For most of the last three decades, the pitch for an Irrevocable Life Insurance Trust was simple: you own too much, the estate tax is coming, and you need an ILIT to hold a policy whose death benefit will write the check. The trust was drafted with a single mission — pay the estate tax — and no one thought much about what would happen if that mission changed.
The mission has changed. The federal estate tax exemption now sits at roughly $15 million per person. Washington’s exemption, though far lower at $3 million, still leaves a significant number of families in a position where estate tax is no longer the primary threat. The bigger bite, for many, is income tax — specifically the capital gains tax that lands on heirs who sell appreciated assets after death, compounded by Washington’s 7% capital gains surcharge. And for families thinking generationally, there is a third use for that death benefit: seeding a dynasty trust that compounds wealth outside the transfer tax system entirely.
An ILIT drafted in 2005 with rigid estate-tax-only distribution language is not equipped for any of this. The irony is that ‘irrevocable’ does not have to mean ‘inflexible.’ A well-drafted modern ILIT can give the trustee the discretion — and the tools — to redirect the death benefit toward whichever need turns out to be greatest at the moment it matters.
Why the Old Single-Purpose ILIT Falls Short
Consider a trust drafted in the early 2000s, when the federal exemption was $1 million and rising. The document says something like: ‘Upon the death of the insured, the Trustee shall distribute such amounts as are necessary to pay the estate taxes of the insured’s estate, and shall distribute the balance in equal shares to the insured’s descendants.’
That language worked when the exemption was $1 million. Today, with a $15 million exemption, the estate may owe zero federal estate tax. The trust’s primary instruction — pay the estate tax — calls for a distribution of zero. The balance clause kicks in, and the entire death benefit passes outright to the beneficiaries, exposed to their creditors, their divorcing spouses, and their own estate tax at the next generation’s death. The trust accomplished nothing that a simple beneficiary designation would not have done, and the family lost every opportunity to use that capital strategically.
Or suppose the estate does owe Washington estate tax — over $1 million on a $6.5 million estate — but the surviving spouse’s real problem is a $1.8 million unrealized capital gain on the family’s rental portfolio that did not get a full double step-up because of a titling issue. The trust pays the estate tax bill and pushes the rest out the door. No one can use the remaining proceeds to address the capital gains exposure — the trust’s language does not contemplate it.
Drafting for Broad Trustee Discretion
The foundation of a modern ILIT is trustee discretion that is broad enough to cover the full range of post-death needs, not just one of them.
Rather than directing the trustee to pay estate taxes and distribute the balance, the trust instrument should authorize the trustee to apply the death benefit, in the trustee’s discretion, for any combination of the following purposes:
• Payment of federal and state estate taxes, including Washington’s estate tax, whether by direct payment, loan to the estate, or purchase of assets from the estate at fair market value.
• Providing liquidity for income taxes owed by the estate or its beneficiaries — including capital gains taxes triggered by post-death asset sales, and specifically Washington’s capital gains tax.
• Retaining proceeds in continuing trust for the benefit of one or more beneficiaries, under whatever distribution standards the trust specifies, for as long as applicable law allows — including the option to hold assets in a multi-generational or dynasty structure.
• Making distributions for the health, education, maintenance, and support of beneficiaries, either outright or in further trust.
This kind of drafting does not lock the trustee into a single use case. It lets the trustee assess the landscape after the insured’s death — when the actual estate tax bill, capital gains exposure, and family circumstances are known — and deploy the money where it does the most good.
The Trust Protector: A Safety Valve for the Unforeseeable
Broad trustee discretion handles the range of known possibilities. A trust protector handles the possibilities no one anticipated at drafting.
A trust protector is a designated individual — typically not the grantor, the trustee, or a beneficiary — empowered to make limited modifications to the trust’s terms without court intervention. Powers commonly granted to an ILIT trust protector include:
• Removing and appointing trustees, including the authority to appoint a corporate trustee if circumstances warrant.
• Modifying administrative provisions to comply with changes in tax law or state trust law enacted after the trust’s creation.
