A—Rights Of Creditors In Insurance
Society has long recognized the individual`s obligations to provide for his or her family. Insurance was developed to protect against contingencies that might destroy or diminish one`s ability to meet those obligations. To aid the achievement of those objectives federal and state statutes limit the rights of creditors in insurance where the individual has not sought to use this approach merely to avoid payment of debts.
If there were no insurance exemption from the claims of creditors, the purpose for owning insurance would be undermined. The financial security of an insured`s dependents would depend upon whether the insured was solvent or insolvent at the time of death. This is why state laws limit creditors` rights to help insure that the persons for whom insurance was intended receive at least some of the proceeds regardless of the insured`s solvency.
A majority of states also exempt the cash values available to policyowners during their lifetime. An insured individual can receive favorable treatment even where the United States Government is a creditor for unpaid income taxes.
State laws determine the liability of insurance providers for unpaid income taxes of deceased policyowners. In fact, Federal bankruptcy laws take a backseat to state exemption laws in determining property available to a bankruptcy trustee for the benefit of creditors.
In summary, state exemption laws were created to allow insurance to perform its intended functions and to help prevent the dependents of an insured from becoming a financial burden on society.
For generations, society was plagued with the economic burdens caused by the death of a family`s breadwinner. The opportunities for accumulating enough wealth to support a family after the death of the primary provider were extremely limited. Dependents were often incapable of self-support and became a financial burden to the community at large.
Because death was unavoidable, untimely and devastating, people sought a method of achieving at least partial economic relief. Eventually, people began forming small groups, wherein members contributed to a group fund to help provide economic relief for families when a family member died.
This short historical background explains how and why the basic idea of life insurance was first conceived. Life insurance evolved, not as a commodity for sale, but as a social institution.
Life Insurance As A Social Institution
Today, more than ever before, people are conscious of planning for a secure financial future. They try to plan ahead for vacations, new homes, retirement, and for the welfare of their families in the event of death. The age-old problem of providing food, shelter, clothing and an education for dependents upon the death of a breadwinner is as pertinent as ever. This is where the basic, inherent function of life insurance is most vividly demonstrated—it allows us to create an estate for the benefit of our dependents. As a practical matter, it is the only protection available to people with limited sources of income.
Recognizing the importance of life insurance, the U. S. Supreme Court has declared that "insurance for dependents is, in the thoughts of many, a pressing social duty. If not a duty, it is at least a common item in the family budget, kept up very often at the cost of painful sacrifice, and abandoned only under dire compulsion" [Burnet v. Wells, 289 U.S. 670].
Favorable Treatment For Proceeds
At this point, one might conclude that the problems of a breadwinner`s premature demise have been solved. However, this is not so, unless we can somehow be assured that the available insurance will be used for the support of his or her dependents. If insurance were subject to the unlimited rights of the a decedent`s creditors, we could conceivably end up with a debt-free decedent but no estate. Dependents would seek support elsewhere and the purpose of insurance would be defeated.
Fortunately, this problem has not been overlooked. Every state legislature has enacted laws limiting creditors` rights, when it comes to life insurance proceeds. These laws have not been enacted to discriminate against the claims of legitimate creditors or to encourage placing property beyond the reach of those creditors. Instead, they simply recognize the importance of a policyowner`s obligations to support his or her family, thus providing some assurance that efforts to meet such obligations after his or her death will be at least partially successful.
Premiums Paid In Fraud Of Creditors
The life insurance exemption is primarily for the good of the public. It allows proceeds to pass to an insured`s dependents free from the claims of most creditors. However, most states do not extend that privilege to people who pay life insurance premiums with the intent to defraud their creditors.
With certain exceptions, the right to recover premiums paid in fraud of creditors is limited to a recovery from the proceeds of the insurance [Doethlaff v. Penn. Mutual Life Ins. Co., 117 F.2d 582, cert. denied, 313 U.S. 579]. When an insurance policy with a limited annual premium is involved, a creditor may be limited to recovering only excess premium paid. Some states provide for limited recovery only of the premiums paid in fraud, with interest.
Generally, policyowners do not secure life insurance to defraud creditors. It is the exception, rather than the rule. In most cases, the issue of fraud does not arise.
Which State Law Applies?
When dealing with the rights of creditors to obtain insurance proceeds or cash surrender values, there may be a question about which state`s law applies. The courts have reached no single solution to the problem.
Under the Bankruptcy Act, the allowance for exemptions granted to bankrupt individuals, prescribed under state laws, expressly refers to the law of the state in which the individual resided "for the 180 days immediately preceding the date of the filing of the petition, or for a longer portion of such 180-day period than in any other place" [11 U.S.C. §522(b)].
As a general rule, in the absence of a clearly expressed intent by either party, courts have followed one of two tests concerning which state law should govern an insurance contract in actions involving creditors other than in non-bankruptcy proceedings: (1) the place of making of the contract, or (2) the place of the performance of the contract [Couch on Insurance 2d, §§29.121, 29.122].
