ELITE ADVISOR BEST PRACTICES
Corporate Owned Life Insurance
Does COLI make sense for underfunded benefit plans?
By Guy Baker
- Life insurance death benefits are tax-free under IRC 101. But when paid to a corporation, the death proceeds are included in the taxable income under the AMT (Alternative Minimum Tax).
- With the pressure being put on employers (unions, cities, states, school districts) by low interest rates, many plans are looking for nontraditional sources of capital—including life insurance.
- Life insurance can be considered an asset class. Like a zero coupon bond, it has no current tax impact (unless it is a modified endowment contract). Unlike bond values, which fluctuate with interest rate changes, life insurance proceeds remain constant when held to maturity.
There have been a number of recent reports about how large corporations are using life insurance on their employees to make a profit. One example: A New York Times article castigatingFreedom Communications, a media company in Southern California, for using employee death benefits to enhance the profits of the company. Other companies like Winn Dixie, Camelot Music and Walmart faced major lawsuits and IRS scrutiny over corporate owned life insurance (COLI).
Is COLI bad, or has the creativity of the insurance industry jeopardized the ethical and legitimate uses of the product for the benefit of tax deductions and corporate profits?
Fundamentally, there is nothing wrong with a corporation (or other entity) using life insurance to “cost recover” benefits payable under sophisticated executive bonus plans or deferral programs. If the insurance can be structured to fund the agreement and recover the costs, why wouldn’t a corporation use this financing method if it can be shown to make strong economic sense? This is, in fact, how insurance was used for many decades.
Insuring against loss of key employees
The doctrine of key man coverage has been existent since the 1940s. Solomon Heubner made famous the concept of human life value. This concept calculated the present value of future income and showed the prospective insured parties why insuring their income made good economic sense. It was a short distance from human capital to cost replacement. How much does a company (and its employees) stand to lose if a key person crashes and never comes back to work? There is no tried and true formula, and each employee makes a different contribution. But a multiple of salary is certainly a good place to start.
Why would a corporation want to own insurance on the lives of employees? One reason is to increase company profits. Life insurance death benefits are tax-free under IRC 101. But when paid to a corporation, the death proceeds are included in the taxable income under the AMT (Alternative Minimum Tax). This gets the camel’s nose in the proverbial tent. It is the first time life insurance benefits have been considered taxable income for anyone.
You have probably read about underfunded health care costs and pension benefits. With the pressure being put on employers (unions, cities, states, school districts) by low interest rates, many of these plans are looking for nontraditional sources of capital. Life insurance is potentially another type of asset class. It is much like a zero coupon bond with no current tax impact (unless it is a modified endowment contract). Bond values can change based on interest fluctuations—not so with life insurance proceeds held to maturity. Life insurance was never meant to be an investment. But the present value of future death benefits can be a considerable sum that would go a long way toward shoring up those deficits. Banks are another example of how life insurance has become an asset class unto itself. Bank-owned life insurance (BOLI) is used by many banks as a way to increase yield on their assets and use that yield to provide benefits to key employees and executives.
Insurance as an asset class
When insurance is considered as an asset class, what many people don’t then consider are the underwriting standards used before a policy can be issued. Besides insurability, there are financial and legal standards that must be met. Is there, in fact, an insurable interest? Equally important, employees must give their permission to the employer to insure them. Companies will not issue policies as key coverage unless they are convinced the insured parties know they are being insured and agree that the employer can be the beneficiary. In most cases, death benefits are shared between the employees’ beneficiaries and the company.
In the final analysis, there is nothing wrong with using life insurance death benefits payable to the employer as a way to recover the cost of benefits provided through employee benefit plans. But when the tax advantages required to make life insurance competitive with other financial products are used to create tax deductions or unfairly create profit for an entity, then the use has crossed a bright line that has been regarded as sacrosanct for nearly 100 years. As is the case with many good ideas and products, it takes only a few to ruin it for the many. Hopefully, insurance carriers will be more diligent in their efforts to protect the product that has served so many for so long.