Beneficiaries usually pay no income tax on the death benefit payments.

You must consider estate taxes because if you own a policy on your own life, the death benefits are included in your estate for federal estate – tax purposes unless the money goes to your surviving spouse (and he or she is a U.S. citizen). When death benefits go directly to a beneficiary other than your spouse (such as a child or sibling) they’re included as part of your estate.

You are considered to own a policy if you possess so-called "incidents of ownership." (IRC Section 2042), You have incidents of ownership if you retain the power to change policy beneficiaries, change coverage amounts, cancel the policy, etc. If someone other than your spouse is your life insurance beneficiary and you have a large estate, your life insurance policy could cause an estate tax bill.

Set up an irrevocable life insurance trust to own the policy. The trust pays the premiums and the life insurance death benefits go to whomever you name as the trust beneficiary. With this rather simple arrangement, there are no federal income taxes and no federal estate taxes on the death benefits.

Set up an irrevocable life insurance trust to buy an insurance policy on your life. Buy enough coverage to pay the estate taxes that would be owed upon your demise. That way, your heirs won’t need to sell your business just to pay the estate taxes. Because the trust owns the policy, the death benefits won’t be included in your estate. Nor will any federal income tax be due.

You and your co-owners can buy insurance on each others’ lives to fund a buy/sell agreement. That way, when a co-owner dies, the surviving co-owners can use the death benefits to buy out the decedent’s ownership interest.