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You are about to read three true tax stories. Two are sad. One is happy.

Story #1. Sam called to tell me his dad, Joe, died two years ago. Joe left $1.6 million in life insurance (plus various other assets, including the family business, worth about $4 million) to his wife, Mary. Mary died five weeks ago, leaving everything to their three children.

Sorry, but it was too late to do effective tax planning. Of the $1.6 million in life insurance, $880,000 was lost to the IRS. A simple irrevocable life insurance trust (ILIT) would have saved every penny of the life insurance—tax-free—for the kids.

Story #2. The facts are almost the same (but of course are about a different family than in story #1), except this time the life insurance policy ($2 million) on Joe's life was owned by Success Co. (a C corporation owned 100 percent by Joe), which received the $2 million when Joe died. Mary died shortly after Joe. Sam, who was running Success Co., shared his parents' wealth with his sister, Jan. The $2 million in insurance proceeds, paid to Success Co., will be socked with at least three taxes: the alternative minimum tax, an increase in estate taxes on Mary's death because Success Co. is worth more, and the tax cost of getting the insurance proceeds (via dividends) out of Success Co. to Sam and Jan. Estimated loss in various taxes to the IRS: $1,180,000. Only $820,000 to Sam and Jan. A real tax tragedy!

Burn this rule into your memory: The family corporation (whether a C corporation or an S corporation) should never own or be a beneficiary of life insurance on the life of a major stockholder (one exception: A financial institution requires the insurance as part of the lending process). An ILIT (such as in story #1) would have prevented a more than $1 million loss to the IRS.

Story #3. This time Joe called while he was very much alive. He had $8 million in life insurance on his life: some owned by him, some owned by Success Co. We analyzed his insurance policies and the rest of his entire financial situation. Our analysis led to this decision: Cancel all of the old policies (Joe and Success pocketed $802,000 in cash surrender value). Joe replaced the $8 million in insurance with $11 million in second-to-die coverage (with Mary). All premiums will be paid by a subtrust (part of Success Co.'s profit-sharing plan). The result: $802,000 tax-free in pocket to start, and ultimately, $11 million in insurance with zero premium cost to Joe, Mary or Success Co. The entire $11 million insurance proceeds will escape estate taxes. The plan not only saves taxes, it actually will create wealth with no out-of-pocket cost to Joe and Mary. The lesson should be clear: Start your planning today . . . while you are alive.

The easiest way for a successful business owner to create tax-free wealth is by the proper use of life insurance. Unfortunately because of the complexity of the law, life insurance is also the easiest way to enrich the IRS if you make a mistake. There are dozens of ways that can cause you to fall into an insurance tax trap, for example: wrong ownership of the policy, wrong beneficiary or wrong kind of policy. The list could go on and on.

What to do? It's a three-step process. (1) Have an expert analyze your existing policies; (2) Set up a plan—new policies may be required—that gets you the most insurance coverage needed for the lowest premium cost; (3) Make sure the proceeds of your policies (old and new) escape the IRS tax net. Result: Instead of losing huge amounts of dollars to the IRS, you enrich your family.