".
See also
- Stranger-originated life insurance
When there is no "insurable interest" between the policy owner and the insured.
External links
- COLI Best Practices Act
- Leftcoaster blog Blog coverage regarding the Washington state legislation
- Dead Peasants Insurance: FAQ