Funding Estate Liquidity with Corporate-Owned Life Insurance

How COLI creates ready cash for estates

Corporate-owned life insurance (COLI) places a life policy in the corporation’s name so the business—not an individual or trust—receives the death benefit when the insured person dies. That death benefit can provide immediate, liquid funds to pay estate taxes, creditor claims, payroll and operating expenses, and to implement buy‑sell agreements without forcing a fire sale of business assets.

In my practice advising owner-operated businesses, I’ve seen COLI used successfully to avoid rushed sales of ownership interests and to stabilize payroll and operations during a difficult transition. But COLI carries tax, legal, and governance trade-offs that require careful planning with tax and estate counsel.

Why businesses use COLI for estate liquidity

• Immediate liquidity: Death benefits are typically paid in cash and can be accessed quickly.
• Business continuity: Funds can be earmarked to buy out heirs, fund key-person replacement, or pay payroll.
• Possible tax advantages: Death benefits are generally received income-tax free by the policy owner in many situations (see IRS guidance), though special employer‑owned rules and other exceptions apply.

These strengths make COLI particularly useful for closely held and family businesses where much of the value sits in illiquid business assets.

Important federal tax rules and practical implications

• Income tax treatment of proceeds: Life insurance death benefits are generally excluded from gross income under federal tax law when paid by reason of death (see IRS Topic No. 403). That means the corporation typically receives the proceeds without being taxed as income (IRS).
  Source: IRS — Topic No. 403: Life Insurance Proceeds (https://www.irs.gov/taxtopics/tc403)

• Employer-owned / business-owned restrictions (IRC §101(j)): Since 2006, employer-owned life insurance (EOLI) on an employee’s life is subject to notice and consent rules and other requirements before death benefits can be excluded. If those requirements are not met, the tax treatment can change. Companies must also track and report certain EOLI information to the IRS and to the insured.
  Source: IRS guidance on employer-owned life insurance (see IRS Q&As and §101(j) summaries).

• Premium deductibility: Premiums paid by a corporation for a policy it owns are generally not deductible as ordinary business expenses when the corporation is the direct beneficiary and the policy is for the corporation’s benefit. That contrasts with other employee benefit plans where rules differ (consult counsel).

• Inclusion in the insured’s estate: If the insured retained incidents of ownership (rights to change beneficiary, access cash value, surrender the policy) at death, policy proceeds may be included in the insured’s taxable estate under IRC §2042. Likewise, transfers of ownership within a short look‑back window (commonly three years) may cause inclusion. This is a key area to address in planning.

Because these rules are technical, it’s essential to confirm compliance with current law and to document consent and disclosure when policies are employer-owned.

Common COLI structures used to fund estate liquidity

1. Company-owned, company-beneficiary: The corporation owns the policy and is the beneficiary. Typical uses: key‑person protection, liquidity for buy‑sell funding when shares are owned by the company. Careful corporate governance is required to show the business purpose.
2. Company-owned with promise to heirs or buy‑sell: The company receives proceeds and follows a preexisting agreement (buy‑sell or shareholder agreement) to transfer value to heirs or remaining owners.
3. Split-dollar and nonqualified deferred compensation funding: COLI may be used to fund benefits under split-dollar arrangements or to secure unfunded deferred compensation liabilities. These arrangements have distinct tax and accounting rules.
4. Corporate-owned, assigned to an ILIT or third-party trust: In some cases the company may initially own a policy and later transfer it to a trust that is structured to keep proceeds out of a decedent’s estate, but transfers can trigger transfer‑in‑trust rules and require advance planning.

Each approach has pros, cons, and different tax/accounting treatments.

