Life insurance policies are taken out--in most cases--to provide financial benefits (i.e., money) to the heir(s) of the insured. For most people, the heir is the spouse, then children, then grandchildren.
Of course, life insurance policy benefits are not paid out until the death of the insured. That's why it's called a death benefit. But with death comes the inevitable estate tax, commonly referred to by opponents of the tax as the "death tax". Sure, the wealth of a deceased passes to his or her spouse tax-free, but this results in a mere delay of estate taxes because Uncle Sam will get his full cut when the surviving spouse dies. That means less for your children and grandchildren if the value of the estate exceeds certain thresholds.
The logical question, then, is why have a life insurance death benefit paid into an estate that is soon to be taxed? Its a good question.
The good news is there are ways to "shelter" life insurance proceeds from death taxes. The common strategy is to hold the policy inside an irrevocable life insurance trust (ILIT) that has an independent trustee. When the insured dies and the policy pays the death benefit, such funds go into the trust and are invested as directed by the trustee (and the trustee invests the monies as stipulated by the trust document). Funds are then periodically distributed to the surviving spouse, once again as directed by the trust document. Then, upon the spouse's death, the money that remains in the trust is distributed to his or her heirs.
Again, the purpose of an ILIT is to remove life insurance...