On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006 (Pub. L. No. 109-280) (the "Act") which imposes new restrictions on employers wanting to benefit from certain tax advantages on corporateowned life insurance, commonly referred to as COLI. The new rules are effective as of August 17 and apply to COLI policies issued or materially changed after that date.

In the past, the payments of death benefits on COLI policies were generally not taxable to employers. Under the new rules, however, death benefits on COLI policies can still receive tax-free treatment, but only if an employer: (1) limits coverage to certain individuals; (2) obtains the informed consent of such individuals; and (3) annually reports to the Internal Revenue Service and keeps records regarding its COLI policies. If these conditions (outlined below) are not satisfied, the Act limits the tax-free treatment of death benefits to the sum of the premiums and other amounts paid by the employer for the COLI policy.

Insured Status

To qualify for the tax-free treatment of death benefits, the Act limits coverage to the following individuals:

  • Insureds who were employees within 12 months of death; or
  • An insured who was, at policy issuance, a director, "highly compensated employee" within the meaning of section 414(q) of the tax code, or "highly compensated individual" within the meaning of section 105(h)(5) of the tax code.

An employer can also receive tax-free treatment on death benefits when they are paid to an employee’s heirs or used to purchase from the heirs the employee’s equity interest in the employer.

Notice and Consent

The Act also requires that employers obtain the informed consent of any employee before enrollment in a COLI policy. Specifically, the Act’s notice and consent requirements are met if, before policy issuance, the employee:

  • Is provided written notice regarding the policy and the maximum amount for which the employee could be insured;
  • Is provided written notice that the employer is the beneficiary of any death benefits; and
  • Provides written consent to being insured and that coverage may continue after the employee terminates employment.

IRS Reports and Records

In addition, employers must report annually to the Internal Revenue Service and keep records as may be necessary for purposes of determining whether the conditions for tax-free treatment are satisfied. The Act requires the following information to be reported:

  • The number of employees at year end;
  • The number of employees insured under COLI policies;
  • The total amount of COLI in force;
  • Information regarding the employer’s business (i.e., name, address, type of business in which the employer is engaged); and
  • Confirmation that the employer has valid consent for each insured employee (or, the number of insured employees for whom such consent was not obtained).

Although many industry representatives believe that the new COLI rules essentially codify into federal law COLI best practices, the new rules impose greater responsibility on employers. Notably, employers must document notice and consent forms for each insured employee before policy issuance and comply with the reporting and recordkeeping requirements. In addition, unless an employer can show that it satisfies all of the conditions for tax-free treatment, death benefits on COLI policies that are in excess of the sum of the premiums and other amounts paid by the employer will be taxable.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.