Policy provisions that instruct payments be made at an insurance provider`s home office will not implicate the laws of the state in which the office is located [United States Mortgage & Trust Co., Adm. v.Ruggles, supra] except where a provision and other facts show an intention of the contract`s parties, the insured and the company that the law of that state should control [Tate v. Hain, 181 Va. 402, 25 S.E. (2d) 321]. When an insurance contract provides that payments are to be made in the state in which a company is located and that the contract is subject to the law of that state, the court will abide by the provision as long as the applicable law of that state is not contrary to the public policy of the state in which the action is brought [Annis v. Pelkewitz, 287 Mich. 68, 282 N.W. 905].
an insured exercises a policy option to convert to a different type of
policy after having changed his or her residence, the law of the state
governing the original policy will continue to control the policy [Aetna Life
Insurance Co. v. Dunken, 266
An economic depression or catastrophe can reduce the value of or eliminate a family`s savings leading to insolvency or bankruptcy and possibly leaving a family`s breadwinner with little or nothing to pass on to the remaining family members. Consequently, upon death, the estate`s property may be subject to overwhelming claims of creditors.
Fortunately, state exemption laws give policyowners a degree of security concerning who will receive the insurance benefits they have accumulated, and a measure of protection against the claims of creditors and trustees in bankruptcy.
One might characterize life insurance as a "creditor-free" investment. This point is further demonstrated by the trend of broadening the application of these statutes to cover any beneficiary without regard to relationship or dependency, either actual or implied.
These substantial immunities help diminish the fear that our plans will not be carried out due to the demands of our creditors. This significant advantage serves to further sharpen the edge of the sword in the hands of the life underwriter.
The following sections concern the rights of creditors after the death of a policyowner. See "Rights of Beneficiary`s Creditors"in this Subdivision, for an explanation of beneficiary creditor rights. Keep in mind that each state has its own statutes and court interpretations. [See the digest of state laws in Subdivision B of this Section.]
Application Of Statutes
In general, all state insurance exemption laws provide protection from the claims of an insured`s creditors. But what if someone other than the insured takes out a policy?
Some state laws do not directly address this situation. A few states merely provide that all proceeds payable to a named beneficiary, due to the death of the insured, are exempt. Some simply apply the exemption to "all moneys, benefits, privileges, or immunities...," up to certain limits. However, most states re on the creditor`s side when a person takes out insurance on the life of another, if the policy is in favor of a person other than him or herself. This facet of the exemption law provides a more true and meaningful fulfillment of the intended purpose of such statutes—to help protect a policyowner`s dependents.
Protection Of Creditors
Under the laws of most states, a life insurance exemption does not apply to premiums paid with the intent to defraud creditors. The statutes usually provide that, "premiums paid with the intent to defraud creditors inure to the creditors out of the proceeds."
Thus, creditors may be able to recover from the proceeds of life insurance, to the extent of such premiums paid. And some statutes even allow creditors to recover premiums paid, plus interest.
Even where the exemption does not contain an express provision concerning fraud against creditors, courts have provided that "Statutes exempting the proceeds of insurance may not be used as a means of perpetrating or protecting fraud" [McConnell v. Henochsberg, 11 Tenn. App. 176; La Borde v. Farmers St. Bk., 116 Neb. 33, 215 N.W. 559].
Some statutes merely establish annual exemption limits that the insured can spend to insure his or her life for the benefit of a spouse and children. Here, the creditor generally can only recover any excess paid for premiums over the amount allowed by statute.
In conclusion, the objective of state legislatures and the courts appears to be to maintain a balance between effective continuation of exemption laws and avoidance of gross injustices to the rights of creditors.
Effect Of Beneficiary Designation
virtually all states, the exemption is granted only if the policy is payable
to, or "in favor of," a person other than the insured or the person
who has taken out the insurance. Thus, in most of these states, insurance
payable to a policyowner`s estate would not qualify for the exemption.
However, in a few states, insurance payable to the estate is diverted to the
surviving spouse and children, or to other specific statutory beneficiaries.
[See this discussion under the heading "Statutory Beneficiaries"in
Subdivision B, Section 20 of this Service.] Also, Louisiana specifically
provides that the beneficiary, "including the insured`s
estate," is entitled to the proceeds—as against any debt of the
beneficiary existing at the time the proceeds are made available for his or her
Some of the laws, as noted, apply only for certain beneficiaries, such as the insured`s spouse, children or other dependent relative.
few states, such as
The act that the proceeds paid to a trustee for the benefit of a beneficiary, instead of to the beneficiary directly, does not appear to alter the exempt status of those proceeds. Either by statute or court decision, this rule seems to have been generally adopted [In Re Philips, 7 F. Supp. 807; Gagnon v. Marcous, 85 N.H. 237, 157 A. 82; In Re Bosak, 12 F. Supp. 278; and note also the various state statutes].
Right To Change Beneficiary
In most states, the exemption is specifically allowed for a new beneficiary, "whether or not the right to change the beneficiary has been reserved." Therefore, the proceeds are exempt, when, at the time of payment, the policy was payable only to the beneficiary under the terms of the exemption statute.
Irrevocable Beneficiary Designation
Where there has been no reservation of any power to change a beneficiary, it is generally held that the beneficiary acquires a vested interest under the policy as soon as it becomes effective. Apparently, such irrevocable beneficiary designations do not adversely affect any allowable exemption of the insurance proceeds. Rather, it seems to present an even stronger basis for the exemption. In fact, a North Dakota court held that, because of a beneficiary`s vested interest, if he or she dies before the insured, the proceeds will be payable to the beneficiary`s estate or assignee [Anderson v. Northern & D. Trust Co., N.D. 571, 288 N.W. 562].
