The richest single source of settlement candidates on any estate planning shelf is the ILIT holding a policy purchased to pay an estate tax the client will no longer owe. Federal exemption levels after the 2025 legislation left a large number of these trusts funded for a liability that has evaporated — verify the exact 2026 exemption amount before you put a figure in a client memo — while the premium obligation continues indefinitely.
The trustee sitting on that policy has an affirmative duty under Uniform Prudent Investor Act principles to monitor it, not merely to pay premiums out of Crummey contributions. Surrendering without pricing the secondary market is where the exposure sits, because surrender establishes a number without ever testing what the asset was worth.
Send a redacted policy cover page. One page starts a free review of a trust-owned or individually owned policy; first read is typically one to two business days, with no obligation to you, the trust, or the client. Call (305) 209-7183.
In This Article
- Over-Insured ILITs: Finding Them in Your Own Files
- The Trustee’s Monitoring Duty on Trust-Owned Life Insurance
- Tax Mechanics the Drafting Attorney Should Know Cold
- Kentucky’s Inheritance Tax Adds a Local Wrinkle
- The Three-Year Rule and Other Drafting Traps
- Kentucky’s Regulatory Frame
- How a Referral Works
- Frequently Asked Questions
Over-Insured ILITs: Finding Them in Your Own Files
The profile is consistent. An irrevocable life insurance trust drafted when the exemption was a fraction of today’s, funded with survivorship or single-life permanent coverage sized to a projected estate tax, and now holding a policy whose original purpose no longer exists. The grantor is often in their late seventies or eighties, the premium has grown as cost of insurance rose, and nobody has revisited the file in a decade.
A file review that pulls every ILIT, checks the current exemption against the projected taxable estate, and flags trusts where the coverage is now unnecessary is a defensible client-service exercise on its own. What you do with the flagged policies is a separate decision — but you cannot make it without the list.
The Trustee’s Monitoring Duty on Trust-Owned Life Insurance
A trustee governed by prudent investor principles holds an asset and must manage it, and a life insurance policy is an asset with performance characteristics. The minimum diagnostic is a current in-force illustration run at both guaranteed and current assumptions, not the carrier’s annual statement. A current-assumption universal life policy projected to lapse at 87 is a materially different holding from a guaranteed UL funded to 121.
Where the trustee is a family member — which is most ILITs — the monitoring duty is real and the sophistication is usually absent. Advising the trustee on what a review packet should contain is a low-cost, high-value piece of counsel that also documents your own file.
Tax Mechanics the Drafting Attorney Should Know Cold
Three rules cover most conversations. First, the character of gain is two-tier: gain up to cash surrender value over basis is ordinary income, and gain above cash surrender value is capital gain. Second, basis is generally total premiums paid — Rev. Rul. 2020-05 conformed IRS guidance to the 2017 Tax Cuts and Jobs Act change and removed the old reduction for cost-of-insurance charges under Rev. Rul. 2009-13, which is a material improvement for sellers.
Third, a reportable policy sale triggers IRC Section 6050Y information reporting, meaning Forms 1099-LS and 1099-SB flow among the buyer, the issuer, and the seller. Your client will receive forms and will call you about them. Coordinate with the client’s CPA before closing rather than after; see our overview of life settlement taxes in Kentucky.
| Proceeds component | Tax character | Authority | Practice note |
|---|---|---|---|
| Amount up to basis | Generally tax-free return of basis | General principles; Rev. Rul. 2020-05 on basis | Basis is generally total premiums paid |
| Gain up to cash surrender value over basis | Ordinary income | Two-tier gain framework | Confirm the carrier’s CSV as of the sale date |
| Gain above cash surrender value | Capital gain | Two-tier gain framework | Holding period drives short vs. long term |
| Terminal or chronic illness sale | Generally excluded from income | IRC Sec. 101(g) | Physician certification requirements apply |
| Any reportable policy sale | Information reporting to all parties | IRC Sec. 6050Y — Forms 1099-LS, 1099-SB | Warn the client the forms are coming |
| Policy transferred within three years of death | Proceeds may be pulled into the gross estate | IRC Sec. 2035 | Sequence ownership changes carefully |
Kentucky’s Inheritance Tax Adds a Local Wrinkle
Kentucky is one of a small number of states that still imposes an inheritance tax, assessed on the beneficiary’s class rather than on the estate. Class A beneficiaries — generally close family — are exempt, while more remote relatives and unrelated beneficiaries fall into classes that are taxed. Verify current classes, exemptions, and rates for 2026 before relying on them.
That matters here because life insurance proceeds payable to a named beneficiary and estate assets are treated differently, and because the beneficiary class of an ILIT’s remainder takers can change the after-tax comparison between keeping coverage and settling it. It is one more reason the analysis is state-specific rather than a national rule of thumb.
