How Is Corporate-Owned Life Insurance Taxed?

Corporate-owned life insurance is taxed under a set of overlapping rules that generally deny the corporation any deduction for premiums, let the policy’s cash value grow tax-deferred, and deliver the death benefit income-tax-free — but only if the corporation completed specific notice and consent paperwork before the policy was issued and the insured fits one of the statutory categories. Miss the paperwork or the categories, and the death benefit becomes ordinary corporate income above what the company paid in premiums.

The rules sit in several sections of the Internal Revenue Code, and each one governs a different moment in the policy’s life. Here is how each stage is treated.

Premiums Are Not Deductible

A corporation cannot deduct premiums on a life insurance policy when it is a beneficiary of that policy. That is the direct rule of IRC Section 264(a)(1).¹ The Treasury regulations extend the same result to any policy covering an officer, employee, or person financially interested in the business where the taxpayer is directly or indirectly a beneficiary.²

The type of permanent policy does not matter — whole life, universal life, and variable universal life all fall under the same rule. Annual payments and lump-sum payments are treated the same way. Premiums reduce after-tax earnings, full stop.

Cash Value Grows Tax-Deferred

The offsetting advantage is inside the policy. As long as the contract qualifies as life insurance under IRC Section 7702 and stays in force, the annual increase in cash value is not taxed to the corporation. That inside buildup compounds without a current tax drag, which is the reason permanent COLI is used at all instead of term coverage.

How the corporation gets at the cash value while the insured is still alive matters a great deal. On a partial withdrawal from a policy that is not a Modified Endowment Contract, IRC Section 72(e)(5)(C) treats amounts received as taxable only to the extent they exceed the corporation’s investment in the contract.³ Premiums come back first, tax-free. Only once withdrawals exceed cumulative premiums does gain start being taxed. This is the basis-first, or FIFO, rule.

Policy loans work even better on a non-MEC. A loan against cash value is not a distribution at all — it is a debt owed to the insurer, secured by the policy. As long as the policy stays in force, borrowing against it creates no taxable event.

The MEC Trap

All of those favorable access rules disappear if the policy becomes a Modified Endowment Contract. Under IRC Section 7702A, a policy is a MEC if cumulative premiums paid during the first seven contract years exceed the net level premium that would fund the policy’s benefits over seven level annual payments — the 7-Pay Test.⁴ Once a policy fails, the MEC label sticks.

Distributions from a MEC are taxed on a gain-first basis. Accumulated gain comes out first and is ordinary income immediately. Policy loans from a MEC are also treated as taxable distributions, so the loan strategy that makes non-MEC policies attractive stops working. And on top of the income tax, IRC Section 72(v) adds a 10 percent penalty to any taxable MEC distribution. The statutory exception for taxpayers who have reached age 59½ is meaningless for a corporate policyholder, so a corporation effectively pays the penalty on every taxable MEC distribution it receives.⁵

The 7-Pay Test also runs again when the policy is materially changed. Increase the death benefit or otherwise modify the policy, and the test recalculates using the insured’s current age and the new benefit, with a fresh seven-year testing period.⁴ A policy that passed at issue can fail after a coverage bump.

Death Benefit: Tax-Free Only If You Qualified in Advance

IRC Section 101(a)(1) is the general rule most people know: life insurance proceeds paid by reason of the insured’s death are excluded from the recipient’s gross income. For employer-owned policies issued after August 17, 2006, Section 101(j) rewrites that starting point. The default is that the death benefit is taxable. The corporation can exclude only what it paid for the contract; the rest is ordinary corporate income.⁶

Two things restore the full exclusion. The corporation must have satisfied the notice and consent requirements before the policy was issued, and the insured must fit one of the categories in Section 101(j)(2):

An employee of the corporation at any point during the 12 months before death.
A director of the corporation when the policy was issued.
A highly compensated employee under IRC Section 414(q) when the policy was issued, using the annually indexed compensation threshold.
Among the highest-paid 35 percent of all employees when the policy was issued.

