any companies recognize that the skills and abilities of
their employees are invaluable to the conduct of their businesses.
Therefore, they try to use life insurance to reward employees and
protect their businesses by setting up company-owned life insurance
(COLI) programs that include buying policies on their employees lives.
The basic business reason for COLI is to protect the company on the death of employees whose services are vital to the company’s operations. However, because this can create financial benefit to a company (since it gets a business deduction for the policies and the proceeds from the policies when the employees die), the IRS will look at COLI programs closely, and Congress has set limits on the deductibility of their associated costs.
Business purpose and economic substance. The first consideration in determining the validity of COLI costs is a business purpose test: The insurance must be for a valid business reason and must have economic substance. Economic substance depends on whether, from an objective viewpoint, a transaction is likely to produce economic benefits aside from tax deductions. If, in buying the policies and naming itself as beneficiary, no real debt is involved or the transactions are shams, deducting the costs will be denied. If these programs are set up simply for tax reasons, the costs associated with COLI will be disallowed.
Premiums. In general, a business cannot deduct premiums paid on a life insurance policy (even though they are otherwise deductible as a trade or business expense) if the company is directly or indirectly a beneficiary under the policy and the policy covers the life of a company officer or employee or any person (including the company) with a financial interest in the business. If an employer takes out a policy to protect itself from loss in the event of an insured employee’s death, the employer is considered as benefiting directly or indirectly. When a corporation names itself beneficiary of a policy to fund a buy–sell agreement providing for the redemption of any employee’s stock at that employee’s death, the corporation cannot deduct the applicable premiums. Thus, even if the premiums otherwise would be a valid business expense, they are not deductible if the employer is directly or indirectly a beneficiary.
Interest on COLI policies. Generally, no deduction is allowed for interest paid or accrued on any debt with respect to company-owned life insurance policies covering current or former officers or employees of any current or former trade or business carried on by the company or any individual with a financial interest in such trade or business.
Key persons. Businesses often buy key person coverage on the lives of top executives. There is an exception to the interest disallowance rule for interest on debt with respect to life insurance policies covering key persons.
A key person is an individual who is either an officer or a 20% owner of a corporation’s total combined voting power or who owns a 20% capital or profits interest in a noncorporate entity. The number of people who can be treated as key persons may not exceed the greater of (1) five individuals or (2) the lesser of 5% of the total number of officers and employees of the taxpayer or 20 individuals. In addition, the amount allowed as a deduction for interest paid or accrued on debt with respect to policies covering key persons is subject to an interest rate cap.
An Uncertain Future
While COLI programs often serve valid business purposes, they are also viewed as an area of possible abuse. As such, Congress has changed and restricted the rules relating to these programs over the past few years. In the current climate, in which Congress is closely scrutinizing corporate tax shelters, further changes and restrictions may result.
For a discussion of this and other recent developments, see the Tax Clinic, edited by Beth Brooke, in the January 2000 issue of The Tax Adviser.
—Nicholas Fiore, editor
The Tax Adviser