• Adjusting distribution standards — for example, tightening them to preserve a beneficiary’s eligibility for government benefits, or broadening them to address a beneficiary’s changed circumstances.
• Adding or excluding beneficiaries within defined parameters (most commonly, limiting additions to the grantor’s lineal descendants).
• Changing the trust’s governing law to a more favorable jurisdiction — which may matter for creditor protection, state income tax, or perpetuities rules.
The trust protector does not manage the trust on a day-to-day basis. The role is a safety valve: it sits unused until something happens that the original trust document could not have anticipated, and then it allows a targeted correction without the expense and delay of court proceedings.
For ILITs in particular, the trust protector is valuable because the death benefit may not be needed for decades after the trust is signed. Tax law, family dynamics, and the economic environment will all shift in ways that no drafter can predict. Building in a trust protector ensures the trust can adapt.
Decanting: Modernizing an Existing ILIT
If you have an existing ILIT that was drafted without these flexible provisions, it may not be too late.
Decanting is the process by which a trustee distributes the assets of an existing trust into a new trust with updated terms. Think of it as pouring the contents of an old container into a new one — the assets move; the old restrictions stay behind. Washington has a comprehensive decanting statute (RCW 11.107) that provides a clear procedural framework.
The scope of a trustee’s decanting power depends on the discretion granted in the original trust:
• If the trustee has broad discretionary authority not limited to an ascertainable standard, decanting can significantly expand the trust’s flexibility — including adding trust protector provisions, extending the trust’s duration, modifying distribution standards, and restructuring beneficiary shares.
• If the trustee’s authority is limited to an ascertainable standard (such as health, education, maintenance, and support), the beneficial interests in the new trust must be ‘substantially similar’ to those in the original — but administrative provisions can still be modernized.
Procedurally, Washington’s statute requires at least 60 days’ written notice to qualified beneficiaries and holders of powers of appointment before the decanting takes effect. The statute also imposes important guardrails: a trustee cannot use decanting to increase their own compensation, and the new trust cannot reduce tax benefits (such as marital or charitable deductions) that the original trust would have provided.
Decanting is not a panacea. It works best when the original trust grants the trustee at least some meaningful discretion. But for many ILITs drafted ten, fifteen, or twenty years ago with rigid estate-tax-only language, decanting into a modern, flexible successor trust can be transformative — without requiring the grantor to start from scratch or surrender the existing policy.
Funding the ILIT: Split-Dollar Arrangements
An ILIT is only as useful as the policy it holds, and permanent life insurance premiums are substantial. The traditional approach — the grantor makes annual gifts to the trust, which uses Crummey withdrawal powers to qualify each gift for the $19,000-per-beneficiary annual exclusion — works, but it has limits. A policy with a $100,000 annual premium and only three Crummey beneficiaries means $43,000 per year is eating into the grantor’s lifetime gift tax exemption.
A private split-dollar arrangement is an alternative that can dramatically reduce the gift tax cost of funding the ILIT.
In a typical private split-dollar structure, the grantor enters into an agreement with the ILIT to share the cost and benefits of the policy. The arrangement can operate under either of two IRS-recognized regimes:
• Under the economic benefit regime, the grantor pays the bulk of the premium and retains a right to recover the greater of the premiums paid or the policy’s cash surrender value. The ILIT’s annual taxable benefit — the amount treated as a gift — is limited to the cost of the pure insurance protection for that year, measured by IRS Table 2001 rates or the insurer’s lower published term rates. For a second-to-die policy on a healthy couple, this cost can be remarkably small in the early years.
• Under the loan regime, the grantor’s premium payments are treated as loans to the ILIT, bearing interest at the Applicable Federal Rate (AFR). The ILIT pays interest annually (or the grantor gifts the interest amount to the trust). The advantage is that the gift exposure is limited to the below-market portion of the interest, which can be minimal when AFRs are moderate.
Both regimes require careful structuring and independent administration to avoid IRS challenges. The split-dollar agreement must be properly documented, the trustee should be independent (not the grantor), and the arrangement must have economic substance beyond tax avoidance. Recent Tax Court decisions — Levine, Morrissette, and Cahill — underscore that the IRS scrutinizes these structures and will seek estate inclusion under §2036 or §2038 if the grantor retains too much control or the documentation is deficient.
