Corporate- and bank-owned life insurance (COLI and BOLI)

Corporate-owned life insurance (COLI) is life insurance that a company buys on its employees, with the company as owner and beneficiary. Bank-owned life insurance (BOLI) is the same thing held by a bank. Employers use it to offset the cost of employee benefits and to informally fund executive pay promises; the income tax advantages (tax-deferred growth and a generally tax-free death benefit) are why it exists, and the 2006 notice-and-consent law and bank regulators' rules are why it is closely governed.

How COLI works

The employer applies for permanent life insurance, usually universal or variable universal life, on a group of employees, often officers and highly paid staff. It pays the premiums, owns the policy and receives the death benefit. The cash value grows inside the policy and the employer can access it by loans or withdrawals, subject to the usual cash value rules.

Employers generally buy it for one of three reasons:

1. Informal funding for benefits. A company that has promised deferred compensation or supplemental retirement benefits to executives buys COLI whose growth and death proceeds are meant to offset the future cost. The policy belongs to the company, not the executive, and the executive has no claim on it.
2. Offsetting benefit costs. The after-tax return on the policy is used to help pay for health, retirement or other benefits across the workforce.
3. Key person or buy-sell coverage. See key person life insurance.

The product is a standard life policy; what is distinctive is who owns it and why. The policy must still meet the definition in IRC section 7702; see section 7702.

How BOLI differs

Banks and thrifts buy BOLI under the same tax principles but subject to bank regulation. In 2004 the federal banking agencies (OCC, Federal Reserve, FDIC and the Office of Thrift Supervision) issued an interagency statement on the purchase and risk management of life insurance (OCC Bulletin 2004-56, December 7, 2004). It reminds institutions that BOLI must be consistent with safe and sound banking practices and flags liquidity, transaction, reputation and compliance risks; examiners look at prepurchase analysis, ongoing risk controls, and especially the limit on a bank's aggregate cash surrender value of BOLI (OCC Bulletin 2004-56). Details of current supervisory expectations should come from the bank's own primary regulator.

Banks may hold BOLI in a general account (the insurer's portfolio backs it and the bank bears credit exposure to the insurer) or a separate account (assets segregated, with investment risk and insurer credit exposure managed differently). Banks often watch the insurer's financial strength closely because the asset is a large share of capital; see AM Best, S&P, Moody's and Fitch ratings explained.

The rules that shape COLI

Notice and consent: IRC section 101(j)

For employer-owned contracts issued after August 17, 2006, IRC section 101(j) limits the tax-free death benefit to the premiums and other amounts the employer paid, unless:

• before issue the employee received written notice that the employer intends to insure them and the maximum face amount, and that the employer will be a beneficiary,
• the employee gave written consent (which can continue after employment ends), and
• one of the statutory exceptions applies: the insured was an employee within 12 months before death, or was a director, a highly compensated employee or a highly compensated individual when the policy was issued, or the proceeds go to the insured's family, designated beneficiary, trust or estate, or are used to buy an ownership interest from them (IRC section 101).

The employer reports annually on Form 8925, filed with its tax return, the number of employees covered by employer-owned contracts issued after August 17, 2006 and the total amount of employer-owned life insurance in force (IRS About Form 8925). Plain explanation: section 101(j) notice and consent.

This law followed a wave of lawsuits and press coverage in the 2000s over companies that insured rank-and-file workers, sometimes without telling them, and kept the money when they died. Notice and consent is the response.

Interest deductions: IRC section 264

IRC section 264 limits deductions tied to life insurance. Premiums are not deductible when the taxpayer is a beneficiary (section 264(a)(1)). Interest on debt that secures or finances life insurance is generally not deductible (section 264(a)(4)), with an exception for up to $50,000 of indebtedness per key person under section 264(e). Section 264(f) denies a business a deduction for interest expense in proportion to the unborrowed cash value of policies it owns. An exception applies to contracts covering a 20-percent owner, officer, director or employee (IRC section 264).

Insurable interest and state law

The employer needs insurable interest in the employee, and some states restrict insuring non-key employees or require consent regardless of federal law. See insurable interest: who can buy life insurance on whom and your state's insurance department.

Risks for the employer

• Cash value tied to the insurer. A general-account policy is only as strong as the insurer; guaranty association limits apply to policies but may not cover large corporate holdings fully. See state life and health guaranty associations.
• Taxable surprise. Missing the notice-and-consent step can cost the tax-free treatment of proceeds.
• Illiquidity. Surrender charges and taxes on gains if the policy is terminated.
• Accounting. Employers carry the cash surrender value as an asset, and changes can affect earnings.
• Reputation. Policies on rank-and-file employees can draw criticism even when legal.
• Interest deduction loss. Leveraged designs can be partly or wholly nondeductible under section 264.

What employees should know

If you are asked to sign a notice and consent form, you are agreeing that your employer may insure your life and be the beneficiary. Federal law does not stop an employer from doing so once the form is properly signed. Read the maximum face amount, note whether consent continues after you leave, and ask whether any part of the proceeds will go to your family. Your own coverage needs are separate; see is life insurance through work enough?.

A hypothetical example

Say a regional bank uses BOLI on 25 senior officers to help offset the cost of a supplemental retirement plan. It collects written consents before issuing the policies, files Form 8925 with each year's tax return, and reports the cash value as an asset. At an officer's death, the bank receives the death benefit, generally income tax-free, and the officer's family receives the supplemental retirement benefit promised under the separate plan, not the insurance proceeds. The example is illustrative.

Key takeaways

• COLI is employer-owned life insurance on employees; BOLI is the same held by a bank and overseen by banking regulators.
• It is used to informally fund benefits and executive pay, not to give employees coverage.
• For contracts issued after August 17, 2006, IRC section 101(j) requires written notice and consent, and Form 8925 reports employer-owned coverage.
• IRC section 264 limits deductions for premiums and for interest tied to policy cash value.
• Employers should use a tax professional and, for banks, their primary regulator's guidance.