Company-Owned Life Insurance: Notice, Form 8925, and Exclusion Rules

Company-owned life insurance is taxed under a specific set of rules in the Internal Revenue Code: premiums paid by the business are never deductible, the policy’s cash value grows tax-deferred, and the death benefit is excluded from the company’s gross income only if the employer completed a written notice and consent process with the insured before the policy was issued, the insured falls into a qualifying category under Section 101(j), and the company files Form 8925 with its return each year the contract is in force. Miss any piece of that and the exclusion collapses down to the premiums paid, with everything above that amount taxed as ordinary income.

Premiums, Cash Value, and Death Benefits

Three tax outcomes drive every COLI decision, and they cut in different directions.

Premiums are not deductible. IRC Section 264(a)(1) denies any deduction for premiums on a life insurance policy when the taxpayer is directly or indirectly a beneficiary.¹ Because the company owns the policy and collects the proceeds, every premium dollar is paid with after-tax money. Build that into the projections from day one.

Cash value growth is tax-deferred. The increase in cash surrender value each year, whether it comes from investment returns or a guaranteed crediting rate, is not taxed to the corporation as it accumulates. That deferral is the main reason companies use COLI to informally fund liabilities that build over 10 to 20 years, such as nonqualified deferred compensation obligations.

The death benefit is generally excluded from income under IRC Section 101(a)(1).² For employer-owned contracts, Section 101(j) then adds a gate: if the employer does not meet the requirements described below, the exclusion is limited to the total premiums the company paid, and anything received above that is ordinary income.³

Notice and Consent Before the Policy Is Issued

This is the step companies most often mishandle, and once the policy is issued there is no way back. Before issuance, the employer must complete a three-part written process with the employee to be insured. The employer must notify the employee in writing that it intends to insure the employee’s life and state the maximum face amount of coverage. The employee must provide written consent to being insured and acknowledge that coverage may continue after the employee leaves the company. And the employee must be informed in writing that the employer will be a beneficiary of the proceeds.²

Timing is defined generously. IRS Notice 2009-48 treats a policy as “issued” on the latest of three dates: the application date, the effective date of coverage, or the formal issuance date. If there is a gap between coverage becoming effective and formal issuance, the employer can still complete the consent process during that window.³ Keep the original signed forms indefinitely; the IRS can ask for them at any point during the life of the policy or after a death benefit is paid.

Who the Insured Has to Be

Proper notice and consent alone is not enough. The insured also has to fit one of the categories in Section 101(j)(2)(A) for the full death benefit exclusion to apply.

The most commonly used exception covers anyone who was still an employee at any point during the 12 months before death. A second exception applies when the insured was, at the time the policy was issued, a director, a highly compensated employee, or a highly compensated individual.²

Those two compensation-based tests are not the same test. A “highly compensated employee” is defined under IRC Section 414(q) by reference to a compensation threshold, which is $160,000 for 2026.⁴ A “highly compensated individual” is defined by reference to IRC Section 105(h)(5), meaning a person within the highest-paid 35 percent of all employees.² Meeting either test at the time of issuance qualifies the insured, regardless of what happens to their pay later.

A separate exception preserves the exclusion when the death benefit is paid to the insured’s family members, estate, or designated personal beneficiaries rather than to the company. If proceeds are split between the corporation and the employee’s heirs, document which exception covers which portion.

Form 8925 Every Year

Every company that owns one or more employer-owned life insurance contracts issued after August 17, 2006, has to file IRS Form 8925 with its federal income tax return each year the contracts remain in force.⁵ The form reports the number of employees insured, the total insurance in force at year-end, and whether valid consent was obtained for each insured employee.⁶

The consent question is the one to watch. If the form reveals that valid consent was not obtained for some insured employees, the company has essentially told the IRS that the future death benefits on those policies may not qualify for the full Section 101 exclusion. No specific dollar penalty is enumerated in the statute for failing to file Form 8925, but the IRS takes the position that a return filed without required attachments may be treated as incomplete, which can extend the statute of limitations or invite broader scrutiny. Keeping the consent forms and the annual 8925 filings together is the cleanest way to protect the death benefit’s tax status years down the road.

Two Ways the Exclusion Can Still Be Lost Later

Transfer for Value

If a COLI policy is transferred to another party for valuable consideration, the death benefit can lose its tax-free status under the transfer-for-value rule in IRC Section 101(a)(2). The recipient can then exclude only the price paid for the policy plus subsequent premiums; the rest is taxable income. Several transfers are exempt from the rule: transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.² The risk shows up during corporate reorganizations, mergers, and buy-sell arrangements where policies change hands. Landing outside every exception in one of those transactions can undo years of planning in a single closing.

