Many experts believe strong bipartisan support for the proposed COLI Best Practices Act gives it an excellent chance of passage in 2005.

This year’s version was introduced in the House on May 11, 2005, as HR 2251, COLI-BPA, with 29 of 41 House Ways & Means Committee members as co-sponsors. In the Senate, COLI-BPA was re-introduced by Senators Grassley and Baucus (S 219).

The following is an assessment of the likely impact of this legislation.

The Act would require business process changes in 4 areas: participant consent and notice forms, eligibility screening, tax reporting and record keeping.

Participant consent and notice forms. Under the proposal, life insurance death benefits received by an employer on an employee’s life would be taxable (in excess of basis) under new Internal Revenue Code Section 101(j)–unless, before policy issue, the employee: a) is notified in writing of the employer’s intent to insure the employee’s life; b) provides written consent to being insured and that the coverage may continue after the insured terminates employment; and c) is informed in writing that the employer will be a beneficiary of any proceeds payable at the employee’s death.

While many COLI firms already have incorporated consent forms into their business process, the COLI-BPA proposal will require notice forms that specify the maximum policy face amount the employee “could be insured for at the time the policy was issued.” The use of the future conditional tense (“could be”) may raise issues for aggregate funded plans where the client has an initial premium budget but has no idea if and when additional coverage might be needed to cover future cash flows. Regulations on this point would be helpful.

Even if notice and consent requirements are met, the employer’s death benefits would be taxable under Section 101(j) (other than those going to the insured’s family or trust, or used to buy an insured’s business interest). This applies unless the insured was: a) an employee during the 12 months preceding death or b) at time of policy issue, a director, or among the highest paid 35% of all employees or “highly compensated” as defined by IRC Section 414(q). Section 414(q) includes 5% owners and those earning over $95,000 in the “highly compensated” definition.

Eligibility screening. If the bill passes, case designers will need to use a new, bright-line compensation test to screen and eliminate employees below the $95,000 threshold. This would be interesting for several reasons.

For example, case designers looking to bulletproof nonqualified plans from ERISA have not had a bright-line compensation test to ensure employees are in the “top hat” group. As a result, providing clients with guidance in the ERISA area has been difficult. The Department of Labor has yet to issue regulations defining the “top hat” group phrase.

Some plans have tried to define the class of “eligible employees” for top hat purposes by establishing a minimum compensation threshold–despite the IRC Section 414(q) regulations taking the position that Section 414(q) will not control the ERISA issue as to whether a plan is top hat. Under COLI-BPA, case designers could confidently use compensation as a “tax” screen but not an ERISA/top hat screen.

Tax reporting. With the exception of including certain COLI information related to book-tax differences on Schedule M-3 of the corporate 1120 tax return, currently there is no federal tax reporting with respect to COLI. Under the bill, “applicable policyholders” owning life insurance on lives of employees would be required to file an annual return showing:

  • number of employees at year-end

  • number of insured employees

  • total amount of insurance in force at year-end under such contracts

  • employer name, address and tax identification number

  • type of business; and

  • that the employer has a valid consent for each insured.

While the tax reporting requirement likely was intended to address broad-based COLI programs, it casts a much wider net. For example, as a condition of extending credit, lenders frequently require firms to take out an insurance policy on 1 or more key people to guarantee loan repayment.

If a lender requires a sole proprietor to buy a $25,000 term policy to cover an outstanding loan, the reporting requirement would seem to be triggered, because the proposal uses the term “employer-owned life insurance contract” and doesn’t discriminate as to employer size or type or policy face amount.

Record keeping. Those owning 1 or more “employer-owned life insurance contracts” during any year are required to keep such records as may be necessary for determining whether COLI-BPA requirements are met.

Because COLI-BPA enactment is likely, planners need to consider the likely effective dates. The current draft of the bill will apply to life policies issued after date of enactment. If a policy issued before that date is exchanged under IRC Section 1035, the new contract would be grandfathered.

Because of the anomalous way the statute is drafted, it appears as if material changes or material increases in death benefits on a policy issued before the enactment date would cause that contract to be subject to the new rules. Unfortunately, the bill does not define “material change” or “material increase in death benefit.”

The fact that an exchange protects grandfathering but a material change to an existing contract does not is one of the most important features of the legislation. Case designers and producers need to comprehend this fully and be able to articulate it to clients. Finally, if a policy issued before the date was a “master” contract, adding new lives would cause only the new lives to be subject to COLI-BPA.

COLI-BPA is relatively issue-free. But reviewing business processes now will ensure a seamless transition. And, for producers, it’s a good reason to meet with clients, TPAs and advisors.