A Trust As Beneficiary
As noted earlier, the exemption of insurance proceeds from the claims of an insured`s creditors will not usually be altered simply because they are paid to a trustee for the benefit of a named beneficiary rather than directly to the beneficiary. [See Sections 20 and 21 of this Service for a discussion of Life Insurance Trusts.]
Insured`s Estate As Contingent Beneficiary
As a general rule, policies specifying that proceeds be payable to the policyowner`s estate are subject to the creditors` claims.
Many statutes specifically provide that the exemption granted for proceeds payable to a named beneficiary, or to certain classes of beneficiaries, applies "whether or not the policy is payable to the insured, if the beneficiary dies first." However, such statutory language has not been interpreted to extend the exemption when a beneficiary dies before the insured, and the insured or the insured`s estate receives the proceeds.
Other states have indicated that a designation of an insured`s estate as a beneficiary does not negate the exemption if the statute directs the proceeds to be paid to the insured`s spouse, family or heirs, and members of the exempt class of statutory beneficiaries are available to receive the proceeds.
When considering whether the proceeds made payable to the insured`s estate are subject to the claims of creditors, the applicable statutes, the terms of the contract and the intention of the parties must be considered.
Limitations On The Exemption
Most states do not limit the amount of insurance entitled to the exemption. In those states, all insurance satisfying the requirements as to beneficiary designation that is not purchased in fraud of creditors, is exempt.
Some states, however, do limit the amount of insurance that is exempt from the creditors` claims. The limits of some of these statutes are expressed as an amount of the total insurance proceeds while in others they are expressed as a specific amount of premium dollars paid annually.
in states that limit the exemption, the limitation applies both to
proceeds and to cash values. However, in
Most states exempt insurance only from the insured`s creditors. But a few states have statutes that also expressly exempt insurance proceeds from the claims of a beneficiary`s creditors.
In other states, the policy can include a clause, commonly known as a spendthrift trust clause, protecting the beneficiary from claims of his or her own creditors. Although this protection is not automatic, it can be obtained if the insured specifically includes such a clause in the policy settlement provisions. However, in most states, even in the absence of such statutory provisions, an exemption of the proceeds from beneficiary`s creditors can be obtained by including a spendthrift trust clause in the policy settlement provisions. This clause can also be obtained by placing the policy in a life insurance trust and including a spendthrift trust provision in the trust instrument.
The first issue to be discussed concerns creditors` rights regarding the cash value of a policy during the lifetime of the insured. Next, the rights of the beneficiary`s creditors regarding death proceeds are examined. In each of these situations, the first question concerns whether the law of a particular state protects the beneficiary from the claims of creditors. The second question concerns the rights of a beneficiary`s creditors in the absence of a protective statute.
Statutory Rights Granted To Beneficiary`s Creditors During Insured`s Lifetime
Most state laws exempting life insurance proceeds from creditor claims refer only to the insured`s creditors. Such statutes have generally been held not to provide any protection against the claims of the beneficiary`s creditors [Sam Levy Co. v. Davis, 125 Tenn. 342, 142 S.W. 1118].
several state statutes expressly provide at least some protection against
claims of a beneficiary`s creditors. For example, under a
Rights Of Beneficiary`s Creditors During Insured`s Life When No Statute Exists
In the absence of a statute exempting the proceeds of life insurance from the claims of the beneficiary`s creditors, he possibility of these creditors obtaining the cash values depends primarily on whether the beneficiary possesses a property right in the policy. If the beneficiary does not possess a property right, his or her creditors cannot obtain the cash values.
case held that, when an insured reserved the right to change the beneficiary,
creditors could not obtain the cash values of the policy [Dellafield v.
On the other hand, when an insured`s beneficiary or assignee owns a policy, creditors may be able to receive the cash values if the state has no exemption law protecting the cash surrender value from beneficiary creditors.
If a policy is assigned to an insured`s wife and she later becomes bankrupt, the trustee in bankruptcy may have rights to the cash value of the policy, as of the bankruptcy petition date [In re Jacobson, (D.C. N.J.) 24 F. Supp. 749; in accord, In re Clark, (D.C. Mich.) 169 F. Supp. 391].
Statutory Rights Of Beneficiary`s Creditors In Insurance Proceeds
Two classes of state laws exempt life insurance policy proceeds from claims of the beneficiary`s creditors:
exemption laws of the first classification ((1), above) automatically provide
for exemption from the beneficiary`s debts. However, only a few state
laws have this type of statute. One example is
A larger number of states have laws of the second classification ((2), above). These laws permit the insured to include a spendthrift trust provision, stating that the proceeds shall not be assignable and shall be exempt from claims of the beneficiary`s creditors.
most instances, the laws protect insurance proceeds left with the
insurance company under an optional settlement arrangement set up by the
insured to invoke the protection available. For example, see the summary of the
Spendthrift Trust Clauses
Some typical spendthrift trust provisions are listed on the following page. Such provisions have been upheld in life insurance policies by various courts [Michaelson v. Sokalove, 169 Md. 529, 182 A. 458; Mullen v. Trolinger, 237 Mo. App. 939, 179 S.W.2d 484; Chelsea-Wheeler Coal Co. v. Marvin, 134 N.J. Eq. 438, 35 A.2d 874; Crossman Co. v. Rauch, 263 N.Y. 264, 188 N.E. 748; Provident Trust Co. v. Rothman, 321 Pa. 177, 183 A. 793].