Modified Endowment Contract Status

A COLI policy funded too quickly in its early years can be reclassified as a modified endowment contract, which reshapes the tax treatment of everything the company draws out of the policy while the insured is alive. A policy fails the seven-pay test and becomes a MEC if the total premiums paid at any point during the first seven contract years exceed what would have been needed to fully pay up the policy in seven level annual installments.⁷

Once a policy is a MEC, two penalties apply. Distributions and loans are taxed on a last-in, first-out basis, so gains come out before basis and every dollar of gain is ordinary income. Distributions taken before the recipient reaches age 59½ are hit with an additional 10 percent tax on the taxable portion.⁸ The age threshold applies to the recipient, which in COLI is the corporation itself. MEC status cannot be reversed for that contract.

A material change to the policy, such as increasing the face amount or adding riders, restarts the seven-year testing period with a recalculated premium limit. Rerun the seven-pay test with the insurance advisor before adding premium after any such change. The death benefit itself is still tax-free under Section 101 even for a MEC, so the exposure is really to companies that plan to access cash value through loans or partial withdrawals during the insured’s lifetime.

Interest Expense Disallowance

Owning COLI can reduce a company’s deductions for interest on unrelated debt. IRC Section 264(f) requires a pro-rata disallowance of interest expense based on the ratio of the company’s unborrowed policy cash values to its total assets. This applies to all policies issued after June 8, 1997.¹

The math: the IRS compares the average unborrowed cash value in the life insurance policies to the sum of all the company’s assets (including those policies). Whatever percentage the policy values represent, that same percentage of total interest expense for the year becomes non-deductible. For a company carrying meaningful debt alongside a sizable COLI portfolio, the disallowed amount can be material.

An important exception narrows the impact. The disallowance does not apply to a policy that covers a single individual who is a 20-percent owner, officer, director, or employee of the business at the time coverage begins.¹ Most COLI on key executives will qualify. Companies that insure broader groups need to factor the disallowance into projections.

Separately, IRC Section 264(a)(4) prohibits deducting interest on any debt used to purchase or carry a life insurance policy. A narrow exception under Section 264(e) allows a deduction for interest on up to $50,000 of borrowing per insured individual, but only when the insured is a “key person,” defined as an officer or 20-percent owner, and subject to a numerical cap on how many individuals can be treated as key persons.¹

Loans and Surrenders During the Insured’s Life

Borrowing against a COLI policy’s cash value is generally not a taxable event as long as the policy stays in force. The loan reduces the net cash surrender value on the balance sheet, and interest accrues on the outstanding balance. If the loan is never repaid, the death benefit at the insured’s death is simply reduced by the outstanding loan amount, and the reduced benefit still qualifies for its Section 101 treatment.

The trap is a lapse or surrender with a loan outstanding. At that point, the company realizes a taxable gain equal to what it receives (including the loan balance that is treated as discharged) minus total net premiums paid. A policy in force for decades can generate a large taxable event if it is surrendered without planning, and an outstanding loan can inflate the recognized gain well beyond any cash actually received. Model the tax cost before surrendering.

Section 409A Exposure When COLI Funds Deferred Compensation

COLI is often bought to informally fund a nonqualified deferred compensation plan. An NQDC plan is a contractual promise to pay an executive in the future, and it sits outside ERISA’s vesting, funding, and fiduciary rules because it is maintained for a select group of management or highly compensated employees.⁹ The policy’s growing cash value can loosely track the liability under the promise, and the death benefit can cover the obligation if the executive dies before benefits are due.

The COLI policy itself does not create Section 409A problems. The exposure lives in how the NQDC plan is drafted and administered. Section 409A governs the timing of deferrals and distributions under nonqualified plans, and violations are punished at the executive level: all vested deferrals become immediately taxable, plus a 20 percent additional tax, plus interest computed at the underpayment rate plus one percentage point running back to the year the compensation was first deferred or vested.¹⁰

Those penalties land on the executive, not the company, but most plans require the employer to make the executive whole, so the economic hit usually comes back to the business. A 409A failure on a plan holding $2 million in deferred compensation can produce a combined tax-and-penalty bill above $1 million once retroactive interest is included.

Common triggers include allowing executives to change deferral elections after the plan’s deadline, accelerating payments outside the six permitted distribution events, and failing to define a fixed payment date or schedule. If the plan is used to fund NQDC, have tax counsel review the plan document specifically for 409A compliance, separate from any insurance-side review of the COLI contract.

1
Office of the Law Revision Counsel. 26 USC 264 – Certain Amounts Paid in Connection With Insurance Contracts
2
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
3
Internal Revenue Service. Notice 2009-48 – Treatment of Certain Employer-Owned Life Insurance Contracts
4
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs, as Adjusted
5
Internal Revenue Service. Form 8925 – Report of Employer-Owned Life Insurance Contracts
6
eCFR. 26 CFR 1.6039I-1 – Reporting of Certain Employer-Owned Life Insurance Contracts
7
Office of the Law Revision Counsel. 26 USC 7702A – Modified Endowment Contract Defined
8
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
9
Internal Revenue Service. Nonqualified Deferred Compensation Audit Technique Guide
10
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans