Corporate Owned Life Insurance (COLI)

Corporate-owned life insurance (COLI) is a common funding vehicle for non-qualified deferred compensation plans. Essentially, COLI is a life insurance policy owned by the employer that insures the lives of one or more employees of the employer. The policy typically covers the lives of several executive employees and can be used for a variety of purposes that may or may not bear any relation to the anticipated actual financial loss to the employer on the death of the covered employees.

Since the employer is the owner and beneficiary of the COLI policy, the employer retains all rights to the benefits under the policy, including the cash value buildup and the death proceeds. The employee has no interest in the policy (other than being named as the insured). Typically, the employer purchases cash value life insurance policies on individual employees and pays the premiums for the policies. If structured properly, the cash value that accumulates under the policy will not be subject to tax as it accumulates. The employer is permitted to borrow against the policy. These borrowed funds then may be used to pay the policy premiums and/or to fund non-qualified plans. Furthermore, the interest paid on any loan against the cash value may be deductible by the employer.

In terms of funding non-qualified plans, COLI is attractive because it provides actual (and psychological) assurance to employee plan participants that their benefits under the non-qualified plan will not be endangered by the employer's cash flow demands, ensures the employer that assets will be available for distribution to participating employees, thereby reducing or eliminating a financial strain on the employer when it is time for distributions to occur, and provides tax-free buildup of cash value.

If you wish to use COLI to fund a non-qualified plan, you should know that there are a couple of risks involved. For instance, if a COLI policy is the only source of funds for the payment of your obligations under a non-qualified plan and the insurance company experiences severe financial difficulties, you may be unable to access the policy's cash value to pay the plan's benefits.

In addition, a disparity between the estimated earnings (earnings projected at policy issue) under the policy and the actual earnings may leave the employer with insufficient cash value to pay plan benefits when due. It is important, therefore, to evaluate carefully the insurance company's financial stability and earnings history.

Amounts paid to an employee under a non-qualified plan that is funded by a COLI policy are generally deductible by the employer. This deduction is available in the year in which the amounts are includable in the income of the recipient (to the extent the payments are ordinary and necessary business expenses). Basically, this means that the employer gets the deduction when the employee gets the money. The fact that the source of the funds used to pay the deferred compensation is a COLI policy does not change this result.

With respect to the premiums paid by an employer on a COLI policy, no deduction is allowed. This is because the employer is the direct beneficiary under the policy. The general rule is that no deduction is allowed for premiums paid on any life insurance policy covering the life of any officer or employee of the employer--or of any person financially interested in any trade or business carried on by the employer--when the employer is directly or indirectly a beneficiary under the policy.

The final deduction question involves interest on loans to the employer from a COLI policy. It is possible for such interest to be deductible by the employer, assuming that certain conditions are met. If four of the first seven years' policy premiums have been paid without borrowing from the policy, interest paid by the employer on loans from the COLI policy is deductible, to a certain extent.

More particularly, for policies purchased after June 20, 1986, no deduction is allowed for interest on loans totaling more than $50,000 per insured individual under policies covering the lives of officers, employees, and other financially interested parties. Therefore, the employer is allowed to purchase separate COLI policies on any number of its employees and deduct the interest on a loan of up to $50,000 from each policy.

The policy's cash value buildup is not taxed currently. In general, life insurance policyholders can accumulate cash value in the policy free of taxation as long as the policyholder allows the cash value to accumulate inside the contract.

An employer's withdrawals of cash value under a life insurance policy generally are treated as a nontaxable recovery of investment in the contract (premiums paid minus dividends and prior cash distributions). However, withdrawals that exceed the employer's investment in the contract will be treated as income to the employer. Loans are not treated as distributions under the policy and therefore are not subject to taxation.