Done correctly, though, split-dollar allows a grantor to fund a multi-million-dollar policy inside an ILIT with a fraction of the gift tax exposure that outright premium gifts would require.
A Note on Premium Financing
You may hear about institutional premium financing — borrowing from a bank to pay life insurance premiums, using the policy’s cash value as collateral. In today’s interest rate environment, institutional premium financing is generally uneconomic. When the cost of borrowing exceeds the policy’s internal rate of return, the strategy destroys value rather than creating it, and the collateral risk can leave the borrower exposed to margin calls.
There is, however, a related concept worth noting: private self-premium financing from a related party. Rather than borrowing from a bank at commercial rates, a grantor (or a grantor’s entity) can lend funds to the ILIT at the Applicable Federal Rate — which, for a long-term note, may be materially below what a bank would charge. The economics are better because the interest stays in the family, and the grantor’s note receivable is a frozen-value asset in the grantor’s estate (growing no faster than the AFR). This is functionally similar to a loan-regime split-dollar arrangement, and shares many of the same structuring requirements: the loan must be properly documented, interest must be paid or accrued, and the trustee must act independently.
The point is not that one structure is universally better than the other. It is that the ILIT’s drafter and the family’s advisors should be thinking about funding flexibility from the outset — building in provisions that allow the trust to accept premium payments through gifts, split-dollar, intra-family loans, or some combination, depending on what makes economic sense at the time.
Use Case: Estate Tax Liquidity
This is the traditional use case, and it remains important — particularly in Washington. While the federal exemption has risen dramatically, Washington’s $3 million exemption means that a family with a home in the Puget Sound region, a retirement account, and a modest investment portfolio can easily exceed the threshold. A $6.5 million Washington estate falls in the 19% bracket of the state’s rate table — a base tax of $910,000 plus 19% of the amount over $6 million, for a total of roughly $1,005,000 in state estate tax.
The ILIT provides a pool of cash, outside the taxable estate, that the trustee can use to pay that bill — typically by lending money to the estate or purchasing assets from it at fair market value. Without the ILIT, the family may need to sell the house, liquidate investment accounts, or borrow against real property to satisfy the tax, often on a compressed timeline.
Use Case: Capital Gains Liquidity
This is the use case that has become increasingly important, and the one that most older ILITs are not equipped to address.
When an heir inherits appreciated property with a stepped-up basis and sells it shortly after death, the capital gains tax may be modest or zero. But the step-up is not always available. Sometimes it is lost by accident — through a titling error or an IRD asset — and sometimes it is given up on purpose.
The intentional case is the more interesting one. Suppose a client gifts a rapidly appreciating asset into an intentionally defective grantor trust (IDGT) precisely to freeze its value and remove future appreciation from the taxable estate. That move can save a great deal of estate tax, but it comes with a deliberate trade-off: an asset transferred out of the estate by lifetime gift does not receive a basis step-up at death. The client has made a conscious choice to accept a future capital gains cost in exchange for a present estate-tax saving. It is sound planning, not a mistake — but it leaves a bill for someone to pay when the IDGT trustee eventually sells the asset.
Add Washington’s 7% capital gains tax (9.9% for gains above $1 million), and the combined federal-plus-state rate on long-term gains can approach 30%. On a $2 million gain, that is $600,000 in tax.
This is exactly where a well-drafted ILIT earns its keep. The same family can hold a life insurance policy in an ILIT, and the trust can be drafted so that, when the IDGT trustee sells the appreciated asset and triggers the capital gains tax, the ILIT trustee uses the death benefit to provide the liquidity to pay it. The ILIT and the IDGT are separate trusts doing separate jobs — one holds the appreciated asset outside the estate, the other supplies tax-free cash — but drafted together they let a family pursue an aggressive freeze strategy without forcing a fire sale to cover the resulting income tax.
