Most of us have heard of it -- corporate owned life insurance (COLI). In the 80s and part of the 90s, it was one of the ultimate gimmicks. It had great tax treatment and great accounting treatment, and yes, it often performed well. But, over time, COLI began to get a bad name. Battling for tops among the reasons were two: brokers of COLI products were making what were viewed by many as unconscionably large profits selling the product; and many companies were buying what was known in the pejorative as janitor's insurance. That is, they were buying life insurance policies on everyone down to the janitor to fund perquisites and benefits for top executives.
Well, over time, these benefits of COLI have eroded. Someone could write a book on just that, but that discussion is for a different day here. But, in the latest blow to COLI, the IRS has released Revenue Ruling 2011-9 . What, you may ask is this, and what does it do? It adds particular teeth to [Internal Revenue] Code Section 264(f). So? What in the world is Code Section 264(f) and why do you care? Be patient, dear reader.
Section 264 is entitled Certain Amounts Paid in Connection with Insurance Contracts. Subsection (f) deals with expensing certain related interest costs on a pro rata basis.
Here is why this matters.
As COLI laws have been tightened, companies that purchase COLI have become more and more concerned about having an insurable interest in the individuals on whom they purchase insurance. So, for example, if Microsoft purchases life insurance on Bill Gates, even the most cynical among us would probably argue that Microsoft does, in fact, have an insurable interest in his life. But, suppose instead, Microsoft purchased insurance on the life of Horatio Hornblower [Note: to the best of my knowledge, they have neither done this nor considered it]. Even the most fervent COLI supporters among us would likely argue that there is no insurable interest there.
Where this turns grayer is with regard to policies held on past employees, or when a policy on a past employee is exchanged for one on a current employee. I digress. Code Section 1035 generally allows a policyholder to exchange one bona fide policy for another without creating a taxable event. So, as the insurable interest rules have tightened, many companies have routinely exchanged policies on employees who have recently terminated for policies on employees who have recently joined. That sounds innocent enough, doesn't it?
Now, let's look at Section 264(f). It says that, in general, a portion of a taxpayer's interest deduction based on the ratio of the sum of the unborrowed cash values on life and annuity contracts it owns to the adjusted basis of all of the taxpayer's assets is disallowed. Notably, Section 264(f)(1) provides an exception for officers, directors, employees, and 20% owners at the time of policy issuance. So, if all of your COLI is held on the exempted group, you get your full interest deduction. Right?
Not so fast. There is a good chance that some of the policies that you hold on the exempted group were not originally held on the exempted group. In other words, some of these policies were acquired through the use of Section 1035 Exchanges. And, the exchanges were likely (a euphemism here for perhaps 100% certain) done after the original insureds were no longer in the exempted group.
According to this ruling, both new and old policies that were acquired through a 1035 exchange after the original insured was no longer in the exempted group are not exempted. This would say that an employer needs to contemplate the termination of an employee and perform the exchange prior to that employee's termination. I think most would say that this is not practical.
From a reality standpoint, here's what this does. When COLI no longer has its most favorable tax treatment, it becomes what is sometimes referred to as an underperforming asset.. According to the revenue ruling, if an exchange is not done on a timely basis, either the interest deduction goes away because of the untimely exchange or the company now holds a policy on an individual who is no longer exempted. What did Joseph Heller call his book: "Catch-22"?
What should companies do about this? Companies that hold COLI need to check all of their policies to see which ones no longer get them the presumed deduction. Then, they need to make decisions with regard to those policies to see if they should somehow unwind them and use the assets for other purposes. Worse yet, the stated proposal of the current administration is to take away the exemption in Code Section 264(f)(1).
We can help you wade through this mess.
But, as always, neither this author nor his employer provide tax, legal, or accounting advice. This can only be obtained from someone licensed to provide such counsel.