Gideon Rothschild and Daniel S. Rubin
Life insurance policies have long played a signifi cant role in reducing taxes. They’re favored under the Internal Revenue Code in several signifi cant ways, as discussed in chapter 12. Specifi cally, (1) earnings within the life insurance policy are not taxable as they accumulate; (2) accumulated income generally can be withdrawn from the policy as loans without income tax effect; and (3) the policy’s death benefi t is generally not subject to income taxation. In addition, through the use of a properly drafted irrevocable “insurance” trust, the death benefi t may also be made to pass to or for the benefi t of the owner’s intended benefi ciaries without the imposition of estate or generation-skipping transfer taxes.
Tax savings are not, however, the only benefi t that can be gained by owning life insurance. Potentially even more signifi cant, at least to certain individuals, is that life insurance is one of a very few forms of investment that’s often inherently protected from creditor claims. Private placement life insurance (PPLI), in particular, lends itself to so-called asset protection planning and for many individuals will be a principal motivation for the investment. But it is important to understand the broader asset-protection planning benefi ts of life insurance before considering the particular benefi ts that might be afforded by private placement life insurance policies.
Certain classes of assets are favored by statute so as to provide their owner, or debtor, a greater level of protection from the claims of creditors than would other classes of assets. Usually this heightened creditor protection is provided because the asset class is a type that’s considered essential for the debtor and/or the debtor’s family to maintain at least a minimum level of fi nancial well-being and thereby avoid becoming a burden to the state. In all cases, the extent of such creditor protection is, of course, tempered by society’s proper concern for the creditor’s competing rights to access the debtor’s property toward satisfaction of the creditor’s legitimate claims.
Exemption statutes frequently name life insurance as one such favored asset class. Life insurance is favored with an exemption from creditor attachment because it can help to ensure the fi nancial subsistence of the debtor’s spouse and/or dependents following the death of the “breadwinning” debtor. However, the statutory exemption afforded to life insurance varies (sometime extensively) by jurisdiction and is also likely subject to some lesser or greater extent to the vagaries of judge-made law.1 Notwithstanding these differences, the potential value of such an exemption to a debtor or potential debtor means that the exemption for life insurance warrants a careful and considered review by estate and asset-protection planners.
Consideration of the potential creditor protection afforded to life insurance is, however, complicated by the several capacities in which the debtor may be interested in the policy—that is, whether the debtor is the owner of the policy, the insured, or both. Alternatively, the debtor may be the benefi ciary of the policy, or the debtor may be the owner of a policy that names his or her estate as the benefi ciary of the policy. Since the exemptions afforded to life insurance are intended to further particular public policy goals (that is, protecting the debtor’s dependents from fi nancial destitution in the event of the debtor’s untimely demise), the relationships between the owner and the insured and between the owner and the benefi ciary are often key to determining whether and to what extent the particular life insurance policy at issue may be protected from creditor claims.
The Federal Exemption
The federal bankruptcy exemption for life insurance policies owned by the debtor can be found at Section 522(d)(8) of the U.S. Bankruptcy Code.2 The federal bankruptcy exemption for life insurance shields unmatured policies owned by the debtor (other than a credit life insurance contract) and up to $8,0003 of the debtor’s aggregate interest in any accrued dividend or interest under, or loan value of, an unmatured life insurance contract, provided that the insured is either the debtor or an individual of whom the debtor is a dependent. Since federal bankruptcy law broadly defi nes a “dependent” as including a spouse, whether or not the debtor’s spouse is actually dependent upon the debtor, the exemption will apply without further inquiry as long as either the debtor or the debtor’s spouse is the insured.4
The effect of the foregoing exemption is obviously to protect the actual insurance element of the life insurance policy and little else, since only a minimal amount of the cash surrender value of the policy is afforded any exemption. That the primary intent of the Bankruptcy Code as it relates to the exemption of life insurance is to protect a dependent’s interest in the life insurance policy, rather than the owner’s own interest, is further supported by Section 522(d)(11)(C) of the Bankruptcy Code.5 That section concerns the benefi ciary of the policy as the debtor (rather than the owner of the policy as the debtor) and exempts the debtor’s entitlement to the proceeds of a life insurance contract, without any specifi c dollar limitation, to the extent that such proceeds are “reasonably necessary” for the support of the debtor and any dependent of the debtor. Although the federal bankruptcy exemption of an unmatured life insurance contract without the exemption of any signifi cant portion of the cash surrender value may prove invaluable in certain limited circumstances (for example, if the debtor has become uninsurable since the life insurance policy was originally purchased), it obviously does not provide signifi cant opportunities for asset protection or prebankruptcy planning for the insured.
