You probably think of a life insurance policy as something you own personally. After all, you applied for it, you pay the premiums, and when you die, the money goes to your family.
That’s how most policies work. What surprises many people is that this arrangement, while simple, can create a significant tax problem for larger estates. A trust can own a life insurance policy instead, and for the right family, that change in ownership makes a meaningful difference.
Why Ownership Matters for Estate Tax
Life insurance proceeds are generally free of income tax when a beneficiary receives them. That’s a common and accurate piece of information. What people often miss is the separate estate tax question.
Under federal law, specifically IRC Section 2042, life insurance proceeds are included in your taxable estate if you held any “incidents of ownership” in the policy at the time of your death.
The term is defined broadly. It includes the right to change the beneficiary, surrender or cancel the policy, assign it, or borrow against its cash value. Simply put, if you have any meaningful control over the policy, the IRS treats the death benefit as part of your estate.
For a $2 million policy owned by someone with an estate already near or above the federal exemption, that inclusion can trigger a 40% federal estate tax on the full death benefit.
So, yes, the proceeds are income-tax free but not necessarily estate-tax free. That distinction is where the planning begins.
South Carolina has no state estate tax, so this concern is purely federal. The federal exemption is currently $15 million per individual, and $30 million for married couples using portability.
Families below those thresholds don’t need to worry about this issue. For families approaching or above them, trust ownership of life insurance is a well-established solution.
How an ILIT Works
An irrevocable life insurance trust, commonly called an ILIT, is a trust specifically designed to own one or more life insurance policies. The trust is the policy owner and the named beneficiary.
You, as the insured, hold no incidents of ownership. Because the policy belongs to the trust rather than to you personally, the death benefit falls outside your taxable estate under IRC Section 2042.
The structure requires you to give up control. The trust is irrevocable, which means its terms are fixed once it is created. You cannot serve as trustee, and you cannot be a beneficiary. You name an independent trustee, whether a trusted individual or a professional, who holds all authority over the policy.
To keep the policy in force, you make gifts to the trust each year. The trustee uses those funds to pay the premiums. In 2026, the federal annual gift tax exclusion is $19,000 per recipient. Premium contributions structured within that limit generally avoid gift tax and do not reduce your lifetime exemption.
There is one procedural requirement tied to the annual exclusion. Contributions qualify only if the beneficiaries have a present right to withdraw the funds. Each year, the trustee sends written notices to the beneficiaries, called Crummey notices, informing them that a contribution has been made and that they have the option to withdraw it.
In practice, beneficiaries allow the withdrawal window to close without taking action, and the trustee then uses the funds to pay the premium. The process looks formal, but it’s a straightforward part of annual trust administration.
New Policy vs. Transferred Policy
You have two paths when establishing an ILIT. The trust can apply for a new policy from the outset, with the trust named as owner and applicant from day one. Or you can transfer an existing policy you currently own into the trust.
The distinction matters because of the three-year rule. If you transfer an existing policy to an ILIT and die within three years of the transfer, the IRS pulls the death benefit back into your taxable estate. The transfer is disregarded for estate tax purposes, as if it never happened.
Having the ILIT apply for a new policy avoids this problem entirely. The trust owns the policy from the moment it is issued, so no transfer ever occurs and the three-year rule is never triggered. For most people doing new planning, this is the cleaner approach.
What Happens to the Proceeds
When you die, the insurance company pays the death benefit directly to the trust. The trustee then manages and distributes those funds according to the trust’s terms.
One common and practical use of the proceeds is providing liquidity to your estate. If your estate holds illiquid assets, a closely held business, farmland, real estate, assets that cannot be quickly converted to cash, your heirs may face pressure to sell those assets to cover estate taxes and administration expenses.
The ILIT can make loans to your estate or purchase assets from it, injecting cash without requiring a forced sale. Your heirs keep the assets you intended them to keep, and the estate has the funds it needs.
Beyond liquidity, the trust distributes remaining proceeds to your beneficiaries under whatever terms you specified when you created the trust. Those terms can include age-based distributions, managed distributions for a beneficiary with special needs, or structured payouts over time.
Other Scenarios
The planning described above addresses a specific problem: keeping a large death benefit out of a taxable estate. For most families in the Low Country, that concern doesn’t apply.
However, other types of trusts hold life insurance for entirely different reasons, and the motivation has nothing to do with taxes.
Parents of young children commonly name a revocable living trust or a testamentary trust as the beneficiary of a life insurance policy rather than naming the children directly. The reason is straightforward.
A minor cannot legally receive a life insurance payout. If your child is under 18 when you die, a court must appoint a guardian to manage the funds until your child reaches adulthood, at which point the full amount transfers outright with no conditions.
Naming a trust as beneficiary changes that outcome entirely. The trustee receives the proceeds and manages them according to terms you established in advance.
You decide what the money can be used for, how distributions are made, and at what age your child receives funds directly. A well-drafted living trust or a testamentary trust built into your will can serve as the beneficiary and provide a protective structure for your children.
We Are Here to Help!
As you can see, there are different approaches that can be taken when you’re planning your estate. There is no one-size-fits-all plan, and this is why personalized attention is needed. This is exactly what you will receive when you work with our firm.
To set the wheels in motion, call our Bluffton, SC estate planning office at 843-815-8580 or send us a message through our contact page.
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