A number of state statutes specifically provide for the creation of spendthrift trusts. In these trusts, a beneficiary usually has an interest in trust income due in periodic payments, but has no power to transfer the ownership of that interest. In addition, creditors have no rights to attain the interest. (Some of the details of these statutes will be found in the state law summaries in Subsection B.)
Most of the states that do not have statutes recognizing spendthrift trusts have at least realized their validity through judicial decisions. However, in a few states, there appears to be no statute or court decision dealing with spendthrift trusts at all.
A discretionary trust is one in which a beneficiary is entitled only to the income or principal a trustee sees fit to give. Such a beneficiary cannot attempt to compel the trustee to pay or to apply, for his or her own use, any part of the trust property [Restatement of Trusts, §155]. Also, creditors cannot assert their claims against a beneficiary`s interest. n effect, such a trust can restrict the beneficiary`s creditors as effectively as a spendthrift trust agreement.
Spendthrift trust laws, as distinguished from spendthrift trust clauses in insurance policies, are relevant to life underwriting in two ways: first, in the direct application of the law, in the case of a life insurance trust containing spendthrift trust provisions; second, in states providing no special statute or legal decision regarding the validity of an insurance policy`s spendthrift trust clause. In the second scenario, state law will give strong consideration to the status of the policy clause in the event it is challenged.
Typical Clause Used By Insurer In Settlement Provisions
"It is agreed between the Company and the policyholder: That any funds retained by the Company in accordance with this agreement may be mingled in whole or in part with its general corporate funds as a part thereof; that no beneficiary shall have the right to assign, anticipate, alienate or commute the payments becoming due, or his or her right, title or interest therein, except as may be specifically provided herein; that all moneys payable or retained hereunder, whether of principal or interest, shall be free from claims of creditors of the beneficiary or beneficiaries and from all legal process to levy upon or attach the same; that this agreement shall be subject to, governed by and construed in accordance with the laws of the State of Connecticut; and that all payments hereunder shall be made at the Home Office of the Company in Big City, Connecticut, where this agreement is made and is to be performed."
A Short Clause In A Life Policy
"The benefits payable to any beneficiary hereunder after the death of the insured shall not be assignable nor transferable nor subject to commutation or encumbrance, nor to any legal process, execution, garnishment or attachment proceeding."
Another Short Clause Used In Settlement Provisions
"It is agreed that, except so far as may be contrary to the laws of any state having jurisdiction in the premises, no part of the proceeds nor interest thereon shall in any way be subject to any legal process to levy upon or attach the same for payment of any claim against any beneficiary, and no beneficiary shall have the right to withdraw any part of the proceeds or interest thereon except as herein provided."
A Typical Clause In A Trust Or Will
"I further direct that the payments of all the beneficiaries of my estate be made to such beneficiaries in person, or upon their personal receipt, and that no interest of any beneficiary be assignable in anticipation of payment or be liable in any way for such beneficiaries` debts."
Another Short Clause For Use In A Trust or Will
"Each payment, right or interest granted to every beneficiary of this trust is subject to the condition, however, that it shall not be assigned nor encumbered by such beneficiary nor levied, attached or garnished by any creditors of such beneficiary."
Spendthrift Trust Clauses Where There Is No Statute
The rights of a beneficiary`s creditors to insurance proceeds are sometimes in doubt when the state in which the policyowner resides does not have a law which either expressly bars such claims of creditors or permits the inclusion of a "spendthrift clause" in the policy. Two situations might arise:
The majority of states have enacted statutes permitting inclusion of spendthrift trust clauses in insurance policies. If an insured resides in one of these states and the insurance company is located in that state or in another state that has such a statute, no serious problems should arise.
If no statute concerning spendthrift trust clauses exists in a state where a policyowner resides, courts have often upheld such clauses either by reference to the law of the state in which the company is located, by drawing an analogy between the spendthrift clauses and spendthrift trusts, or by considering the clause a part of the contract between the insured and the company.
In one case involving a policy issued by a New York insurance company, the insured elected a settlement option under which monthly payments were to be made to his widow. The supplementary contract contained the following typical spendthrift trust clause: "Unless otherwise provided for herein, neither the supplementary contract nor any benefits accruing thereunder shall be transferable or subject to surrender, commutation, anticipation or encumbrance, or in any way subject to the debts of any beneficiary or payee, or to legal process except as otherwise provided by law." In upholding the spendthrift clause, a Maryland court, in which state the beneficiary resided and which had no special statute, relied upon judicial decisions in that state upholding spendthrift trusts and ruled that the spendthrift clause should receive the same protection [Michaelson v. Sokalove, 169 Md. 529, 182 A. 458].
