Employer-owned life insurance after the Pension Protection Act of 2006.

• Author: Behrenfeld, Craig E.

Many employers purchase insurance policies insuring the lives of their employees. These policies, generally referred to as "corporate-owned life insurance" (COLI) or "employer-owned life insurance" (EOLI), are used to fund employee benefit plans and buy-sell agreements, and to protect employers against the financial consequences of the death of a key employee. Under the general rule of [section]101(a) of the Internal Revenue Code (I.R.C.), (1) the death benefit received by an employer under an EOLI policy is excluded from the employer's gross income. Highly publicized reports of abuses of EOLI policies by employers, however, have caused Congress to impose disclosure, consent, and reporting requirements on employers that must be satisfied in order for employers to exclude EOLI death benefits from gross income.

This article discusses I.R.C. [section]101(j) of the code, which was added to the I.R.C. by the Pension Protection Act of 2006 to combat perceived abuses of EOLI policies. While the abuses of EOLI policies by employers received national attention, the additional requirements imposed on employers under I.R.C. [section]101(j) have received relatively little fanfare. As a result, I.R.C. [section]101(j) has become a trap for the unwary that may result in the taxation of EOLI death benefits in routine transactions.

Abuses of EOLI Policies--Dead Peasants Insurance

Prior to the 1980s, state laws generally required a purchaser of a life insurance policy to have "a significant financial or emotional stake in the [insured's] survival." In the 1980s and 1990s, several states modified their "insurable interest" laws to permit employers to insure all employees, including rankand-file employees. Many employers responded to the change in state law by purchasing insurance policies on the lives of a broad range of employees, including clerical and janitorial workers, which became known as "janitor's insurance" or "dead peasant's insurance." (2) Employers initially benefited from EOLI policies through the receipt of tax-free insurance proceeds upon the death of an insured employee, and from the deduction of interest on debt incurred to finance the premiums payable under the EOLI policies, thereby effectively creating a tax shelter. In 1986, however, Congress generally barred the deduction of interest paid or accrued on any indebtedness with respect to EOLI policies, except in the case of certain "key person" policies. (3) Congress strengthened the rules barring the deduction of interest paid on EOLI policy loans in 1996 and 1997. (4) Nonetheless, employers continued to purchase EOLI policies on a broad base of employees.

The abuse of EOLI policies first gained national public attention in a case involving the Winn-Dixie supermarket chain. (5) Winn-Dixie purchased EOLI policies on approximately 36,000 employees and systematically borrowed against the cash value of the policies to fund the premiums. The income tax savings to Winn-Dixie from deducting the interest payments and related fees were projected to be substantially in excess of potential benefit to Winn-Dixie from maintaining the EOLI program. The Internal Revenue Service disallowed the deduction of the interest and fees under the sham transaction doctrine, arguing that Winn-Dixie's purchase of the EOLI policies lacked economic substance and a valid nontax business purpose, and the Tax Court and the U.S. Court of Appeals for the 11th Circuit agreed.

Winn-Dixie was not alone in maintaining EOLI policies on a broad base of employees. (6) While Congress and the I.R.S. continued to challenge the deductibility of interest and fees incurred in connection with EOLI policies, the public was becoming increasingly concerned with the ghoulish nature of employers profiting from the death of their employees. On October 23, 2003, Spencer Tillman, a former NFL football player who became a sports analyst for CBS, testified before the U.S. Senate Committee on Finance regarding the insurance policy that...