Practical steps to evaluate COLI for estate liquidity

1. Define the liquidity need: Calculate realistic cash needs at the insured’s death—estate taxes, remaining debts, payroll, and working capital—using conservative estimates.
2. Determine ownership and beneficiary structure: Decide whether the company should be owner and beneficiary, or whether an irrevocable life insurance trust (ILIT) or another trust should own the policy.
3. Check employee consent and notice requirements: If the insured is an employee, obtain written notice and consent to meet IRC §101(j) standards.
4. Coordinate with governing documents: Update shareholder agreements, buy‑sell agreements, and company bylaws to reflect the use of COLI and the intended distribution of proceeds.
5. Run tax and estate inclusion tests: Evaluate whether the insured has incidents of ownership that could pull proceeds into the insured’s estate. Consider three‑year look‑back transfer rules.
6. Model alternatives: Compare COLI versus personally owned policies placed in an ILIT, and versus using corporate cash or lines of credit for contingent liquidity.

Pros and cons—quick checklist

Pros

• Fast access to cash at death
• Can be structured to fund buy‑sells and repay debt
• May preserve family ownership without forced asset sales

Cons / Risks

• Premiums are generally nondeductible
• Complex tax rules (e.g., IRC §101(j), incidents of ownership) can change treatment
• Corporate governance and disclosure burdens
• Proceeds owned by corporation may not flow to heirs automatically; contracts must be clear

Example scenarios (illustrative)

• Family business with concentrated ownership: The company buys a COLI policy on the founder and names the company beneficiary. At death, proceeds allow remaining owners to buy the founder’s shares under a buy‑sell without liquidating operating assets.
• Key-person risk: The company insures a top executive with business‑critical relationships; proceeds replace forecasted lost profit and fund short‑term transition costs.

Note: Examples are illustrative and simplified. Real outcomes depend on plan design and legal compliance.

Alternatives and complementary tools

• Irrevocable Life Insurance Trust (ILIT): A common alternative that keeps proceeds outside the insured’s estate and provides direct liquidity to beneficiaries. See our article on Life Insurance Trusts: Funding Estate Taxes and Providing Liquidity for trust‑based strategies.
• Personally owned life policies assigned to the company or to a trust versus direct corporate ownership—each has different estate and income tax consequences.
• Traditional liquidity sources: corporate reserves, bank lines of credit, or installment buy‑outs.

For broader coverage of how life insurance smooths cash needs at death, see our guide on Using Life Insurance to Smooth Liquidity Needs at Death.

Implementation considerations: governance, documentation, and disclosure

• Board approval and documented business purpose: Board minutes should record why the company purchased the policy and how proceeds will be used.
• Written employee consent: For policies on employees, keep written notices and consents in personnel files to comply with employer‑owned rules.
• Integration with shareholder/buy‑sell agreements: The mechanics for transfers and funding must be spelled out to avoid disputes and to ensure the company’s actions align with owners’ expectations.

Common mistakes I see in practice

• Failing to document business purpose and board approval, which can cause stakeholder disputes.
• Ignoring employee consent rules under §101(j), creating later tax surprises.
• Assuming proceeds automatically flow to heirs—without a buy‑sell or trust, the corporation controls the cash.

Final recommendations and next steps

If you’re considering COLI for estate liquidity: start with a clear needs analysis, involve estate and tax counsel early, and align the insurance design with shareholder agreements and corporate governance. In my experience, the best outcomes come from early coordination between owners, the board, and advisors so the policy supports both business continuity and family goals.

Professional disclaimer

This article is educational and does not constitute legal, tax, or investment advice. The federal tax and estate rules discussed are subject to change and hinge on facts specific to each situation. Consult a qualified tax advisor, estate attorney, or insurance specialist before implementing any COLI plan.

Authoritative sources and further reading

• IRS — Topic No. 403: Life Insurance Proceeds (https://www.irs.gov/taxtopics/tc403)
• IRS guidance on employer‑owned life insurance and IRC §101(j) (see IRS Q&As and official publications)
• Consumer Financial Protection Bureau — resources on life insurance and planning (https://www.consumerfinance.gov)

Related glossary pages on FinHelp.io:

• Using Life Insurance to Smooth Liquidity Needs at Death: https://finhelp.io/glossary/using-life-insurance-to-smooth-liquidity-needs-at-death/
• Life Insurance Trusts: Funding Estate Taxes and Providing Liquidity: https://finhelp.io/glossary/life-insurance-trusts-funding-estate-taxes-and-providing-liquidity/