Individuals commonly use life insurance policies to gain financial protection for their beneficiaries, and businesses are increasingly using them as an economic strategy.
However, the rules governing corporate-owned life insurance policies are significantly more complex than those that apply to individual and group policies, particularly concerning taxation. Here is a closer look at what a corporate-owned life insurance policy involves and the current tax laws that apply to obtaining these policies.
About Corporate-Owned Life Insurance
Corporate-owned life insurance, or COLI, is a type of insurance that some businesses may choose to obtain for a critical group of employees that will pay them a benefit should one of those employees pass away.
Organizations may use it to reduce their tax burden thanks to its tax-deductible nature. Some may also use COLI for a broader financial strategy, such as covering the costs associated with replacing employees when they pass away, financing their employee benefits offerings, or maximizing their after-tax net income.
Current Tax Laws
Historically some organizations found ways to take advantage of certain tax benefits associated with COLI that went against the spirit of the Internal Revenue code. Now, companies that are seeking the tax-free death benefits of COLI must meet the following requirements:
- The IRS only allows companies to buy COLI policies for their top third of employees when ranked by overall compensation. In many cases, this group will be made up of higher-tier workers such as managers and those in executive roles.
- When an organization seeks to obtain COLI policies for employees, each individual must be informed in writing that the organization wishes to purchase a policy in their name before proceeds can be paid out.
It is worth noting that employees generally react favorably to the idea of their company acquiring a COLI policy on them. It is a strategy that can improve their employer’s finances and ability to offer competitive benefits, and it comes at no cost to the employee. For these reasons, many of the biggest and most reputable organizations in the nation successfully use this approach. Although there is no way for an organization to force an employee to agree to coverage under a COLI pool, most employees are willing to participate when asked as it would be beneficial to the company upon their death.
The proceeds of these policies’ payouts to an organization when an employee dies will be exempt from paying taxes in cases where the organization is both the owner and the beneficiary of the policy, giving the company ample compensation for the loss of the employee and their individual contributions.
Corporations that own these types of policies are required to file Form 8925 with the IRS every year. The form must indicate the number of employees the organization has at the end of the year in question and the number of those insured via such policies. It must also list the total amount of insurance that the organization has under these policies at the end of the year, as well as the policyholder’s name, address, TIN, and category of business. The form must also show that the policyholder has obtained official consent for every insured employee.
Every state has its own tax rules for COLI policies, but it is nevertheless an approach with many tax advantages when set up correctly.
How Is A Corporate-Owned Life Insurance Policy Used?
A COLI policy can be structured in various ways depending on the organization’s financial objectives. It is often used to pay for nonqualified plans such as deferred compensation.
In other cases, it may produce an organization a death benefit upon the passing of key employees so that they can afford the significant expenses often involved in hiring and replacing key employees.
COLI is also viable for funding buy-sell agreements that pay the organization when a partner passes away. Those funds can then buy out that partner’s shares from their heirs or estate. It can also help to recover the costs associated with funding employee benefits like healthcare.
Meet With The Benefits Specialists To Learn More About Corporate-Owned Life Insurance
Many organizations can reduce their financial risk with corporate-owned life insurance policies. Still, it is essential to have an in-depth understanding of the applicable tax laws and employ a sound strategy to reduce the risks of this approach while maximizing its potential benefits.
To learn more about starting a COLI and other methods to help businesses protect their finances, set up an appointment with the experienced associates at Vector Benefits today or call us at 248-796-0995.
