Estates of Employees Covered by COLI Plans may be Entitled to the Death Benefits Paid to the Employers, but the IRS Says They are not Entitled to a Tax Exclusion for the Benefits

The IRS attacked employers’ deductions for broad-based corporate-owned life insurance (COLI) plans (or “janitor insurance”), arguing that the policy loans, the interest payments and sometimes even the insurance itself are economic shams. At the same time, the estates of rank-and-file employees covered by these plans have sought to recoup the death benefits paid to employers, claiming that the employers did not have an insurable interest in the lives of the employees because the employers’ economic interest in the continued life of the employees was not substantial. In these circumstances, the laws of many states provide that, while insurers still have contractual obligations to pay death proceeds, the estates of the covered employees in whose lives the employer had no insurable interest have a cause of action to recover those proceeds. Although the death proceeds were paid to the employers, courts have recognized the legal claims of the employees’ estates against employers for such proceeds, or have recognized a con- structive trust for such proceeds in favor of the employees’ estates.

While courts seem to be saying that the employees’ estates are the proper recipients of the COLI death proceeds for rank-and-file employees, the IRS has concluded that the amounts so received are not death proceeds, or at least not “amounts received . . . under a life insurance contract, . . . paid by reason of the death of the insured” for purposes of the tax exclusion under I.R.C. § 101(a). In PLR 200528023 (July 15, 2005), the IRS considered facts involving a class action settlement of claims filed on behalf of former employees who died while covered by the employer’s COLI policies, similar to the facts of the Mayo v. Hartford Life Ins. Co. and Tillman ex rel. Estate of Tillman v. Camelot Music, Inc. cases. The facts of the PLR state that initially an employee’s estate brought suit against the employer, claiming that the employer did not have an insurable interest in the life of the employee and, therefore, was not the rightful beneficiary for the policy on his life. The employee’s estate then requested certification of a class of similarly situated employees. In the course of the litigation, the parties settled and the funds paid by the employer were put into a trust for the settlement class. Each qualified former employee’s estate or heir received a proportionate amount of the settlement fund determined on the basis the face amount of each policy. The employee’s estate apparently argued that under the origin of the claim doctrine, the proceeds distributed from the settlement class trust were excludable from income pursuant to I.R.C. § 101(a) because the proceeds retained their character as insurance proceeds paid by reason of death on the insured persons.