What Is Corporate-Owned Life Insurance (COLI)?
Corporate-owned life insurance (COLI) is a type of life insurance policy owned by a company rather than an individual.1 It is a policy that a company purchases on the lives of its employees.
In COLI, the company is both the policyholder and beneficiary, paying premiums and receiving the death benefit upon an insured employee's death, unlike individual life insurance, where the employee and their family hold these roles.
The company purchases the policy to insure the life of a key employee, executive, or owner. In the event of the insured person's death, the company is the primary beneficiary and receives the death benefit payout, typically used to offset the financial impact of losing a valuable contributor to the business.
How Does Corporate-Ownership of Life Insurance Work?
When a company purchases a corporate-owned life insurance policy, it insures the life of a key employee, such as an executive, partner, or highly skilled worker. This coverage helps address potential financial losses tied to that individual’s death. Here's how the process typically works:
- Policy Ownership: The company owns the life insurance policy and pays the premiums. The insured employee must give consent but does not own or control the policy.
- Premiums: The company funds the premiums. Coverage may be structured as term life insurance for a set period or as permanent life insurance that lasts for the employee’s lifetime.
- Death Benefit: If the insured employee dies, the company receives the death benefit. Funds are often used to cover costs such as recruiting a replacement, paying company debts, or offsetting lost revenue.
- Cash Value: Some policies include a cash value component that grows over time. The company may access this value if needed, providing liquidity for business operations.
Companies often work with a life insurance professional or advisor to determine whether this type of policy aligns with their goals and circumstances.
Pros: Benefits of Corporate-Owned Life Insurance
Corporate-owned life insurance, also called company owned life insurance, offers several advantages for businesses and is often used to support long-term business goals. Some of the key benefits are:
- Key Person Protection: COLI helps provide financial support when a key employee dies. The death benefit can help cover lost revenue, recruit and train a replacement, and support the business during a transition period.
- Funding Buy-Sell Agreements: COLI can fund buy-sell agreements by giving remaining owners the funds needed to purchase a deceased owner’s shares. This helps avoid ownership disputes and supports business continuity.
- Offsetting Deferred Compensation Costs: Companies may use COLI to offset deferred compensation obligations for key executives. The death benefit can help cover these liabilities, making it a practical way to support executive benefit plans.
- Estate Planning Support for Business Owners: For business owners, COLI can provide liquidity to an estate. The death benefit may help cover estate taxes and other related expenses.
Tax Benefits of Corporate-Owned Life Insurance
Tax treatment is one reason businesses consider corporate-life insurance ownership.2 Here's how COLI can benefit your business financially:
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Tax-Deferred Cash Value Growth: Some COLI policies build cash value over time. This value grows tax deferred, meaning gains are not taxed while the policy remains in force. Companies may use this feature to manage excess cash more efficiently.
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Tax-Free Death Benefits: In most cases, the death benefit paid to the company is tax free. This provides funds without added tax impact when a key employee dies.
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Business Expense Considerations: COLI premiums are generally not tax deductible. However, the combination of tax deferred cash value growth and tax free death benefits makes COLI appealing for companies focused on long term strategy.
For these reasons, COLI is often included as part of a broader tax approach to help manage costs and support business stability over time.
Cons: Disadvantages of Corporate-Owned Life Insurance
While corporate-owned life insurance can offer benefits for businesses, there are several drawbacks to consider before purchasing a policy. Here are the primary drawbacks of corporate-owned life insurance:
- High Upfront Costs: COLI policies can be expensive, especially whole life or universal life insurance. Premiums are often higher than individual policies due to larger death benefits and cash value accumulation. For small or mid-sized businesses, these costs may be difficult to sustain.
- Ongoing Premium Payments: The company is responsible for paying premiums, which can strain budgets during periods of cash flow challenges. These premiums are generally not tax deductible, making them a long-term expense that must be planned for.
- Taxation of Cash Value Withdrawals: Although cash value grows on a tax-deferred basis, withdrawals or loans may be subject to taxes. Poorly managed distributions can create unexpected tax liabilities and reduce the overall benefit of the policy.
- Potential for Tax Law Changes: The tax advantages of COLI depend on current tax laws. If legislation changes, businesses could lose some of the benefits that originally made the policy appealing.
- Negative Employee Perception: Because the company is the policy beneficiary, some employees may feel uneasy knowing their lives are insured primarily for the company’s benefit. This perception can affect morale, especially if employees see no direct benefit.
- Potential Financial Risks: Cash value can fluctuate based on policy type and underlying asset performance. If a policy is canceled or surrendered early, surrender charges may apply, reducing the cash value and potentially resulting in a loss.
- Long-Term Commitment: COLI is designed for long-term use, and it may take years for meaningful cash value to build. Locking funds into a policy can limit liquidity and reduce flexibility for short-term business needs.
- Potential Legal and Regulatory Scrutiny: COLI policies may attract scrutiny if they appear excessive or designed to exploit tax rules. While different from stranger-originated life insurance, concerns can arise if coverage levels do not align with business needs.
Federal law also requires employers to notify employees and obtain written consent before purchasing COLI policies. Failure to meet these requirements can result in fines or legal challenges.
Types of Corporate-Owned Life Insurance Policies
Corporate-owned life insurance policies are not one size fits all. Businesses can choose from several options, each with different features.
| Policy Type | How It Works | Key Features |
|---|---|---|
| Term Life Insurance | Covers a set period, usually 10, 20, or 30 years | Pays a death benefit if the employee dies during the term. Does not build cash value. |
| Whole Life Insurance | Covers the employee for their lifetime as long as premiums are paid | Builds cash value over time. Coverage lasts for life, as long as your premiums. |
| Universal Life Insurance | Offers flexible coverage and payment options | Allows changes to premiums and death benefits. Builds cash value, with added flexibility. |
When Should Your Business Commit to a COLI Policy?
Corporate-owned life insurance is not limited to large corporations. Businesses of many sizes can use it for financial protection, though it tends to be a better fit for certain situations.
COLI is often more effective for larger organizations with strong resources and long-term strategies. For smaller businesses, the cost, complexity, and tax treatment may outweigh the benefits, making these policies less practical.
Situations Where COLI May Be a Strong Fit
A business may want to consider a COLI policy in the following scenarios:
- Key Employee Dependency: If your business depends heavily on a small group of executives or key employees, COLI can support key person insurance. This helps protect the company from financial disruption if one of those individuals dies unexpectedly.
- Highly Compensated Executives: Businesses with highly compensated executives may use COLI to support executive compensation plans, such as deferred compensation arrangements. This can help companies offer competitive benefits while supporting long-term obligations.
- Tax Planning Needs: Companies seeking tax-efficient ways to manage excess cash or address tax exposure may benefit from COLI’s tax-deferred growth and tax-free death benefits.
Conclusion
Corporate-owned life insurance is important for businesses looking to help protect their financial future and crucial employees. Whether your company relies on a few top executives or simply looking for ways to optimize its tax strategy, COLI helps offers protection and financial growth opportunities. Purchasing a COLI policy helps ensure that your business remains secure even in the face of unexpected challenges.
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Sources
- What is Corporate-Owned Life Insurance (COLI)? https://www.bolicoli.com/coli/.
- H.R.2251 - COLI Best Practices Act of 2005. https://www.congress.gov/bill/109th-congress/house-bill/2251.