A separate exception preserves tax-free treatment to the extent the proceeds are paid to the insured’s family, designated beneficiaries, or estate, or are used to buy an equity interest in the corporation from those parties.⁶

The Notice and Consent Paperwork

Section 101(j)(4) requires three things to be documented before the policy is issued:

Written notice to the employee that the corporation intends to insure the employee’s life, stating the maximum face amount the employee could be insured for under the contract.
Written consent from the employee to being insured, including consent to coverage continuing after the employee leaves the company.
Written disclosure that the corporation will be a beneficiary of the death proceeds.

Complete this after issuance and the exclusion is gone. IRS Notice 2009-48 allows one narrow accommodation: if coverage begins before formal policy issuance, for instance during underwriting, notice and consent can be completed between the effective date of coverage and formal issuance.⁷ That is the only slack in the rule.

Transfer-for-Value Destroys the Exclusion

If a COLI policy is transferred for valuable consideration, IRC Section 101(a)(2) limits the new owner’s exclusion to what it paid for the policy plus subsequent premiums. Everything above that is ordinary income.⁶ The rule catches sales, assignments for value, and exchanges between entities, including transactions that look routine in a corporate restructuring, such as moving a policy from one subsidiary to another.

Five statutory exceptions preserve the full tax-free death benefit:

Carryover-basis transfers, where the transferee’s basis is determined by reference to the transferor’s basis, as in a tax-free reorganization.
Transfers to the insured individual.
Transfers to a partner of the insured.
Transfers to a partnership in which the insured is a partner.
Transfers to a corporation in which the insured is a shareholder or officer.⁸

Moving a policy between sister corporations triggers the rule unless the insured is a shareholder or officer of the receiving corporation. Ownership changes, buy-sell restructurings, and reorganizations all need planning around this before the transfer, not after.

Surrendering the Policy

On a full surrender, taxable gain equals the surrender proceeds minus the corporation’s adjusted basis in the contract. Basis is generally cumulative premiums paid, reduced by any prior tax-free withdrawals or dividends received.³ Pay $500,000 in premiums, take no withdrawals, surrender for $700,000, and $200,000 is ordinary income.

The basis-first rule that helps on partial withdrawals still applies at surrender for a non-MEC, but because the corporation is taking everything at once, the gain portion is unavoidable. For a MEC, the result is worse: gain-first treatment and the 10 percent penalty on the taxable portion.

Annual Reporting

Any corporation that owns one or more employer-owned life insurance contracts issued after August 17, 2006 must file IRS Form 8925 every year the coverage stays in force, attached to the corporation’s income tax return.⁹ The form reports the total number of employees, the number insured under COLI contracts, and the total face amount of coverage in force at year-end. It also asks whether the corporation holds a valid consent for each insured employee, and if not, how many employees lack one.¹⁰

Keep the signed notice and consent forms for the life of every policy. They are the proof that Section 101(j)(4) was satisfied, and without them the death benefit is taxable by default. Records of premium payments, withdrawals, loans, and any policy changes should also be kept to track basis and to support the policy’s non-MEC status if the IRS asks.

A Note for Larger Programs

One additional cost applies mainly to broad-based COLI. Under IRC Section 264(f), a corporation must reduce its deductible interest expense in proportion to the ratio of a policy’s unborrowed cash value to total assets, where “unborrowed policy cash value” is the cash surrender value minus outstanding policy loans. There is an exception for a policy covering a single individual who, when coverage began, was a 20-percent owner, officer, director, or employee.¹ Most key-person policies fall inside that exception. Programs that cover many rank-and-file employees are the ones where the interest disallowance actually bites.

1
Office of the Law Revision Counsel. 26 USC 264 – Certain Amounts Paid in Connection With Insurance Contracts
2
eCFR. 26 CFR 1.264-1 – Premiums on Life Insurance Taken Out in a Trade or Business
3
Office of the Law Revision Counsel. 26 USC 72 – Annuities, Certain Proceeds of Endowment and Life Insurance Contracts
4
Office of the Law Revision Counsel. 26 USC 7702A – Modified Endowment Contract Defined
5
Internal Revenue Service. Revenue Procedure 2001-42 – Procedures for Remedying MEC Failures
6
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
7
Internal Revenue Service. Notice 2009-48 – Treatment of Certain Employer-Owned Life Insurance Contracts
8
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
9
Internal Revenue Service. About Form 8925, Report of Employer-Owned Life Insurance Contracts
10
Internal Revenue Service. Form 8925 – Report of Employer-Owned Life Insurance Contracts