In another case, an insurance policy issued by a Pennsylvania insurance company provided a settlement option that restricted monthly installments from being alienated, commuted or assigned by the beneficiary. New Jersey—which, at that time, had no statute on this subject—was the state of residence of both the insured and the beneficiary. (Now insurance spendthrift trusts are upheld in New Jersey under N.J. Stats. Ann. §17:35B-12.) In another action in the New Jersey courts, brought by creditors of a beneficiary, the court upheld the validity of spendthrift trust clauses by drawing an analogy between these clauses and spendthrift trusts, which are valid in New Jersey [Chelsea-Wheeler Coal Co. v. Marvin, 134 N.J. Eq. 432, 35/A.2d 874].
In yet another New Jersey case, neither the insured nor his wife were residents of the state. The husband and wife had separated, and the husband was receiving an annuity under a group insurance contract issued by a New Jersey insurance company. The wife, a resident of California, brought an action in New Jersey to attach the annuity payments for alimony payments which had been awarded her by a California court. The New Jersey court, denying the wife`s claim, gave credence to a policy provision prohibiting such assignment. In addition to the general public policy reasons the court relied on, it was pointed out that in the wife`s state of residence, she would not have been able to recover because California gives effect to such clauses [Hoffman v. Hoffman, 8 N.J. 157, 84 A.2d 441].
In a fourth case, where the policyowner and the insurance company were both located in the same state—a state with no statute concerning spendthrift trust clauses—the court upheld such a clause on the grounds that the donor-insured had a right to place such restrictions on his property if he so desired. It was ruled that these restrictions would govern until the property came into the beneficiary`s hands [Mullen v. Trollinger, 237 Mo. App. 939, 179 S.W.2d 484].
Because the rights of creditors vary greatly from state to state, it is necessary to consult the appropriate state statutes and court decisions. Even though a state can generally give effect to spendthrift trust clauses, there may be some creditors (such as the state itself, for unpaid taxes; or dependents with claims, for support or alimony) who will have rights to insurance proceeds.
Changing Exempt Proceeds To Non-Exempt Property
When a beneficiary invests or converts exempt life insurance proceeds into other forms of property, the result cannot be predicted with any degree of certainty. In some cases, the exemption has been upheld as long as the proceeds are directly traceable to the non-exempt property. However, other cases have held that the exemption is automatically lost when a beneficiary puts the proceeds into non-exempt property, and that the property will no longer be exempt from beneficiary`s creditors.
Exemption Still Available
In an Iowa court decision, a statute exempting insurance proceeds from prior debts of a widow-beneficiary was upheld—property purchased with the insurance proceeds was exempt from liability for all such debts [Cook v. Allee, 119 Iowa 226, 93 N.W. 93].
In New York, where a spendthrift trust clause can protect insurance proceeds from the claims of a beneficiary`s creditors, such an exemption has been held to continue as long as the fund, or the property purchased with it, is identifiable with its source. Therefore, when the beneficiary invested exempt proceeds in an annuity, they were still identifiable with their source and, consequently, still exempt from the beneficiary`s creditors [Gardiner v. Rauch, 179 Misc. 606, 39 N.Y.S.2d 652, aff`d 264 App. Div. 897, 40 N.Y.S.2d 333].
In Washington, where proceeds are exempt from debts of beneficiaries as well as those of the insured, property belonging to a beneficiary that was acquired solely with money received under a life policy (purchased entirely out of exempt proceeds) is exempt to the same extent as the proceeds themselves [Northern Savings and Loan Ass`n v. Kneisley, 193 Wash. 372, 76 P.2d 297].
Exemption Not Available
The Kansas law exempting certain insurance proceeds from the beneficiary`s creditors, will not apply if those proceeds have been invested by the beneficiary in non-exempt property. In a Kansas case, a beneficiary invested the proceeds in savings and loan association stocks, so the exemption was negated, and the stock was made available to the beneficiary`s creditors [Independent Savings and Loan Ass`n v. Sellars, 149 Kan. 652, 88 P.2d 1059].
Furthermore, a Missouri court held that when insurance proceeds, exempt from the beneficiary`s creditors, were used to buy land, the land itself was not exempt from the creditors [Bank of Brimson v. Graham, 335 Mo. 1196, 76 S.W.2d 376].
In addition, an Ohio case ruled hat no exemption existed for money borrowed jointly by an insured and his wife on an exempt life policy. The husband and wife were joint defendants in a creditor`s suit. While the suit was in process, the couple joined in a policy loan application, borrowing $5,000 on policies in which the wife was beneficiary. The loan value was received by the insured who then turned it over to his wife. The Ohio Court of Appeals, in [Kuhn v. Wolf, 59 Ohio App. 15, 16 N.E.2d 1017], held that the money was not exempt under Ohio exemption statutes. The exemption was nullified after the policyowner obtained the money, and the funds should have been turned over to his creditors.
A majority of states provide total or partial exemption of the proceeds of endowment and cash surrender policy provisions, group insurance, fraternal benefit insurance, and disability benefit and annuity policies. Most exemptions are provided by statutes, while some are provided by case law.
All 50 states, the District of Columbia and Puerto Rico have statutory provisions that exempt fraternal benefit insurance from the creditors` claims. By a narrow margin, the majority of state statutes exempt group insurance proceeds.
Also, a majority of states have statutes exempting annuity payments and disability benefits. About 30 states have statutes exempting annuities, while more than 40 states exempt disability benefits. About half of the annuity exemption statutes have limits on the monthly cash amount exempt from the creditor`s claims.
