Taxes on a Universal Life Insurance Policy Bought by an Employer

Why Employer-Owned Universal Life Policies Raise Tax Questions

When an employer purchases a universal life insurance policy on an employee, the transaction stops being a simple employee benefit and becomes a planning question with tax implications on multiple fronts. The Internal Revenue Service treats these policies differently depending on who owns the contract, who is insured, and how the cash value grows. Understanding the tax framework helps employers design compliant plans and helps employees anticipate their tax exposure.

The core issue is that the IRS views employer-owned life insurance (often called COLI) as a deferred compensation arrangement. The employee has not paid for the coverage, so the economic benefit is taxable unless a specific exception or limitation applies. Universal life adds complexity because of its flexible premiums and cash value component, which can grow on a tax-deferred basis inside the contract.

Premium Deductibility for the Employer

In most cases, the employer cannot deduct the premiums paid on a universal life policy owned by the company and insured on an employee's life. Under Section 264 of the Internal Revenue Code, premiums paid on a key-person or employer-owned life insurance policy are generally nondeductible. This rule exists to prevent a double tax benefit: the employer would otherwise deduct the premium while the employee enjoys the policy's value tax-free.

There is a narrow exception under Section 162 if the policy is part of a bona fide nonqualified deferred compensation plan that meets strict requirements, including written documentation, substantial risk of forfeiture, and actual participation by the employee. Even then, the deduction is subject to nondiscrimination rules and reporting obligations. Without meeting these tests, the premiums flow through as a taxable benefit to the employee.

Tax Treatment of Cash Value Growth

Universal life insurance builds cash value on a tax-deferred basis inside the contract. When the employer owns the policy, the question becomes whether the growth is currently taxable to the employee. If the policy is treated as a nonqualified deferred compensation arrangement, the employee may recognize income as the cash value increases, depending on the economic benefit doctrine.

In practice, many employer-owned universal life policies are structured so that the cash value remains inside the contract and is not currently accessible to the employee. However, if the employee has a vesting interest, a loan provision, or a guaranteed access to cash values, the IRS may treat the growth as currently taxable income. This is a key planning point for employers using universal life as a vehicle for executive benefits.

Death Benefit Taxation

The income tax treatment of the death benefit depends on the ownership structure and the transfer-for-value rule. If the employer owns the policy and is the beneficiary, the death proceeds generally flow income tax-free to the company under Section 101(a). The company may then distribute the proceeds to the employee's estate or beneficiaries, but the tax characterization at that point depends on how the distribution is structured.

If the policy is transferred for value to the employee or an irrevocable trust, the excess of the proceeds over the basis may be subject to income tax. For employer-owned universal life, the basis is typically the after-tax premiums paid, which can be minimal or zero if premiums were nondeductible. This makes the full death benefit potentially taxable to the recipient if the transfer-for-value rule applies.

Employee Reporting and Withholding

When the employer owns the policy and the employee is insured, the IRS generally requires the employer to include the cost of insurance in the employee's W-2 wages each year. This is calculated using IRS Table 2001 or similar guidance, based on the insured's age and the coverage amount. The employer must withhold income tax and payroll taxes on that amount.

Universal life policies complicate this because the cost of insurance can vary from year to year as the cash value grows and the net amount at risk changes. Employers must track the annual cost of insurance carefully and update their reporting. Failure to report and withhold properly can result in penalties and interest, and the employee may face a surprise tax bill at filing time.

Reporting and Compliance Obligations

Employer-owned life insurance arrangements trigger several IRS forms and reporting requirements. Section 61 policy reporting requires the employer to report the aggregate cost of coverage for each insured employee on Form 8925 and provide it to the employee. For policies exceeding certain thresholds, additional disclosures may apply.

The IRS also requires employers to disclose COLI arrangements under the COLI reporting rules, which apply if the employer is the direct or indirect owner of a life insurance contract on an employee and the contract is not an excepted benefit under Code Section 101. These rules are designed to ensure that employees are aware of the arrangement and can plan for the tax consequences. The reporting burden is heavier when the policy has a significant cash value component, as is common with universal life.

Practical Considerations for Employers

Employers considering a universal life policy as part of a benefits or executive compensation package should weigh the tax cost against the benefits. The nondeductibility of premiums, the potential current taxation of cash value growth, and the reporting burden can make the arrangement expensive on a net basis. In many cases, a term insurance policy funded through a retirement plan or a nonqualified deferred compensation arrangement is a more tax-efficient alternative.

If the employer proceeds with a universal life policy, working with a tax advisor and an insurance specialist is essential. The contract should be reviewed annually to ensure that the ownership, beneficiary designations, and access to cash values remain aligned with the intended tax treatment. Proper documentation and timely reporting can prevent costly surprises for both the employer and the insured employee.