Under Congressional attack: corporate-owned life insurance

Risk Management, Feb, 1996 by P. Bruce Wright

The use of corporate-owned life insurance ("COLI") contracts as tax-advantaged funding vehicles has recently emerged as an important issue in Washington. Both the House and Senate have passed COLI legislative proposals that will change the deductibility of these policies.

In a leveraged COLI transaction, a corporate owner and beneficiary of a life insurance policy derives a cash flow benefit by leveraging tax-deductible loan interest against tax-free income from the policy. Leveraged COLI programs have been described by the Senate Finance Committee staff as "the economic equivalent of a tax-free savings account owned by a company into which it pays itself tax-deductible interest." The use of leveraged COLI contracts increased significantly after the Tax Reform Act of 1986 limited co orate deductions to the interest on life insurance policy loans of no more than $50,000 per employee. In reaction, many corporations began to insure larger numbers of employees so the aggregate borrowing (and the amount of deductible interest) could be increased.

During the summer of 1995, scrutiny of leveraged COLI arrangements increased in the House Ways and Means Committee. Apparently in response to reports in the Wall Street Journal and other publications that reported some companies had as man as 300,000 employees covered under a COLI program, the committee proposed a bill that would eliminate the deductibility of all interest incurred after 1995 on COLI (and other business-owned life insurance) policies, without regard to the size of the employer, number of insureds or other matters. The original proposal did not "grandfather" existing policies, but allowed a phase-in of the gain realized by surrendering policies affected by this provision over a four-year period beginning in 1996. The proposal, passed by the House on October 26, was softened somewhat by providing a phase-in of nondeductibility over four years and by grandfathering contracts issued prior to mid-1986.

On October 27th, the Senate passed a proposal that would:

A. Disallow any interest deductions for COLI loans taken out after 1995;

B. Allow the deduction of interest on pre-1996 loans for a phase-in period of five more years;

C. Grandfather policies purchased before june 20, 1986, but require the use of a "market" rate of interest;

D. Provide an exception for interest (at a market rate) on indebtedness with respect to life insurance on the greater of five "key persons," or 5 percent of employees;

E. Allow a four-year phase-in of income on policies surrendered in the next five years; and

F. Provide the issuing insurer with a "DAC tax" benefit in the year the policy is surrendered.

Congress ultimately agreed to follow the Senate proposal, with the following modifications:

A. The number of individuals that may be treated as "key persons" was limited to the greater of five individuals or 5 percent of officers and employees, subject to an overall limit of 10;

B. The phase-in period for the allowance of interest deductions on pre-1996 loans was limited to three years, the applicable interest rate (the lesser of the contract borrowing rate or Moody's Corporate Bond Yield Average - Monthly Average Corporates) percentage was phased down from 100 percent to 70 percent over three years and the amount of interest considered deductible during the phase-in period was modified to exclude contracts on the lives of more than 20,000 insured individuals;

C. The phase-in exception for the allowance of interest deductions with respect to life insurance contracts entered into in 1994 or 1995 was extended to pre-1997 loans; and

D. The computation of the market rate of interest in the case of grandfathered policies was modified.

P. Bruce Wright is a partner with the law firm of Leboeuf, Lamb, Greene & MacRae in New York and a member of Risk Management's Editorial Advisory Board.