Rights Of Creditors In Endowment Policies
Some cases have raised questions concerning creditors` rights to the cash values of endowment policies payable to a spouse or other beneficiary if a policyowner dies, and to him or her if till alive at maturity.
When there is no fraud, the statutes of several states expressly exempt proceeds of endowment policies from creditor claims when the beneficiary is the insured`s dependent, or a member of his or her immediate family. The laws of a few states include in this category the cash surrender values of endowment policies.
In the absence of an expressed statutory provision, the status of an endowment policy`s cash value where the insured is a beneficiary of the endowment benefits, but a third party is beneficiary to the death benefits) may be uncertain if no related court decision has occurred in the state.
In these cases, the cash values were held exempt pending maturity of the policy in an insured`s favor or a change of beneficiary for the personal advantage of the insured, at which time the bankruptcy proceedings ere reopened and the endowment proceeds distributed. At this point, the endowment proceeds became available to creditors as unadministered assets of the bankrupt.
Rights Of Creditors In Disability Income
In the absence of specific statutory provisions, disability benefits payable to policyowners are subject to creditors` claims and are not protected by insurance exemption statutes [Legg v. St. John, 296 U.S. 489].
The state statutes exempting disability, accident and health benefits from creditors`s claims an be found in the state law digests in Subsection B. As with life insurance exemption statutes, statutes exempting disability benefits will not apply o policies issued and debts contracted before the statute`s enactment [Samuels v. Quartin, 108 F.2d 789].
Rights In Annuities
Most insurance exemption statutes do not extend to annuity contracts in which the purchaser is the annuitant [In re Walsh, 19 F. Supp. 567; In re Powers, 115 F.2d 69]. Therefore, in the absence of specific statutory provision, creditors have rights to annuity contract funds.
A number of states have statutes exempting annuity contracts from creditor claims, but these statutes are so varied that the laws of each state need to be consulted. Some states exempt income payable to a person who purchases an annuity, while others provide that proceeds are exempt only when a person buys an annuity for someone other than him or herself. Also, cash surrender values of annuities are exempt in some states.
Congress has chosen not to enact bankruptcy laws that would supersede state laws regarding creditors` rights. Congress has, instead, created a dual system of exemptions: the Bankruptcy Act. The Act creates a "uniform" system of exemptions and provides that the debtor can choose between the state exemptions and the uniform federal exemptions, unless state law specifically prohibits use of the federal exemptions. Most states have statutes prohibiting debtors from using federal exemptions, so state exemption laws will control most cases.
Insurance policies will be exempt from bankruptcy proceedings to the extent the applicable law exempts insurance from creditors` claims. If the applicable law does not provide for exemption of the cash value of life insurance, the cash surrender value owned by the bankrupt individual is subject to creditors`s claims. The bankrupt individual can either pay the amount of the cash surrender value to the bankruptcy trustee and retain the policy (or policies), or pass the policies to the trustee as an asset.
Exemptions Under The Bankruptcy Act
The Bankruptcy Act provides that an individual debtor can choose to exempt either:
This gives the debtor a choice between the federal exemptions and the state elections, unless state law specifically prohibits the federal exemptions. Because most states have enacted statutes prohibiting the use of the federal exemptions, debtors rarely have the ability to choose (see Digest of Insurance Exemption Laws in Subsection B of this Section).
Federal exemptions cover several categories of property including:
A debtor facing bankruptcy in a state that allows a choice between state and federal exemptions should compare the exemptions listed above with the exemptions of his or her state. It will also be important to compare the state and federal exemptions for other types of property, in order to determine which set of exemptions is more favorable.
Exempt Under Applicable Law
Exemption law provisions determine whether the cash values of a bankrupt policyowner`s insurance will pass to the trustee in bankruptcy. If the insurance is exempt property under state law, the trustee will have no rights to it.
Not Exempt Under Applicable Law
Where applicable statutes do not exempt insurance policies, they will be subject to bankruptcy proceedings. In these cases, the cash surrender value of any insurance owned by a bankrupt individual will be available to the trustee as an asset of the bankrupt individual.
If a policy has no cash surrender value, or if a company has loaned the full surrender value, the trustee will acquire no interest—the policy remains the bankrupt individual`s property [Burlingham v. Crouse, 228 U.S. 459; Curtis v. Humphrey, 78 F.2d 73, cert. denied, 296 U.S. 605].
Payment Of Cash Value
Titles to property belong to trustees as of the date a bankruptcy petition is filed. Therefore, if a policyowner dies while bankrupt, the trustee would be entitled only to the policy`s cash surrender value and the beneficiary would take the balance of the proceeds Everett v. Judson, 228 U.S. 474]. However, under a statute exempting cash values, the trustee cannot obtain any of the cash value.
Either a bankruptcy judgement or a trustee`s taking possession of a bankrupt individual`s property is public notice of bankruptcy proceedings. An insurance company is protected if it, in good faith, pays a bankrupt individual the cash value of his or her policy before either of these events occurs. However, if the company pays the cash value after one of these events, it will not be protected and may have to pay the cash value again [Lake v. New York Life Insurance Co., 218 F.2d 394, cert. denied 75 S. Ct. 606].
