How insurance can trim your tax bills
The world’s most powerful companies use sophisticated strategies to eliminate taxes. If you are a corporate executive, you might be able to take advantage of variations on these strategies — one of them being life and death.
Big money is involved. A recent report from the Center for Effective Government and Institute for Policy Studies shows that of America’s 30 largest corporations, seven paid their chief executive officers more than they paid in federal income taxes in 2013. All of these firms were highly profitable, collectively reporting more than $74 billion in U.S. pre-tax profits — and a combined $1.9 billion in refunds from the Internal Revenue Service.
Insurance is another way to reward top execs without drawing so much from corporate coffers, and also save on taxes. With the insurance stratagem, the policies come with the minimum death benefit you can buy with the maximum amount of cash allowed under IRS guidelines. Section 7702(e) of the tax code provides guidance as to how you borrow earnings out of a life insurance contract using zero-cost loans, which are not taxable events.
Large companies began using entity-owned life insurance — banks (BOLI), corporations (COLI), trusts(TOLI) and capital split dollar policyholders – more than 30 years ago, when E.F. Hutton developed the first versions of what later came to be known as a universal life insurance contract.
Human resources consultancy Aon Hewitt estimates that new COLI (corporate owned life insurance) policies worth at least $1 billion are put in place every year. Most recently, companies used these vehicles primarily to fund employee benefits such as health care, deferred compensation and pensions.
The subject of intensifying regulation and growing litigation in recent years, COLI — aka “dead peasant” or “dead janitor” insurance — now comes with conditions. Policies can only be purchased on the highest-compensated third of employees. Any employee named as the insured on a COLI policy must be notified in writing, before purchase of the policy, of the company’s intent and if the company is a partial or total beneficiary. Failure to give such notice often incurs taxes on eventual payouts.
Nevertheless, the cash inside the insurance begins to perform like an investment with limited downside risk – and you pay no tax on the earnings or growth. Banks and sophisticated investors typically choose investments with principal guarantees offered from long-established insurance companies that provide a platform for such liquidity, safety of principal, rate of return and tax-free access to growth when properly structured.
Instead of paying taxes on their investments, corporations use a portion (approximately one-fourth) of the savings to pay for life policies on key employees — taking advantage of one of life’s only guarantees, death. They fund the contracts using tax-deductible debt, benefiting from deductible contributions, tax-deferred growth and tax-free access.
Among options of such policies, you can:
► Borrow against the life insurance via zero-cost loans and allow the guaranteed death benefit to pay off the loans when the insured dies.
► Sell your own death benefit to a pool of investors.
► Use the death benefit to transfer wealth to selected beneficiaries tax-free.
Almost every penny that goes to pay for the life insurance is recovered — unlike costs of taxes or management fees, which are lost forever. But complexity of tax rules for this kind of investment grows alongside increasing public awareness and scrutiny.
Policy guarantees are based on the claims-paying abilities of the issuing insurance company. Consult a qualified financial advisor for the best guidance.
AdviceIQ — @adviceiq on Twitter — is a USA TODAY content partner offering financial news and commentary. Its content is produced independently of USA TODAY.