This article discusses what you need to know in order to understand whether your sale is affected, and if so, what to do about it to assure a valid COLI sale provides the best possible tax outcome.

First and foremost, “COLI” stands for “company owned life insurance”.  More specifically, it refers in the new tax context to any “employer-owned life insurance contract”.  COLI is a term that applies generally to ANY life insurance policy owned by an employer engaged in a trade or business where the employer is directly or indirectly a beneficiary of that insurance policy.  The key point here is use of the word “ANY”.  It means just what it says.  ANY employer-owned life insurance on the life of an insured who is an employee of the employer at the time the policy is issued is generally subject to the new rules.  The only general exception is for insurance on the life of an employee who is neither a US citizen nor a US resident. 

Thus, the key to successful COLI sales is to figure out what the minimum requirements are in order to avoid having the death benefits be subject to income tax when paid to the business at the insured’s death.

The first, and most basic requirement to avoid income taxation, is “notice and consent”.  Before the policy is issued, the employer must provide the insured employee written notice that the employee’s life is being insured, and the employer must obtain the employee’s written consent to being insured.  The employer’s notice must indicate that the employer will be the beneficiary and must also disclose the maximum amount the employee is to be insured for.  The employee must provide written consent to being insured and must acknowledge that the insurance may be continued beyond the employee’s period of employment.  These are the minimum requirements just to get into the ballgame.  If the employer fails to provide written notice and/or obtain written employee consent, nothing else matters.  Proceeds paid to the employer at the insured employee’s death will be taxable to the extent they exceed what was paid for the policy, even if one of the exceptions discussed later happens to apply.  Be forewarned!

To help you address at least this minimum requirement, OMFN has developed a notice and consent form for you to use as part of a COLI sale.  The form number is ADMIN 5307 and the form resides on SalesLink.  The form should be completed by the employer and employee and then it should be photocopied, with a copy given to Underwriting as evidence that this minimum requirement has been satisfied.  This is now a pre-issue requirement for all OMFN issued COLI business.  The employer and employee also should retain copies for their files.  NOTE:  It is REQUIRED that the employer maintain a file of signed copies!  The employer will have to attest to having and maintaining such a file when the employer files an annual information return with the IRS!  While the onus on compliance appears to rest with the employer, clearly companies and agents will want to protect themselves and help clients assure they at least “get in the ballgame”.  This form is designed to help you do that.

Once in the ballgame, what next?  Next is to figure out what the applicable exceptions to the income tax rule are and which ones can be taken advantage of so that policy proceeds will in fact be income tax-free when paid.  Here are the available exceptions.

1.      The insured individual was an employee at any time during the 12 month period before the individual’s death.

2.      The insured individual was a director or a “highly compensated employee” or a “highly compensated individual” at the time the contract was issued.

a.      A “highly compensated employee” is an employee who during the prior year was a 5% or greater owner of the business or had compensation in excess of an annually adjusted dollar amount.  For 2005, the threshold is $95,000. 

b.      A “highly compensated individual” is an employee who is one of the five highest paid officers of the business and those generally in the highest paid 35% of all employees of the business. 

3.      The policy proceeds are payable to:

a.      A member of the family of the insured;

b.      A person designated as a beneficiary of the policy (other than the employer) by the insured;

c.      A trust for the benefit of someone who satisfies “a” or “b” above;

d.      The insured’s estate;

e.      The business, if used to purchase an equity interest (including partnership capital and profits) in the business from anyone named in “a”, “b”, “c”, or “d” above. 

Clearly, the rules are very specific.  The problem is they may ensnare the unwary.  For example, most agents who read this are at least somewhat familiar with key employee insurance.  Do the new rules now apply to this basic and fundamental sale?  You bet.  The employer owns and is beneficiary of the policy on the key employee’s life.  Fits the description to a “T”, doesn’t it?  Unless notice and consent requirements, as well as one of the exceptions just listed, are met, death benefits could be taxable to the extent they exceed what the employer paid for the policy!

What about entity-purchase arrangements, such as corporate stock redemptions or partnership entity purchase buy-sell arrangements?  Same result.  The employer MUST provide notice, receive consent, AND one of the exceptions listed above must be met.  Don’t try taking any shortcuts.  The law is broadly drafted and in the end taking a shortcut simply means everyone probably loses.

How about endorsement split dollar plans?  Absent guidance to the contrary, these arrangements also seem to be subject to the new rules.  After all, the employer owns the policy and at least a portion of the death proceeds are payable to the employer (generally the greater of the cumulative premiums or the cash value).  But what about collateral assignment split dollar?  A case could probably be made supporting being subject to the new rules, too.  While the employer isn’t the named owner, the employer may have certain incidents of ownership under the split dollar agreement.  Better to be safe than sorry…when in doubt, get the notice and consent requirements satisfied and figure out what exception(s) from the list provided earlier might apply.

There is one class of business insurance that should be exempt from the new rules…cross-purchase buy-sell arrangements.  Since the employer does not own the policies involved, nor is the employer directly or indirectly a beneficiary, these arrangements should be outside the purview of the new rules.  So, too, will most insurance policies owned under an employer’s qualified retirement plan.  But whenever in doubt, be certain to discuss the anticipated arrangement with the client’s other advisors, especially the employer’s attorney, just to make sure everyone is aware of the new rules and that the desired benefits of having the insurance in place actually come to pass.

Still another area that might trip some folks up is that of 1035 exchanges.  The new rules are generally applicable to policies issued on or after August 18, 2006.  This provides a general “grandfathering” for policies issued prior to that date, as well as for policies issued after the effective date of the new rules under a 1035 exchange involving a policy issued prior to the effective date.  HOWEVER, if a grandfathered policy is exchanged under Code section 1035 for a new policy on or after August 18, 2006, the new policy may well be subject to the new rules if the new policy provides coverage that is “materially changed” from the prior coverage.  Any material increase in death benefit, for example, will bring the new policy under the new rules.  To be safe, if any substantive change is contemplated as the result of a new sale, it is best to satisfy the notice and consent requirements and to identify an exception that will allow the death proceeds to be received by the employer on an income tax-free basis.

As always, if you have questions about these new rules, or about the tax implications or ramifications of any sale of a life insurance or annuity contract, call or email me.  At OMFN, we will always do our best to give you the best possible answers to questions related to your specific question.  While we cannot and will not give specific tax or legal advice, we will do our best to help you gain an understanding of generally applicable tax rules so that you can be sure that what you propose fits with the client’s objectives and helps achieve them.  Above all, do no harm!

The information in this communication (or in any attachment) was not intended or written to be used or referred to, and cannot be used or referred to (i) for the purpose of avoiding penalties under the Internal Revenue Code, or (ii) in promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).  Clients should consult with their own tax advisor about tax information and their personal situation.  All subject matter contained in this email is subject to change without notice.