By Caroline McKay, JD, LLM, AEP^®

Life insurance can be an especially valuable planning tool for affluent and ultra-high-net-worth families because it creates immediate liquidity at death, generally through an income-tax-free death benefit. That liquidity can help provide for family members, equalize inheritances, fund business or other legacy objectives, and—perhaps most importantly for clients with taxable estates—provide cash to help satisfy estate tax and other obligations without forcing the sale of illiquid or appreciated assets. But advisors must recognize an important distinction:  income-tax-free does not necessarily mean estate-tax-free. If the insured owns the policy or retains certain rights over it, the death benefit is generally included in the insured’s taxable estate, potentially increasing the very estate tax liability the insurance was intended to help address.

This disconnect between income tax and estate tax treatment is a primary reason clients incorporate irrevocable life insurance trusts (ILITs) as part of a broader estate plan. When properly structured and administered, an ILIT can remove life insurance proceeds from a client’s taxable estate while preserving the income-tax-free liquidity and flexibility the insurance was intended to provide.

For CPAs advising high-net-worth individuals, business owners, real estate investors, and other clients with taxable estates, understanding the mechanics of ILIT planning is essential. Equally important is recognizing that successful ILIT planning depends not only on trust drafting, but also on ongoing administration, tax reporting, and annual compliance reviews.

Income Tax Exclusion Versus Estate Tax Inclusion 

One of the most important concepts in life insurance planning is the distinction between income tax exclusion and estate tax inclusion. While death benefits are generally excluded from income taxation under Internal Revenue Code (IRC) § 101(a), the proceeds are included in the insured’s gross estate under § 2042 if the insured retains incidents of ownership at death. For affluent clients, this distinction can have significant consequences. A life insurance policy purchased to provide liquidity may inadvertently increase the size of the estate and, in turn, create or amplify estate tax obligations. 

An ILIT is designed to address this estate tax issue by having the trust, rather than the insured, own the life insurance policy. The ILIT may purchase a new policy directly, or an existing policy may be transferred to the trust (subject to important estate tax rules discussed below). If the ILIT is properly structured and administered, and the insured does not retain incidents of ownership or other prohibited powers over the policy, the death benefit can generally be excluded from the insured’s taxable estate. At the insured’s death, the proceeds are paid to the ILIT and administered by the trustee for the benefit of the trust beneficiaries, providing liquidity and long-term planning benefits without direct ownership by the insured.

Taxes & Beyond: Why Clients Use ILITs

Clients who own closely held businesses, commercial real estate, investment properties, or other illiquid assets often face a significant mismatch between the value of their taxable estates and the liquidity necessary to pay taxes and expenses at death. Because estate taxes are generally due within nine months of death, heirs may be forced to sell assets quickly, potentially at depressed values or under unfavorable market conditions. By owning life insurance outside the taxable estate, an ILIT can provide a source of tax-efficient liquidity to meet estate obligations, preserve family wealth, and avoid the forced sale of important assets.

Beyond estate taxes, ILITs can serve an important role in long-term family wealth planning. Trust provisions allow grantors to control how and when beneficiaries receive assets while protecting those assets from creditors, divorcing spouses, and spendthrift behavior. Rather than distributing proceeds outright, an ILIT can establish long-term governance and stewardship over inherited wealth.

ILITs are also frequently used to equalize inheritances among family members. For example, when a closely held business or other illiquid asset is intended to pass to one child, life insurance proceeds held in an ILIT can provide comparable value to other heirs without requiring division, sale, or disruption of the underlying asset. In this way, an ILIT can help achieve equitable outcomes while preserving family harmony.

Understanding the ILIT Structure & Incidents of Ownership

While the legal structure of an ILIT is relatively straightforward, its effectiveness depends on both proper design and ongoing administration. The trust owns the life insurance policy and is named as the policy beneficiary, while the grantor typically makes contributions to the trust that are used to pay premiums. The trustee is responsible for administering the trust and carrying out its provisions for the benefit of the trust beneficiaries, who ultimately receive the proceeds in accordance with the terms of the trust.

Maintaining a clear separation among these parties is critical. The estate tax benefits of an ILIT largely depend on ensuring that the insured does not retain incidents of ownership or other powers that could cause the policy proceeds to be included in the taxable estate. For this reason, the insured generally should not serve as trustee, and care must be taken to avoid arrangements that could be viewed as indirect control over the policy or its proceeds.

Treasury Regulation § 20.2042-1 defines incidents of ownership broadly. The term includes not only direct ownership of a policy, but also rights that give the insured economic control over the policy, such as the ability to designate or change the beneficiary, surrender or cancel the policy, assign or revoke an assignment, pledge the policy as collateral, or borrow against the policy’s cash value. Importantly, estate inclusion under § 2042 depends on whether those powers exist, not necessarily whether the insured ever exercised them. As a result, advisors must look beyond title ownership and consider the rights retained by the insured and how the policy and trust are administered in practice.

A separate estate tax consideration also arises under the three-year rule of IRC § 2035. If an insured transfers an existing policy to an ILIT and dies within three years of the transfer, the policy's entire death benefit may be brought back into the insured's gross estate, effectively negating the intended estate tax benefit of the transfer. For this reason, practitioners often recommend that new policies be acquired directly by the ILIT rather than transferred after issuance. When an existing policy must be moved into an ILIT, additional planning techniques—such as a bona fide sale to a grantor trust or the use of qualifying marital trust provision—may help mitigate estate inclusion concerns.

