A case study on ILITs: What went wrong, how to fix it, and best practices for prevention

Editor: Mo Bell-Jacobs, J.D.

A case study on ILITs: What went wrong, how to fix it, and best practices for prevention

Irrevocable life insurance trusts (ILITs) continue to be a cornerstone of estate planning for many clients. Advisers often recommend ILITs to accomplish key objectives: excluding life insurance proceeds from the insured’s taxable estate and providing liquidity at death. Ideally, this occurs by funding premiums through annual exclusion gifts under Sec. 2503(b) without increasing gift or estate tax liability or reducing the client’s lifetime gift and estate tax basic exclusion amount under Sec. 2010(c)(3).

While most advisers understand the structural and administrative requirements of ILITs, the generation–skipping transfer tax (GSTT) implications are frequently overlooked. Common oversights include:

• Failing to track the use of generation-skipping tax (GST) exemption since gifts eligible for and under the annual exclusion are not required to be reported on a gift tax return.
• Not electing to affirmatively opt in or opt out of the automatic allocation rules under Regs. Sec. 26.2632-1(b)(2) and not allocating GST exemption intentionally.
• Overlooking the impact of “hanging” Crummey powers under Sec. 2632(c)(3)(B)(vi) (see Crummey, 397 F.2d 82 (9th Cir. 1968)) on a trust’s GST status year by year.
• Neglecting to analyze historical gifts to the trust that had automatic allocations of GST exemption before recommending additional gifts.

These oversights led to complex problems years later, requiring costly and time–consuming corrections.

ILITs can be highly effective, but their success depends on a thorough understanding of both gift tax and GSTT considerations. Proactive management, clear communication, and detailed analysis are essential to preserve the intended benefits and avoid unintended tax consequences. To illustrate common pitfalls and strategies for avoiding them, let us examine a real–world scenario that advisers encounter all too often — one that underscores why diligence in planning and administration is crucial to maintaining an ILIT’s integrity and effectiveness.

What went wrong?

It is May 2026, and you are meeting with clients to determine who needs to file a 2025 gift tax return. One client you’ve worked with since 2020 — when you filed their first (and only) gift return to report an $11.58 million gift of a closely held business entity to a dynasty trust — responds with a list of small gifts and what they casually call their “usual” premium payments. In the past seven years, the client never mentioned paying life insurance premiums, and you fear the policy may be held by an ILIT established many years ago.

The client confirms that the premiums are for a life insurance policy owned by an ILIT. They deposited $40,000 into the ILIT’s bank account in 2025. The client adds that their prior adviser informed them that since all gifts are under the annual exclusion, there was no need to report the gifts on a gift tax return. You ask about their intentions for the trust, and they let you know it is intended to benefit grandchildren.

After several conversations with the client and their previous advisers, the full picture starts to emerge. The ILIT was created in 1991 — the same year the client began paying premiums on the policy. For decades, they have contributed $40,000 to the bank account each year. The ILIT gives their four children withdrawal rights in the amount of the lesser of (1) the pro rata portion of the full contribution or (2) the maximum amount that may be excluded from gifts to the beneficiary under Sec. 2503(b).

So far, all gifts qualified for the gift tax annual exclusion, and no gift was over the annual exclusion in any year, so the prior adviser was correct that, technically, no Forms 709, United States Gift (and Generation–Skipping Transfer) Tax Return, were required to be filed prior to 2020. However, they did not consider the GSTT implications.

After rereading the trust agreement, it becomes clear that the ILIT was intended to be a GST trust as defined in Sec. 2632(c)(3)(B), so there were likely automatic allocations of GST exemption to the trust for transfers made after Dec. 31, 2000. However, there is a provision that explains that if a beneficiary does not exercise the withdrawal right within 30 days, the right shall lapse to the extent of the greater of $5,000 or 5% of the trust assets, and any portion that does not lapse continues and may be exercised in subsequent years.

You quickly realize that these hanging Crummey powers may cause the ILIT not to be a GST trust under Sec. 2632(c)(3)(B) in years where the hanging powers exceed the annual exclusion. GST exemption automatic allocation rules under Regs. Sec. 26.2632–1(b)(2) took effect on Jan. 1, 2001. Before that, from 1991 to 2000, no GST exemption was allocated to the ILIT because the client never filed a Form 709. Timely manual allocation would have been required to exempt these gifts from GSTT, but that did not happen. Starting in 2001, automatic allocation rules applied when the ILIT was a GST trust under Sec. 2632(c)(3)(B).

Suddenly, what seemed simple has now become complex. The ILIT has a mixed inclusion ratio for GSTT purposes, which is not ideal from an administrative perspective, but more importantly, the client wanted the trust to be fully exempt from the GSTT. You remember that back in 2020, before you even knew about this ILIT, the client used all their remaining GST exemption on that $11.58 million gift you advised them on. That once strategic move now significantly limits options for fixing the trust’s GSTT exposure. And to add to the problem, due to prior automatic allocations, the 2020 gift is also not fully exempt from the GSTT.

What started as a routine annual review of gifts has turned into a complex puzzle — so, what should you do now?