U.S. Government Life Insurance Is Exempt
Any life insurance policy issued by the Federal Government is exempt from creditors`s claims. Proceeds cannot be attached or seized before hey are received by the beneficiary. The exemption applies to the creditors of both the insured and the beneficiary.
A state court decided that the exemption was applicable against creditors of an insured`s estate, when the proceeds became payable to the estate, despite a standard clause in the decedent`s will authorizing payment of all debts [In re Beall`s Estate, 384 Pa. 14, 119 A.2d 216].
Please note, the exemption of government insurance payments does not apply to property purchased with those payments.
The Federal Government has the right to collect unpaid policyowner income taxes from life insurance policies. The government can also collect from disability payments, annuity contracts, joint returns and community property.
Right to Cash Values During Insured`s Life
Internal Revenue Code §6334 exempts the following from the Government`s tax levy:
The exempt property statute specifically provides that no property, other than those listed above, is exempt from levy. Note that the cash values of life insurance are not specified as exempt property.
Federal Tax Lien
Code §6321 imposes a tax lien "upon all property and rights to property, whether real or personal," belonging to a taxpayer, if he or she neglects or refuses to pay any taxes. The lien applies to all policies owned by the taxpayer and applies when an assessment is made [I.R.C. §6322]. The lien is even valid with property acquired after the original lien is initiated [Glass City Bank v. U.S., 326 U.S. 265]. It may even apply to a life underwriter`s future commissions [Beeghley v. Wilson, 152 F. Supp. 726].
lien can be attached to property that ordinarily s not accessible
to private creditors, such as funds payable under a spendthrift trust.
Furthermore, state exemption laws are ineffective against it [
government liens extend to a taxpayer`s interest in a partnership, they
do not give rights to a firm`s property. Delinquent tax is not a partnership
debt, therefore lien will not adversely affect the cash values of
partnership-owned insurance policies [
Government Collection Methods
Once the government has established its lien against a taxpayer`s life insurance policies, it can foreclose by: (1) levy upon the insurer [I.R.C. §6332(b)], or (2) civil action in a federal district court [I.R.C. §7403].
A levy is the easiest for the Government, while a civil action can be very slow, requires many hours of work for Government employees and often results in decreased recovery values.
Levy Process Against Company
Code §6332 gives the Government the right to obtain the cash loan value of a delinquent taxpayer`s life insurance policies directly from an insurer. After 90 days of the levy notice, the insurance company is required to pay the Government an amount equal to the lien or the cash loan value, whichever is less. After this payment, the insurance company is discharged from further liability to the owner or beneficiary of the policy.
Action To Foreclose Lien
Once a federal lien has been made against a taxpayer`s interest in a life insurance policy, the government can foreclose on the lien and recover the cash surrender value in an action, under Code §7403 [U.S. v. Bess, 357 U.S. 51; Knox v. Great West Life Assurance Co., 212 F.2d 784]. The appropriate parties, all of whom must join for this action, are persons having liens upon or who claim an interest in the policy [I.R.C. §7403(b)].
the insured, the beneficiaries and the insurance company are made defendants,
as are the assignees if the policy has been assigned. If policyowners or
beneficiaries flee the country, the court may be given jurisdiction over
their policies [
government`s recovery is limited to the extent of its tax lien—the amount a
taxpayer owes (including interest and costs). If the taxpayer has no interest
in a policy, a lien cannot be attached to it [
If a beneficiary (or policyowner) is the insured`s spouse and the tax liability is of a joint nature, the tax lien gives the Government access to either or both of their rights to the policy [I.R.C. §6013(d)(3)].
government liens apply to all policyowner taxpayer rights, they apply to
policies with no cash surrender values. Thus, even when a policy has no
cash surrender value, but only a borrowing privilege, the court can
demand it be sold and the proceeds applied to the tax claim [
When Lien Attaches To Policy Or Automatic Premium Loans
Under certain conditions, when a court grants policy and automatic premium loans to an insurance company, it grants the company super priority status. Super priority status generally means that an insurance company has priority over the government for loans it has made.
To obtain a lien upon a delinquent taxpayer`s property, including life insurance, the government must file notice of the lien in the appropriate state or federal office. Code §6323(b)(9) provides that the government`s lien is not valid against an insurance company`s policy loan when granted before it has actual notice of the lien. If a company grants a policy loan after it has actual notice, it loses its super priority status on the loan unless there is a contractual requirement for an automatic premium loan. However, if the company makes a loan after satisfying a tax levy on the policy, it will be granted super priority status unless the government gives prior notice of any new tax lien.
An automatic premium loan provision is agreed to by most life insurance policyholders when they acquire their policies. Because this is a contractual provision between the insurer and the policyholder, the insurer is required to comply with the contract when premiums are not paid. Code §6332(b)(9)(B) recognizes this responsibility by providing that automatic premium loans made under provisions agreed to prior to the lien will have super priority status. his means that even automatic premium loans made after the actual notice of a lien will have super priority status.
Right To Disability Payments
proceedings against an insurance company, under Code §6332, with a
policyowner as the defendant, the government can claim all monthly income
disability payments due the insured- taxpayer to cover unpaid taxes [
Under the Social Security Act, disability benefits are also subject to government claims for unpaid income taxes [Kane v. Burlington Savings Bank, 320 F.2d 545].
