Purchasing permanent life insurance policies for key executives or other specific employees or directors is a common practice for banks and bank holding companies. Since it pays the premium up front and is the sole beneficiary of the death benefit, the bank is entitled to the buildup of cash surrender value generated from the policy’s investment performance. Banks often use these favorable tax-equivalent yields to offset employee benefit costs, but it is important to deploy these gains appropriately to avoid tax penalties or other financial risks, as outlined in this BOLI tax refresher.
Tax Benefits of BOLI
The primary benefit of BOLI is its treatment for corporate income tax purposes. The buildup of cash surrender value within the policy is included in book earnings but excluded from the calculation of federal taxable income. The death benefit proceeds follow this same model, as long as banks abide by federal rules governing the use of BOLI.
In a 2004 bulletin, the Office of the Comptroller of the Currency (OCC) reminded banks of the supervisory expectations for the purchase and risk management of BOLI. Through this guidance, the OCC stressed the need for bank senior management and boards to conduct both a pre-purchase risk-reward analysis of BOLI and a continuous risk assessment post-purchase.
Keep in mind that the ability of state-chartered banks to purchase insurance (including equity-linked variable life insurance) is governed by state law.
Prohibited uses of BOLI
Life insurance holdings can serve a number of business purposes, but banks (even those that elect to be taxed as an S Corporation) are prohibited from purchasing BOLI for the following reasons:
- Acquisition of shares of stock from the estate of a major shareholder upon his or her death, in order to control the distribution of ownership in the institution
- Provision of estate-planning benefits for insiders
- Generation of funds for normal operating expenses other than employee compensation and benefits
Manage BOLI to Reduce Risk to Earnings, Capital
Banks are not permitted to hold life insurance in excess of their risk of loss or costs to be recovered. Risk of loss can be eliminated if a key employee no longer qualifies due to retirement, resignation or a change of duties. A general rule of thumb for banks is to avoid holding BOLI in excess of 25 percent of its capital. Refer to your institution’s supervisory agency guidelines as definitions of this capital concentration may vary.
What happens if your bank no longer needs BOLI or it exceeds your percentage of capital requirements? Depending upon the type of policy, the institution can incur a tax liability on the cash surrender value buildup and it could also face an additional tax penalty for early surrender. These issues can be mitigated (or avoided altogether) with informed pre-planning. Banks that fail to properly implement a BOLI policy face serious risks to earnings and capital.
BOLI Required Tax Filings and Documentation
Banks with BOLI must include the required Form 8925 with their federal income tax return every year. Signed affidavits from the insured individuals are required at the time the policy is issued and must be kept on file. Failure to obtain this documentation can create a significant taxable income event if the insured individual dies. Provisions of the Pension Protection Act of 2006 limit the tax-free treatment of life insurance proceeds when the stated protocols are not followed. If the affidavit documentation requirements are not met, only the portion of the cumulative insurance premiums paid can be reimbursed tax-free. The remainder of the death benefit proceeds will be taxable as ordinary income.
Banks should familiarize themselves with federal guidance related to BOLI and regularly review existing and planned BOLI policies with insurance and tax advisors. The financial services industry team at RKL has a dedicated team of tax professionals to assist banks with ongoing reviews and overall integration of BOLI into a comprehensive risk management plan. Contact Barry Pelagatti, Financial Services Industry Group leader, for more information on BOLI assistance.