The Three-Year Rule and Other Drafting Traps
Transferring a policy out of an insured’s individual ownership within three years of death pulls the proceeds back into the gross estate under IRC Section 2035. That is a familiar rule when moving a policy into an ILIT; it is easy to forget when restructuring ownership in anticipation of a sale.
Two other traps deserve a checklist line. The transfer-for-value rule can convert otherwise tax-free death proceeds into taxable income in the wrong ownership chain, and a policy subject to a loan can produce phantom income on disposition. None of these are reasons not to sell — they are reasons to sequence the transaction with tax counsel rather than improvising it.
Kentucky’s Regulatory Frame
Kentucky regulates these transactions under its viatical settlement provisions at KRS 304.15-700 et seq., administered by the Kentucky Department of Insurance, with licensure, disclosure, and anti-fraud requirements. Confirm the current 2026 text and any recent amendments before characterizing a transaction in writing for a client.
For the file: confirm the appropriate Kentucky licensure of any provider involved, and confirm that funds will be held by an independent escrow agent and released only when the carrier confirms the ownership change. See our summary of Kentucky life settlement licensing.
How a Referral Works
With the client’s or trustee’s permission, one document starts it: the policy cover page, showing carrier, product type, face amount, and issue date. The read is free, there is no engagement, and there is no obligation to you, the trust, or the client.
The first response is typically one to two business days. Four documents produce an indicative range: cover page, current in-force illustration, latest carrier statement, and a signed HIPAA authorization from the insured. A standard file runs roughly 60 to 120 days from complete documentation through funding. Your client or the trustee controls every decision and can stop at any point before closing. Call (305) 209-7183.
This page is educational only and is not legal, tax, or investment advice for you or your client. Nothing here is an offer to purchase any policy.
Frequently Asked Questions
Why are ILITs the best source of settlement candidates?
Many were funded with permanent coverage sized to an estate tax liability that current exemption levels have eliminated for the client, while the premium obligation continues. Verify the exact 2026 federal exemption before quoting a figure. The result is a trust paying real money for a benefit that no longer serves the trust’s original purpose.
Does a trustee have to consider the secondary market?
Prudent investor principles require monitoring trust assets and making informed decisions, and a policy is a trust asset. Whether a specific duty to obtain a market valuation applies depends on the instrument, applicable law, and the trustee’s counsel. The documented practice of comparing options is what reduces exposure.
How are settlement proceeds taxed?
Generally in two tiers: gain up to cash surrender value over basis is ordinary income, and gain above cash surrender value is capital gain. Basis is generally total premiums paid following Rev. Rul. 2020-05. Terminal or chronic illness sales may be excluded under IRC Section 101(g). Coordinate with the client’s CPA.
What is IRC Section 6050Y reporting?
It is the information-reporting regime for reportable policy sales, producing Forms 1099-LS and 1099-SB among the buyer, the issuer, and the seller. Clients receive the forms and often do not know what they are. Telling them in advance avoids an alarmed phone call the following January.
Does the three-year rule apply to a sale?
IRC Section 2035 pulls proceeds back into the gross estate when a policy is transferred out of the insured’s ownership within three years of death. It most often becomes an issue when ownership is restructured in anticipation of a transaction. Sequence any ownership change with tax counsel.
How does Kentucky’s inheritance tax factor in?
Kentucky still imposes an inheritance tax based on the beneficiary’s class, with close family generally exempt and more remote or unrelated beneficiaries taxed. Verify current classes, exemptions, and rates for 2026. It can change the after-tax comparison between maintaining coverage and settling a policy.
Who regulates these transactions in Kentucky?
Kentucky’s viatical settlement provisions at KRS 304.15-700 et seq., administered by the Kentucky Department of Insurance. Confirming provider licensure and the use of an independent escrow agent are reasonable diligence steps.
What does a review cost the client or the trust?
Nothing. The initial read on a cover page is free with no obligation, and there is no engagement at any stage. The client or trustee can stop before closing and can have counsel review any offer first.
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Related Reading
- Life Settlement Vs Surrender
- Cash Surrender Value Life Insurance
- How It Works Policy Options
- Life Settlement Licensing Kentucky
- Life Settlement Taxes Kentucky
- Education Center
Pine Lake Life Solutions does not purchase life insurance policies and does not provide legal, tax, or investment advice. Information provided is for educational purposes only. Eligibility for any option, including life settlements, is not guaranteed and depends on individual circumstances, policy terms, underwriting, and market conditions. Consult independent legal, tax, or financial professionals before making decisions regarding a life insurance policy.