Employer Owned Life Insurance, It Might Not Be Quite What You Think

Employer Owned Life InsuranceEmployer Owned Life Insurance is a funny topic.  Funny in the way religion divides the masses and causes all kinds of fun (and not very amicable) discussion.  And, a lot like religion, there's a fair deal of mis-interpretation that leads to further distrust and hatred (ok no more religion on the Insurance Pro Blog, ever).

Today, I'm not really interested in discussing the moral ramifications of EOLI (as it's known).  Just the applicability and why this term “Employer Owned Life Insurance” exists.

COLI?

Those of use who have been in the industry for a little while have no doubt run into a topic known as COLI or corporate (sometimes company) owned life insurance.  Employer Owned Life Insurance is (sort of) Corporate Owned Life Insurance, but COLI is more focused on life insurance purchased to fund promises of an executive compensation plan.  EOLI encompasses COLI, but also stretched out to grab other insurance planning purposes like key-man (sorry its sexist, but that's what it's called) and buy sell policies.  So, while COLI is EOLI, EOLI is not just limited to COLI.

If you're confused, don't worry.  We're diving into a more advanced topic in the insurance world, and I'm happy to answer specific question.

Is this Something New?

If we can go around calling indexed insurance products “new” than Employer Owned Life Insurance–in the sense it exists today–was born yesterday.  While the practice of an employer's owning life insurance on a employee, the rules concerning it certainly are.  And for those who think all corporations are evil, and all insurance companies are their sidekick I've got some good news for you.

Remember that story from a few years ago about Wal-Mart and how they had purchased life insurance on rank-and-file employees who didn't even know the insurance existed.  There was a rather nefarious sounding name for this practice: Dead Peasant Insurance.  Oh the horror!  There ought to be a law making that illegal!  There is.

The Pension Protection Act of 2006 implemented some very specific rules about what companies that decided to purchase life insurance on the lives of their employees needed to do in order to ensure that the death benefit on these plans remains tax free.

Now, to be clear, a lot media know-nothings attacked COLI while covering the Wal-Mart story.  Again, I want to emphasize that while semantically they aren't incorrect, only a novice or would refer to this as COLI.  Colloquially speaking, this is not COLI.

Rules, You Say?

The Pension Protection Act of 2006 sought to eliminate any practice of purchasing life insurance on an employee without his or her knowledge and it also wanted to make sure that the employee upon whose life the policy is purchased was more than just a rank-and-file employee.

The rules are simple.

Step One: The employee must be any of the following:

  • Employed at some point during the 12 months preceding death
  • Director or Highly Compensated Employee

This step can also be satisfied if the life insurance policy is part of a buy/sell agreement (i.e. used to purchase a stake in the company) or paid to the insured's heirs.

Step Two: Employer must obtain written consent from the employee to the employer to purchase life insurance on his or her life.  The consent has to be obtained prior to the issue of a policy, and it must include the amount of life insurance the employer intends to purchase.

Step 3: The Employer must file IRS form 8925 every year with its tax return.

If these steps are followed, than the life insurance policy complies with the rules set forth for Employer Owned Life Insurance and the death benefit will remain tax free to the employer.  If these steps are not followed, the death benefit is taxable to the extent there is net amount at risk, deducting whatever premiums the employer paid, at the employers marginal tax rate.

What's the Point?

There are plenty of reasons for an employer to own life insurance on an employee.  The COLI reason listed above (to provide benefits under an executive non-qualified deferred compensation plan), to cover the loss of a key employee, and to ensure funds available to buy out a partner's interest upon his or her passing are prime examples.

The establishment of EOLI rules under the Pension Protection Act of 2006 is an attempt to curtail practices like Dead Peasant Insurance.

Notice that technically the law allows the company to purchase coverage on any employee if it chooses and as long as the employee gives written consent the policy complies with EOLI rule.  But, if the employee terminates employment, the death benefit will become taxable after month 12  from the termination date (this was done intentionally to discourage purchases on rank-and-file employees).

So, companies that have done this since 2006 or plan to do so, need to follow a rather simple, yet important procedure to ensure against tax problems in the future.

Also note that for those policies issued prior to the Pension Protection Act of 2006, there is a grandfathering in place.  Policies that have not undergone a material change are not subject  to Employer Owned Life Insurance rules.


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