A modern ILIT whose terms authorize the trustee to provide liquidity for income taxes — not just estate taxes — can cover this exposure. The trustee lends money to the beneficiary, purchases the appreciated asset at fair market value (giving the seller cash to pay the tax), or makes a distribution specifically earmarked for tax obligations. The flexibility has to be in the trust document; a trustee cannot invent authority that the drafter did not provide.
Use Case: Dynasty Trust Seeding
For families with a longer time horizon, the death benefit from an ILIT can serve as the initial capital for a multi-generational trust.
A dynasty trust is designed to hold assets in trust for children, grandchildren, and potentially further descendants — for as long as state law allows. Because the assets were removed from the grantor’s estate when they entered the ILIT, and the death benefit itself is not subject to estate or generation-skipping transfer (GST) tax if the trust is properly structured, the entire corpus can compound free of transfer tax for generations.
A $5 million death benefit, invested at a modest 6% real return and held in trust for three generations, can grow to over $40 million — all of it outside the estate tax system. Without the dynasty structure, that same $5 million would be subject to estate tax at each generational transfer, potentially losing 40% or more at each step.
The key is that the ILIT must be drafted to permit this outcome. If the trust requires outright distribution of the death benefit to the insured’s children, the dynasty opportunity is lost. A modern ILIT should include the option — not the mandate — to hold proceeds in continuing trust for multiple generations, with the trustee or trust protector empowered to assess whether dynasty treatment makes sense given the family’s circumstances at the time of the insured’s death.
Updating an Existing ILIT: A Practical Checklist
If you have an ILIT that was drafted more than a decade ago — particularly one drafted when the federal exemption was $1 million, $2 million, or $3.5 million — it is worth reviewing with your attorney. Key questions to consider:
• Does the trust’s distribution language contemplate uses beyond estate tax — specifically capital gains liquidity, income tax obligations, and continuing trust for beneficiaries?
• Does the trust include a trust protector provision? If not, can one be added through decanting or judicial modification?
• Does the trust permit decanting — either expressly or through the trustee’s inherent discretionary authority under Washington’s decanting statute (RCW 11.107)?
• Is the trustee someone (or an institution) with the sophistication and independence to exercise broad discretion? If the grantor’s brother-in-law was a reasonable choice in 2003, a corporate co-trustee or successor may be more appropriate now.
• Are Crummey notices being sent consistently and on time? Administrative lapses can jeopardize the annual exclusion and, in extreme cases, the trust’s tax treatment.
• Is the life insurance policy itself still appropriate — the right amount of coverage, the right type of policy, with a carrier that remains financially strong?
• Could a split-dollar arrangement or intra-family loan reduce the gift tax cost of ongoing premiums?
None of these questions have universal answers. They depend on the family’s current net worth, the composition of the estate, the ages and circumstances of the beneficiaries, and the specific terms of the existing trust. But the question itself — ‘does this trust still serve the purpose we need it to serve?’ — is one that every ILIT owner should be asking.
Putting It Together
The irrevocable life insurance trust is one of the most powerful tools in estate planning. It removes the death benefit from the taxable estate, provides liquidity exactly when the family needs it, and — if drafted correctly — can serve as the foundation for multi-generational wealth preservation.
But ‘if drafted correctly’ is doing a lot of work in that sentence. An ILIT drafted twenty years ago for a world where the federal exemption was $1 million is not the same tool you need in a world where the exemption is $15 million, capital gains tax is the primary threat, and Washington imposes its own estate tax starting at $3 million.
The good news is that modern drafting — broad trustee discretion, trust protector provisions, decanting authority, and flexible distribution standards — can build a trust that adapts to whatever the tax landscape looks like when the death benefit is eventually paid. And for existing ILITs that lack these features, Washington’s decanting statute provides a path to modernization without starting over.
If you have an ILIT that has not been reviewed in the last several years, or if you are considering establishing one, I would welcome the opportunity to discuss how flexible drafting can ensure the trust serves your family’s actual needs — not just the needs we could foresee at the time it was signed.
Learn more about our estate planning practice, or schedule a consultation to review your existing plan.
