How Is Corporate-Owned Life Insurance Taxed?

Corporate-owned life insurance is taxed under a bargain: the corporation gives up any deduction for the premiums it pays, in exchange for tax-deferred growth of the policy’s cash value and, if several strict conditions are met, a tax-free death benefit when the insured dies. Miss one of those conditions and the death benefit, which is the whole reason most companies carry these policies, becomes ordinary corporate income. The rules sit across several Internal Revenue Code sections that have to be read together, and the compliance steps have to happen in the right order, often before the policy is even issued.

Premiums Are Never Deductible

IRC Section 264(a)(1) bars a corporation from deducting premiums on any life insurance policy where the corporation is a beneficiary.¹ The reasoning is straightforward: the premium buys a benefit that will arrive tax-free, so deducting the cost would stack two tax breaks on the same dollar. The prohibition reaches every type of permanent coverage, including whole life, universal life, and variable universal life, and it applies whether the corporation pays annually or in a single lump sum. The Treasury regulations extend the same rule to policies covering any officer, employee, or person financially interested in the business when the taxpayer is directly or indirectly a beneficiary.²

The Interest Expense Side Effect

Carrying COLI can also shrink the corporation’s deductible interest expense. Section 264(f) requires a corporation to reduce its interest deductions in proportion to the ratio of the policy’s unborrowed cash value to the corporation’s total assets. “Unborrowed policy cash value” is the cash surrender value minus any outstanding policy loans.¹ The disallowance does not apply to a policy covering a single individual who was a 20-percent owner, officer, director, or employee when coverage began, which effectively exempts most key-person policies. Broad-based programs that insure many rank-and-file workers are where this rule bites.

A separate rule, Section 264(a)(4), disallows any deduction for interest on debt incurred to purchase or carry a life insurance policy. Section 264(e) permits a narrow carve-out: interest on up to $50,000 of indebtedness per insured is deductible if the insured qualifies as a “key person,” meaning an officer or 20-percent owner. The number of key persons is capped at the greater of five people or five percent of the company’s total officers and employees, with an overall limit of 20 individuals.¹

Cash Value Grows Tax-Deferred

While the policy is in force and qualifies as life insurance under IRC Section 7702, annual increases in cash value are not currently taxed. That inside buildup compounds year after year with no tax drag, which is a real advantage over holding the same assets in a taxable corporate account.

If the corporation takes a partial withdrawal from a policy that is not a Modified Endowment Contract, Section 72(e)(5)(C) applies the basis-first rule: amounts received are included in income only to the extent they exceed the corporation’s investment in the contract.³ Premiums come back first, tax-free; only withdrawals beyond cumulative premiums are taxable gain.

Policy loans against a non-MEC policy are better still. A loan is not a distribution. It is a debt owed to the insurance company and secured by the cash value, and so long as the policy remains in force, taking a loan creates no taxable event.

MEC Status Destroys the Access Rules

All of those favorable distribution rules vanish if the policy is a Modified Endowment Contract. Under IRC Section 7702A, a policy becomes a MEC when cumulative premiums paid during the first seven contract years exceed the net level premium that would fund the policy’s benefits over seven level payments, a benchmark known as the 7-Pay Test.⁴ Once a policy fails the test, the MEC label is permanent.

Distributions from a MEC are taxed gain-first rather than basis-first. Any accumulated gain comes out first and is immediately ordinary income.⁵ Policy loans from a MEC are treated as taxable distributions, eliminating the loan strategy that makes non-MEC policies useful for accessing cash value. On top of the income tax, Section 72(v) imposes an additional 10 percent penalty on taxable MEC distributions. The statute waives the penalty for recipients who have reached age 59½, but a corporation has no age, so the penalty effectively applies to every taxable MEC distribution a corporation receives.

The 7-Pay Test is not a one-time hurdle. If the corporation increases the death benefit or makes other material changes, the test recalculates using the insured’s current age and the new benefit, and a fresh seven-year testing period starts. A policy that comfortably passed the original test can fail the new one.

The Death Benefit: Taxable by Default

For most life insurance, Section 101(a)(1) excludes death proceeds from the recipient’s gross income.⁶ For employer-owned policies issued after August 17, 2006, Congress flipped the default. Under Section 101(j), the corporation can exclude only the premiums and other amounts it paid for the contract; the rest of the death benefit is taxed as ordinary corporate income unless two conditions are both satisfied.

First, the corporation must have met the pre-issuance notice and consent requirements. Second, the insured must fall within one of the statutory categories in Section 101(j)(2):

An employee of the corporation at any time 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 (the compensation threshold is indexed annually).
An individual among the highest-paid 35 percent of all employees when the policy was issued.

A separate exception preserves the exclusion to the extent the death benefit is paid to the insured’s family members, designated beneficiaries, or estate, or used to buy an equity interest in the corporation from those parties.⁶

Notice and Consent Have to Happen First

Section 101(j)(4) requires three steps before the policy is issued. Skipping any of them, or trying to document them after the fact, forfeits the death benefit exclusion regardless of the insured’s status.

Written notice to the employee that the employer intends to insure the employee’s life, including the maximum face amount for which the employee could be insured.
Written consent from the employee to being insured, with specific agreement that coverage may continue after the employee leaves the company.
Written disclosure that the corporation will be a beneficiary of any death proceeds.

IRS Notice 2009-48 allows a narrow timing accommodation: when coverage begins before formal policy issuance, such as during underwriting, notice and consent can be completed between the effective date of coverage and formal issuance.⁷ Completing them after issuance is fatal.

Transferring a Policy Can Blow Up the Exclusion

Section 101(a)(2) sets another trap. If a life insurance policy is transferred for valuable consideration, the new owner’s death benefit exclusion is capped at what it paid for the policy plus any later premiums. Everything above that becomes taxable income.⁶ The rule catches sales, assignments for value, and exchanges between entities, including routine-looking moves inside a corporate group.

Five exceptions preserve the full exclusion:

Transfers in which the transferee takes a carryover basis, such as 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.

Transferring a policy between sister corporations, for example, triggers the rule unless the insured is a shareholder or officer of the receiving corporation. Any ownership change calls for advance planning.

Surrendering a Policy

When a corporation fully surrenders a COLI policy for its cash value, the taxable gain is the surrender proceeds minus the corporation’s adjusted basis, which is cumulative premiums paid, reduced by any prior tax-free withdrawals or dividends.³ A corporation that paid $500,000 in premiums and surrenders for $700,000 owes ordinary income tax on $200,000. If the policy is a MEC, the gain comes out first and the 10 percent penalty applies to the taxable portion.

Form 8925 Each Year

Every corporation that owns one or more employer-owned life insurance contracts issued after August 17, 2006 has to file IRS Form 8925 with its annual income tax return for as long as the coverage stays in force.⁸ 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.⁹

Keep the signed notice and consent forms for the life of every policy. They are the corporation’s proof of Section 101(j)(4) compliance, and without them the death benefit is taxable. Keep clean records of premiums, withdrawals, loans, and any policy changes as well, both to track adjusted basis and to show the policy stayed on the right side of the 7-Pay Test if the IRS ever asks.

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
Internal Revenue Service. About Form 8925, Report of Employer-Owned Life Insurance Contracts
9
Internal Revenue Service. Form 8925 – Report of Employer-Owned Life Insurance Contracts