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Life insurance policies taken out by workers' employers

Corporate owned life insurance (COLI), is life insurance on employees' lives that is owned by the employer, with benefits payable either to the employer or directly to the employee's families. Other names for the practice include janitor's insurance and dead peasants insurance. When the employer is a bank, the insurance is known as a bank owned life insurance (BOLI). COLI was originally purchased on the lives of key employees and executives by a company to hedge against the financial cost of losing key employees to unexpected death, the risk of recruiting and training replacements of necessary or highly trained personnel, or to fund corporate obligations to redeem stock upon the death of an owner. This use is commonly known as "key man" or "key person" insurance. Although this article refers only to practice and policy in the United States, key person insurance is used in other countries as well. Primarily in the 1990s, some companies aggressively insured a broad base of employees, as part of general hiring requirements. During the hiring process, employees sign many documents, including life, health and welfare coverage agreements or applications for insurance. Additionally, up until 1984, certain premiums for life insurance were leveraged and deducted. Even today, when a COLI plan's death benefits are paid to an employee's family directly, the company paying the premiums can deduct them from corporate profits and earnings. Today, COLI is most common for senior executives of a firm, but its use for general employees is still sometimes practiced.

Under the Internal Revenue Code (IRC) dealing with life insurance benefits paid due to the death of the insured, the benefits are usually excluded from the taxable income of the beneficiary. Because of the tax free nature of death benefits, the IRC prohibits the deduction of the premiums paid for life insurance when the premium payor is also the beneficiary of the death benefit rather than the individual employee and their family. In addition, loans from insurers secured by policy values are not income and earnings credited to an owner's policy values (known as "inside buildup") by the insurance company are not currently taxed (and may escape taxation altogether if such earnings are not distributed other than as part of the death benefits paid upon the death of the insured).

Interest incurred on indebtedness has historically been deductible, (although the deduction of "personal" interest was largely eliminated in 1986), and in the 1950s a type of "leveraged insurance" transaction began being marketed that permitted an insurance owner to in effect deduct the cost of paying for insurance by (1) paying large premiums to create cash values, (2) "borrowing" against the cash value to in effect strip out the large premiums, and (3) paying deductible "interest" back to the insurer, which was in turn credited to the policy's cash value as tax deferred earnings on the policy that could fund the insurer's legitimate charges against policy value for cost of insurance, etc. The Internal Revenue Service (IRS), via the Supreme Court case Knetsch v. United States (1960), had early success in challenging the bona fides of these types of arrangements as creating legitimate debt and interest eligible to be deducted. However, subsequent court losses and IRC amendments weakened their position, appearing to permit tax deductible borrowing to provide funds to pay insurance premiums, so long as such borrowing did not account for more than three of the first seven annual premiums on the policy (the "4 out of 7" test).

Another IRC amendment limited to $50,000 the amount that could be borrowed (and yet yield deductible interest payments) with respect to any one insured. Although the 4 out of 7 test was exploited in the 1980s by businesses seeking to in effect pay for insurance on employees/shareholders, e. g., on a deductible basis, the introduction of the US$50,000 cap/insured in 1986 in turn led to the creation of broad based leveraged COLI transactions, i. e., those in which the employer would purchase life insurance on hundreds or thousands of (usually low level) employees, that would produce tax savings on interest deductions in excess of the actual cost to the employer of engaging in the transaction. These transactions were deemed by the IRS to be "tax shelters." In a typical broad based leveraged COLI transaction, a corporate employer would purchase policies on masses of lower level employees, sometimes without the employees' knowledge or consent. When an insured employee died, the company received the death benefits, and the employee's family typically received either a small portion of the proceeds or nothing. These policies could remain in place even after the employee quits or retires.