Trusts & Taxes 101: Irrevocable Life Insurance Trusts and Qualified Subchapter S Trusts

Posted by Kathleen Leatherwood and Amber Diulus

There are many different trusts available as a part of estate planning, each constructed in different ways to be the most tax advantageous depending on you and your family’s situations and assets. Two types of trusts, Irrevocable Life Insurance Trusts (ILITs) and Qualified Subchapter S Trusts (QSSTs) can be helpful.

ILITs are particularly useful for individuals and families who have significant life insurance needs, substantial assets they want to protect from creditors or claims, and a desire to minimize their estate taxes. QSSTs can hold S Corporation stock directly, which is of great tax benefit to individuals entitled to receive income from an S Corporation.

What is an Irrevocable Life Insurance Trust (ILIT)?

How an Irrevocable Life Insurance Trust Works

An ILIT trust is centered around a life insurance policy and is advantageous for those looking to minimize or eliminate federal and state estate taxes on the death benefit insurance payouts.

Once an irrevocable trust is established, an existing life insurance policy can be gifted to it, or the trust can purchase a new policy. From there, the grantor makes gifts of cash or other income producing assets to the trust for the payment of the insurance premiums. When the grantor dies, the trust collects the death benefits of the policy and can distribute them to the trust’s beneficiaries or be used to purchase assets from the grantor’s estate. Regardless, the death benefit proceeds are not included as part of the grantor’s taxable estate.

Advantages of an ILIT

Aside from minimizing estate taxes, there are other advantages to using an ILIT:

• Allow the grantor to determine when and how distributions are made to the beneficiaries. This provides more control over the inheritance, dictating how and when the distributions can be used versus beneficiaries receiving the settlement outright.
• Can help families pay estate taxes when the value of the decedent’s assets are tied up in the estate. The trustee of the ILIT has the ability to purchase the estate’s assets. The beneficiaries can then use the proceeds to pay estate taxes while still maintaining control of the estate’s assets.
• Can help taxpayers potentially avoid or minimize gift tax. Normally the payment of the insurance premiums would be considered a gifting transaction and would require the filing of a gift tax return. However, if the contribution is under the annual gifting limit ($19,000 in 2025), it is considered a present interest gift, which means the beneficiaries would have immediate access to the funds. Beneficiaries are then notified of the gift and a timeline to withdraw the funds, typically within 30 days. This is known as Crummey powers. If they decide not to withdraw the contribution, the funds can be used to pay the policy premium and the gift is considered tax-free.
• As the name states, an ILIT is an irrevocable trust, which means once the trust is created, it cannot be changed or revoked. Therefore, the insurance policy would no longer be available to the grantor if they needed access to it.
• If the grantor passes away within three years of transferring a life insurance policy to the trust, the IRS will consider this as part of their taxable estate.

What is a Qualified Subchapter S Trust (QSST)?

How a Qualified Subchapter S Trust Works

A QSST is a trust that can hold S Corporation stock directly. Per Internal Revenue Code Section 1361, a QSST must only have one beneficiary, who must be a U.S. citizen and is treated as the owner of the stock held by the trust. These trusts are different than other S Corporation trusts in that the beneficiary is typically someone other than the grantor of the estate. Grantors/shareholders can gift all or part of S Corporation stock to the QSST and retain voting power while the beneficiary receives the income.

Upon termination of the QSST, the trust’s assets and any income must be distributed to the beneficiary. It’s important that the requirements of the QSST are strictly adhered to; if it loses its trust status the S Corporation will also lose its status. Additionally, if the QSST beneficiary dies, each successive income beneficiary of that trust is treated as consenting to the election unless they proactively refuse to consent to the election.

It's also interesting to note that a QSST can have non-S Corporation assets and still qualify as a QSST. This means part of the trust consisting of assets other than the S corporation stock can be treated as a simple trust, while the QSST portion of the trust will be treated like a grantor trust.

Advantages of a QSST

QSSTs can provide many benefits:

• Grantors/shareholders can use the QSST to make a gift of all or part of S corporation stock and retain voting power while the beneficiary receives the income.
• The trust is treated as a grantor trust, which lowers taxes due to the less compressed income tax brackets for individuals as compared to trusts.
• If the QSST sells the S corporation shares, the election terminates and the trust recognizes the gain or loss on the sale.
• Taxpayers benefit from substantial income and estate tax savings.
• These trusts can be used for estate planning to facilitate the transfer of S corporation stock to a beneficiary.
• A QSST offers continuity of the business and control over management even after the grantor’s death. This aids with a smooth transition of ownership while minimizing estate taxes.

Disadvantages of a QSST

There are some important downsides to using a QSST as well. Namely, with a QSST:

• There can only be one lifetime beneficiary, meaning the beneficiary’s children cannot also benefit from the trust.
• All of the ordinary income must be distributed currently, regardless of need, causing:
  • Potentially unnecessary buildup of the QSST beneficiary’s taxable estate,
  • Exposure to potential lawsuits against the beneficiary and to potential marital rights of a QSST beneficiary’s former spouse, and
  • Full access to the S corporation’s distributed income to an underaged, spendthrift or special-needs QSST beneficiary.
• Because individuals will most likely not want the income generated by all their other assets, including IRA and 401(K) plan benefits, to be automatically distributed to the trust beneficiary, two separate trusts (or at least two separate shares of one trust) will often need to be established for each beneficiary. This can be a downside due to the additional time and expense of creating and administrating the additional trusts.

ILITs and QSSTs can be important tools for estate tax planning, insurance needs and for those looking to maximize the tax benefit of income received from S Corporation stock. Your tax advisers can help you sort through the details of what best suits your current situation and future needs.

Contact Kathleen Leatherwood, Amber Diulus or a member of your service team to discuss this topic further.

Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.