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.
Principles Of The
Insurance Exemption
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.
Historical Background
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].
When
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
Creditor-Free Investment
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.
Rights Of Creditors In
Death Proceeds
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
In General
In
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
own use.
Some
of the laws, as noted, apply only for certain beneficiaries, such as the
insured`s spouse, children or other dependent relative.
A
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.
Generally,
in states that limit the exemption, the limitation applies both to
proceeds and to cash values. However, in
Rights Of Beneficiary`s Creditors
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.
In General
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].
However,
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.
One
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.
Block, (
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:
State
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
In
addition, a
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.
In
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.
Rights Of Creditors In
Other Insurance
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.
Federal Law—Insurance
Under Bankruptcy Act
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.
Federal Law—Government
As Creditor
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
Exempt Property
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].
The
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 [
Although
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)].
Therefore,
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 [
The
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)].
Because
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
In
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].
State Law
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
After
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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