ILIT Funding & Administration

To pay the annual insurance premiums, most ILITs rely on a gift from the trust’s grantor. Depending on the size of the premium and number of beneficiaries within the trust, contributions from the grantor may qualify, in full or in part, for the annual gift tax exclusion under IRC § 2503(b). If a contribution does not qualify for annual exclusion treatment, or if it exceeds the amount covered by the annual exclusion, the non-excluded portion will generally be treated as a taxable gift and will use a portion of the grantor’s lifetime gift and estate tax exemption.

The challenge with annual exclusion gifting is that gifts made to a trust are generally considered future interests, which do not qualify for the annual exclusion. To address this problem, most ILITs include Crummey withdrawal powers. Under a typical Crummey arrangement, ILIT beneficiaries receive a temporary right to withdraw contributions made to the trust. Although beneficiaries rarely exercise these rights, the existence of a meaningful withdrawal period converts a premium contribution into a present-interest gift for gift tax purposes.

In the case of a married grantor, the grantor and grantor’s spouse may elect to split gifts under IRC § 2513, allowing them to effectively double annual exclusion gifts. Even when no gift tax is owed, gift splitting may require the filing of Form 709 gift tax returns.

From a compliance perspective, proper trust funding administration is imperative. In most cases, grantor contributions should be deposited into the trust before premium payments are made, and beneficiaries should receive timely written notice of their withdrawal rights in accordance with the trust terms—often 30 to 60 days. Trustees should also maintain documentation showing that the notices were properly issued and that beneficiaries were given a meaningful opportunity to exercise their withdrawal rights.

GST and Income Tax Considerations

Because many ILITs are designed to benefit multiple generations and may qualify as a “GST trust” as defined in IRC § 2632, generation-skipping transfer (GST) tax planning is a critical and often overlooked part of ILIT funding. 

Many GST planning issues for ILITs arise due to the different rules that apply for gift tax and GST tax purposes related to annual exclusion gifts. Although contributions to an ILIT often qualify for the gift tax annual exclusion through properly structured Crummey withdrawal powers, those same contributions frequently do not qualify for the GST tax annual exclusion. The GST annual exclusion generally applies only to transfers made directly to an individual or to certain trusts with a single beneficiary whose trust assets will be includible in that beneficiary’s estate. As a result, GST exemption may be automatically (but unintentionally) allocated to ILIT contributions unless the taxpayer affirmatively elects out on a timely filed gift tax return.

For that reason, annual ILIT administration should include a deliberate review of GST tax exposure, automatic allocation of GST exemption, any election out of automatic allocation, and related Form 709 reporting requirements. Additional complications may arise when the trust includes “hanging” Crummey powers, which can require ongoing tracking of withdrawal rights, taxable gifts, and the trust’s GST inclusion ratio over time. Failure to properly monitor GST exemption allocations can adversely affect the trust’s GST status and produce unintended transfer tax consequences many years in the future.

From an income tax perspective, most ILITs are intentionally structured as grantor trusts. Under the grantor trust rules, all items of trust income, deduction, and credit are reported directly by the grantor rather than by the trust itself. When the only asset owned by the trust is one or more life insurance policies, there is often little or no income tax to report from year to year. When an ILIT holds assets in addition to life insurance, those assets can grow without being reduced by trust-level income taxes, effectively providing an additional tax benefit for trust beneficiaries. Depending on the trust’s activities and the nature of its investments, fiduciary income tax reporting obligations, including the potential filing of Form 1041, should be reviewed on an ongoing basis.

The CPA's Annual Review Checklist

Because ILITs often operate in the background for years or even decades, administrative errors can go unnoticed until a death benefit is paid, an audit occurs, or estate administration begins. By the time questions arise, the original advisors may have retired, trustees may have changed, and key records may be difficult to locate or no longer exist. As trusted advisors with visibility into a client's overall tax and financial situation, CPAs are well-positioned to identify administrative oversights, compliance gaps, and reporting issues before they evolve into more significant and costly problems.

As part of an annual review, CPAs should consider the following:

• Confirm that trust contributions were made in accordance with the trust's funding strategy and premium obligations.

• Verify that required Crummey withdrawal notices were issued, delivered, and properly documented in a timely manner.

• Review premium payment procedures to ensure policy premiums were paid from the appropriate trust accounts.

• Evaluate whether Form 709 gift tax returns are required, including the impact of gift-splitting elections where applicable.

• Review GST exemption allocations, automatic allocation provisions, and any elections that may be necessary.

• Confirm that life insurance policies, trust assets, and beneficiary designations remain properly titled and coordinated with the client's overall estate plan.

• Identify administrative, recordkeeping, or governance deficiencies that could jeopardize the intended tax treatment of the trust.

• Coordinate with the client's estate planning attorney and insurance advisor regarding any changes in family circumstances, tax law, or planning objectives that may warrant modifications to the trust.

Bottom line: A brief annual ILIT review can help uncover administrative oversights before they become costly tax, estate, or litigation issues, preserving the integrity of the planning strategy for the beneficiaries. 

Caroline McKay, JD, LLM, AEP^®, is head of Advanced Planning at The Coyle Company, where she delivers life insurance knowledge and advanced estate planning solutions to ultra-high-net-worth individuals and families. Drawing on her legal background and advanced tax education, Caroline is widely recognized for her deep specialization in insurance planning, wealth transfer strategies, and tax-efficient solutions. Caroline also focuses on developing and supporting advisor relationships within the ultra-affluent estate planning community.