Right To Annuities
The government, acting under Code §7403, can enforce a lien against a taxpayer`s annuity contracts [Schwarz v. U.S., 191 F.2d 618]. In one case in which both the taxpayer and the insurance company appeared before the court, the insurance company was directed to make annuity payments to the government. The court ruled that the company was to pay the policy`s cash surrender value to the government if all three parties agreed on an amount. On the other hand, if only the company and government agreed on a surrender value, while the taxpayer dissented, the contracts were to be sold at public auction.
Liabilities Of Husband And Wife
When a tax deficiency is found on a joint return, each spouse is jointly and separately liable for the tax [I.R.C. §6013(d)(3)]. Thus, the government can obtain and enforce its lien against policies owned by either spouse.
In a case involving a life insurance policy which gave the beneficiary unlimited power to withdraw the policies from the insurance trust, the husband and wife had filed joint tax returns that were found to be deficient. The court ruled that the government`s tax lien was valid against the trust [U.S. v. Peelle, 159 F. Supp. 45].
In a community property state, each spouse is liable for half of the tax on community income. When separate returns are filed, the government can foreclose a tax lien on the interest each spouse has in any policy, to the extent of the respective spouse`s tax liability [Smith v. Donnelly, 65 F. Supp. 415].
Right To Collect From Assignee
The government can try to collect unpaid income taxes of a delinquent taxpayer from the assignee of his or her life insurance policies, claiming that the assignee is a transferee under Code §6901.
Under the Code, the amount of a transferor`s (policyowner`s) income tax for which a transferee (donee, heir, legatee, devisee or distributee) of his or her property is liable, "at law or in equity," can be assessed against the transferee and collected from the transferor in the same manner. The Supreme Court has held that the law prior to Code §6901 did not create transferee liability, but merely provided a new procedure by which the government might collect taxes from transferees. Now, their degree of liability is determined by the substantive law of the state [Commissioner v. Stern, 357 U.S. 39].
Under state law, the Federal Government can resort only to remedies available to creditors. One of these remedies is the law against transfers that defraud creditors.
In life insurance cases, however, insurance exemption statutes can prevent the execution of these fraudulent conveyance laws. State statutes prevent an insured`s creditors (and often the beneficiary`s creditors as well) from claiming the proceeds of life insurance policies payable to named beneficiaries, and many of these provisions contain only limited exceptions for fraud.
Right To Income Taxes From Death Proceeds
Where Government Has A Lien
If the government has a lien for income tax deficiencies against a taxpayer, it is good only against the cash surrender value of the taxpayer`s insurance policies, calculated as of the date of death. The amount at risk (excess over cash surrender value) is beyond the government`s reach if state law exempts the insurance proceeds from creditors` claims [U.S. v. Bess, 357 U.S. 51; see state law digests in Subdivision B of this Section]. But state law will not prevent the government from collecting the tax from a beneficiary-spouse if he or she and the deceased spouse file a joint return for the period of the deficiency—both joint and separate liability are imposed upon husband and wife when a joint return is filed [I.R.C. §6013(d)(3)].
The equitable doctrine know as "marshalling," in regard to assets, will not be practiced to satisfy a federal tax lien accompanying cash surrender values of life insurance policies if, to do so, it would require ignoring a state statute that exempts insurance proceeds from the claims of creditors [Meyer v. U.S. 375 U.S. 233]. An example of marshalling—the equitable arrangement of creditors` assets—is demonstrated by the following: one creditor is secured by two funds while another creditor is secured by only one of those funds; therefore, equity will compel the twice-secured creditor to extinguish first the fund that is not security for the other creditor.
In the Meyer case, the insured`s policy had been assigned to a bank as collateral before the tax lien developed, and the debt owed to the bank was slightly less than the cash surrender value of the policy. The bank had a right to collect the funds it was due from the entire proceeds, while the IRS could collect only from the cash surrender value. The IRS argued that the bank should be required to satisfy its claims from the proceeds in excess of the cash surrender value, leaving the cash surrender value available for payment of the tax lien. However, the U.S. Supreme Court held that the bank`s prior claim would be treated as a payment made from the cash surrender value first, and only the remainder of the cash surrender value would be available for payment of the tax lien. The widow of the insured received the insurance proceeds above the cash surrender value.
Where Government Has No Lien
a taxpayer`s death, if the government determines a tax deficiency exists, it
will have no lien. Also, it will have no recourse, under Code §6901,
against life insurance proceeds payable to named beneficiaries if state
law exempts such proceeds from creditors [Commissioner v. Stern, 357
State law will generally not exempt life insurance proceeds from creditors if the proceeds are payable to an individual`s estate, his or her executor or administrator, or a trust for the benefit of the estate or a named beneficiary who agrees to use the proceeds for the benefit of the estate. he government`s claim against the estate is usually a higher priority than that of general unsecured creditors. However, the laws of a few states divert insurance proceeds payable to the estate to certain statutory beneficiaries [see heading "Statutory Beneficiaries" in Subdivision B, Section 20, of this Service]. Where the proceeds have been diverted from an estate by state law, the rule of the Stern case would apply.
If the spouse of a deceased taxpayer is the named beneficiary, and the couple had filed a joint return for the year or years in which deficiencies were determined, the surviving spouse will be both jointly and separately liable for the tax [I.R.C. §6013(d)(3)].
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