In many circumstances it is advisable to have life insurance owned by an irrevocable trust, often referred to as an irrevocable life insurance trust (ILIT). The primary tax benefit of having an ILIT own life insurance is to remove the death benefit from the taxable estate of the insured. Accordingly, the death benefit can be used to benefit heirs and be a source of instant liquid cash to pay estate taxes or other obligations associated with the death of the insured.
The general rule of taxation of death proceeds from life insurance is that they are income tax-free, but subject to estate tax in the estate of the insured if the insured had a so-called “incident of ownership.” The most obvious incident of ownership is where the owner of a policy is the insured. There are less obvious incidents of ownership such as being able to change a beneficiary of a policy, being able to borrow from a policy’s cash value, the ability to surrender a policy, or using a policy for collateral.