How to fix it

The client’s 1991 ILIT received annual contributions less than or equal to the gift tax annual exclusion but had inconsistent allocations of GST exemption for decades. Corrective action is necessary to ensure that the client’s intention to fully exempt the ILIT from GSTT is met. Luckily, since 2020, the client has not made any gifts other than ILIT premiums, so inflation increases have added to their current remaining GST exemption available. The remaining GST exemption for remedies is equal to or less than $3.42 million ($15 million 2026 GST exclusion amount minus $11.58 million of the GSTT exclusion the client used as of 2020). The final number depends on the hanging Crummey power analysis discussed above.

You consider the options that you will discuss with the client.

Option 1: Request an IRS private letter ruling under Sec. 2642(g) and Regs. Sec. 26.2642–7 to retroactively allocate GST exemption. This applies to transfers where automatic allocation did not apply (i.e., before Jan. 1, 2001, when the automatic allocation rules went into effect). However, private letter rulings are costly, complex, and uncertain, so this may not be the most practical solution.

Option 2: The pre–2001 transfers qualify for simplified relief under Rev. Proc. 2004–46 because all transfers were within the gift tax annual exclusion amount, and the taxpayer had GST exemption available in those years, provided all other requirements are met. This relief would require filing Forms 709 for applicable years. This relief is not available for post–2000 transfers where hanging Crummey powers caused no automatic allocation to occur.

Option 3: Under Sec. 2642(b)(3), the client can make a late allocation of GST exemption to the ILIT. This allocation would be effective as of the date of filing the late allocation, and the taxpayer could make an election to use the trust’s value for allocation purposes equal to its fair market value as of the first day of the month in which the late allocation is made, so long as they survive the effective date of the allocation. This means that the client may need to allocate more GST exemption now than they would have allocated had they timely allocated GST exemption to the ILIT on a timely filed Form 709. This method is costly and can be time–consuming, but with the GST exemption the client has remaining, it could be the right option. Life insurance is notoriously difficult to value, making it challenging to determine how much GST exemption should be allocated, based on current values, to fully exempt the trust. Should they rely on interpolated terminal reserve value or gross cash surrender value or obtain an appraisal?

Option 4: The client could also consider making a qualified severance under Sec. 2642(a)(3) and Regs. Sec. 26.2642–6 by dividing the ILIT into two trusts, one that is fully exempt from GSTT and one that is fully nonexempt from GSTT. This would simplify the administration of the trust and would not require an allocation of any more of the client’s GST exemption. This could be the right option if the client wishes to make a large GST–exempt gift in the future.

After correcting the mixed inclusion ratio for the 1991 ILIT, you are left with ensuring the 2020 trust is also fully GST–exempt. Because there were automatic allocations prior to 2020, the full $11.58 million was not available to allocate to the 2020 transfer. Anticipating this issue, the 2020 assignment was drafted using formula language tied to the lesser of the client’s available gift or GST exemption. You will need to coordinate with the trustee and attorney to reallocate assets in line with the formula language. Since the 2020 trust was a grantor trust, no income tax true–up is needed.

Best practices for prevention

The consequences of missed GST exemption allocations and inconsistent elections are significant. In this case, the client’s intent was clear, as they wanted the ILIT to be fully exempt from GSTT so that future generations could benefit from the trust assets without having to pay GSTT. The trust now has a mixed inclusion ratio because no GST exemption was allocated to transfers from 1991 through 2000, and the hanging Crummey powers changed the trust’s classification as a GST trust in some years, disrupting automatic allocations of GST exemption after 2001. Automatic allocations of GST exemption prior to 2020 were unknown by the new adviser, complicating the 2020 gifting. Correcting these mistakes can be costly, making prevention crucial.

Although the client was not required to file a Form 709 for gift tax purposes in years prior to 2020, filing would have been necessary to manually allocate GST exemption prior to 2001, when automatic allocation rules did not exist. Had proper allocations been made from the outset, the trust could have been fully exempt from GSTT, and the client’s remaining exemption could have been tracked accurately over time, ensuring the new adviser knew the proper amount of GST exemption remaining for the 2020 gift.

Beginning in 2001, the automatic allocation rules provided some relief, but only in years when the trust qualified as a GST trust. The hanging Crummey powers can disqualify the trust in certain years, and relying solely on the automatic allocation rules creates risk. Best practice is to make an affirmative opt–in or opt–out election on a timely filed Form 709 for the current year and all future years. Importantly, these elections should never be made without client consent. Advisers should confirm and document the client’s intent before making an election.

When you began working with the client in 2020, you were unaware of the ILIT, which led to an inaccurate assessment of available GST exemption. Before recommending any significant gift, advisers should ask about all existing trusts, review historical transfers, and analyze their impact on remaining exemptions.

Circumspection called for

ILITs remain a powerful estate planning tool, but their complexity, particularly with respect to the GSTT rules and Crummey power provisions, requires careful analysis. What seems to the client to be a simple annual premium payment can create decades of unwanted tax exposure if elections and prior gifts are overlooked. Advisers must confirm client intent, document client decisions, review prior gift tax returns, and understand trust provisions thoroughly.

Editor

Mo Bell-Jacobs, J.D., is a senior manager, Washington National Tax, with RSM US LLP and a member of the AICPA Tax Executive Committee.

For additional information about these items, contact Bell-Jacobs at Mo.Bell-Jacobs@rsmus.com.

Contributors are members of or associated with RSM US LLP.