When a person passes away, the survivors need a source of funds to pay for last medical bills, funeral costs, support for the survivors, and often estate taxes. However, many people may have substantial wealth in illiquid assets, such as closely-held businesses, their home or other real estate. Under current tax law, if a person’s net estate exceeds the estate tax exclusion (unlimited in 2010 under present law, but then back down to $1,000,000 in 2011), estate taxes (federal and state) must be paid. We will assume the $1,000,000 estate tax exemption is in effect under the examples below. The estate taxes are very expensive – they start at 41% and quickly go up to 49%, depending on the size of the estate.

In addition, these estate taxes are due nine months after death – in cash. This can devastate many estates (especially those with small businesses or other illiquid assets). Such assets must often be liquidated instead of being preserved for the heirs.

On the other hand, to avoid forced sales, people often buy life insurance. However, if the insured owns the policy, the proceeds themselves will be subject to estate taxes. The net proceeds, after payment of estate taxes, will often only be half of the proceeds paid under the policy. For example, a $500,000 policy owned by the insured will often generate a $210,000 estate tax attributable solely to the insurance proceeds. Thus, only $290,000 of the proceeds will be available to the beneficiaries.

Surprisingly, through the use of a relatively simple and properly drafted life insurance trust, the insurance proceeds will not be subject to estate taxes. The full proceeds will be available to the beneficiaries, free of both estate and income taxes.