Why use life insurance for estate liquidity?
Life insurance is one of the cleanest, most predictable ways to create immediate cash at death. The proceeds typically arrive quickly, are generally paid income tax-free to beneficiaries (IRC §101(a)), and can cover estate taxes, outstanding debts, business buyouts, and final expenses without forcing a sale of illiquid assets like a family business or real estate (IRS: Estate Tax, https://www.irs.gov/).
In my practice over 15 years advising families and business owners, I’ve seen life insurance solve two common problems at death: a shortfall of liquid assets to pay taxes and costs, and the need to preserve business or real property for heirs. With careful structuring, the death benefit can be available to heirs while remaining outside the insured’s gross estate for estate tax purposes.
Source notes: the IRS explains that life insurance proceeds are generally excluded from taxable income (see the IRS life insurance guidance and estate tax pages); consumer-oriented explanations are available from the Consumer Financial Protection Bureau (CFPB) for policy basics (https://www.consumerfinance.gov/).
Core tax rules to understand (plain language)
- Income tax: Death benefits paid on a life insurance policy are generally income tax-free to beneficiaries (IRC §101(a)).
- Estate tax inclusion: A death benefit may nonetheless be included in the insured’s gross estate if the insured owned “incidents of ownership” in the policy at death (see IRC §2033, §2042 and IRS guidance). That inclusion can subject the proceeds to estate tax when the estate exceeds the applicable exclusion amount.
- Three-year rule: If the insured transfers ownership of a policy (or certain incidents of ownership) to another person or trust and dies within three years, the proceeds may be brought back into the gross estate under the related transfer rules (IRC §2035).
- Gift-tax and Crummey powers: When an ILIT is used, premium gifts to the trust are often structured as present-interest gifts using Crummey withdrawal powers so they qualify for the annual gift-tax exclusion.
These rules shape how you structure ownership, premium payments, and beneficiary designations.
Common ways to keep the death benefit out of the insured’s gross estate
- Irrevocable Life Insurance Trust (ILIT)
- How it works: The insured creates an ILIT that purchases and owns the life insurance policy. The ILIT is the legal owner, not the insured. The trustee manages premiums, and the trust is the beneficiary. At death, proceeds go to the trust and then to beneficiaries under trust terms.
- Key benefits: If properly drafted and administered, the death benefit is not part of the insured’s gross estate, removing estate tax exposure.
- Important trap: If the insured transfers an existing policy to the ILIT within three years of death, the three-year lookback rule may include the proceeds in the estate (IRC §2035).
- Practical steps used in my work: Have the ILIT purchase a new policy directly or, if an existing policy is transferred to the ILIT, plan for the three-year window; fund premium payments with Crummey notices so donors get the annual exclusion.
- Third‑party ownership (someone else owns the policy)
- A family member, trust, or a corporation can own the policy. If the insured does not retain incidents of ownership and the owner is unrelated for estate-tax inclusion, proceeds generally aren’t in the insured’s estate. However, business-owned policies have their own rules and income/transfer considerations.
- Survivorship (second-to-die) policies
- These policies insure two lives and pay on the second death. They can be cost-effective for covering estate taxes for married couples and are commonly owned by ILITs for tax exclusion.
- Corporate-owned life insurance
- For business continuity and key-person protection, corporations can own policies. There are special tax rules for corporate-owned policies and for benefits used to buy out a deceased owner’s interest; consult a tax advisor.
For more on trust ownership and alternatives, see our coverage of Using Life Insurance Trusts to Provide Liquidity at Death and Leveraging Life Insurance for Estate Liquidity Without an ILIT.