The State Exemptions
Since the federal exemption scheme for life insurance owned by the debtor is so parsimonious, alternative state exemptions have become the primary focus in asset-protection planning with life insurance. FIGURE 4.1, page 50, contains a tabulation of the statutory exemptions afforded by each of the 50 states and the District of Columbia.
As can be seen in fi gure 4.1, some states follow the model of the federal exemption scheme and provide very limited exemptions for the cash surrender value of life insurance. For example, South Carolina offers an exemption of only $4,000 for the cash surrender value of life insurance (provided that the insured is either the debtor or an individual upon whom the debtor is dependent).6 Proceeds payable to the insured’s spouse, children, or dependents are, however, generally fully exempt from the creditors of the insured.7 Wisconsin also exempts only $4,000 (and only provided that the insured is either the debtor, a dependent of the debtor, or an individual upon whom the debtor is dependent).8 If the debtor is the benefi ciary of the life insurance policy, however, and provided that the debtor was dependent upon the insured, Wisconsin law exempts payments to the extent reasonably necessary for the support of the debtor and the debtor’s dependents.9
Most states, however, have exemption schemes that provide for far greater protection of the cash surrender value of life insurance policies than does the federal exemption scheme. For example, in keeping with its generally pro-debtor stance, the state of Florida specifi cally exempts the entire cash surrender value of life insurance policies from the reach of creditors10 and the entire death benefi t from the creditors of the insured unless the proceeds are payable to the insured’s estate.11 Hawaii similarly specifi cally exempts the entire death benefi t and cash surrender value of life insurance policies from the reach of creditors of the owner of the life insurance policy, provided that the policy is payable to a spouse of the insured or to a child, parent, or other person dependent upon the insured, except (of course) as to premiums paid in fraud to creditors.12 Louisiana also specifi cally exempts the entire proceeds (including the full cash surrender value) of life insurance policies from the reach of creditors, provided that the exemption is limited to $35,000 of the cash surrender value if the life insurance policy was issued within nine months of a bankruptcy fi ling.13
New York’s scheme for the exemption of life insurance14 is worth noting because it clearly distinguishes between the several permutations that can result depending on whether the debtor is the owner of the policy (referred to under the New York statute as the person “effecting the policy”),15 the insured, or the benefi ciary, or some combination thereof. More specifi cally, the New York statutory exemption scheme for life insurance provides that:
(a) If the owner of a life insurance policy insures his or her own life for the benefi t of another (that is, a benefi ciary other than the owner’s estate), that other person shall be entitled to the proceeds and avails of the policy as against the creditors of the owner.16 (In other words, the benefi ciary’s interest in a life insurance policy that is owned by another is protected from claims of the policy owner’s creditors.)17
(b) If the owner of a life insurance policy insures the life of another for the owner’s own benefi t, the owner shall be entitled to the proceeds and avails of the policy as against the creditors of the insured.18 (In other words, the interest of an owner of life insurance in the policy is protected from the creditors of the insured.)
(c) If the owner of a life insurance policy insures the life of his or her spouse for the owner’s own benefi t, the owner shall also be entitled to the proceeds and avails of the policy as against his or her own creditors.19 (In other words, the interest of an owner/benefi ciary of life insurance in the policy is protected from the owner/benefi ciary’s own creditors if the insured is the owner’s spouse.)
(d) If the owner of a life insurance policy insures the life of another person for the benefi t of a third party, the third party shall be entitled to the proceeds and avails of the policy as against the creditors of both the owner and the insured.20 (In other words, the benefi ciary’s interest in a life insurance policy is protected from claims of the creditors of both the owner of the policy and the insured.)
(e) The owner of a life insurance policy, regardless of the identity of the insured, shall be entitled to accelerated payments of the death benefi t or accelerated payment of a special surrender value permitted under such policy as against the creditors of the owner.21 (In other words, the owner’s interest in the cash surrender value of a life insurance policy is protected from claims of the owner’s own creditors.)
Interestingly, even the extensive New York statutory exemption scheme does not cover all possible permutations. For example, in Dellefield v. Block,22 a husband took out two paid-up life insurance policies on his own life in favor of his wife. Thereafter, both the husband effecting the policy and his wife, the benefi ciary of the policy, became debtors of the same judgment creditor. Since §166 of the New York Insurance Law (precursor to the current New York statute) provided that a life insurance policy insuring the owner’s own life for the benefi t of another is protected from a debtor owner’s creditors but did not then expressly provide that the same life insurance policy is protected from a debtor benefi ciary’s creditors, the novel issue arose as to whether a joint judgment creditor could enforce its judgment against the life insurance policies. Based on a liberal interpretation of legislative intent to the effect that the statutory exemption of the debtor/owner’s interest was intended to protect all cases in which a person by investment of his own money insured his or her own life for the benefi t of another, the Dellefield court held that the life insurance policies could not be reached by the parties’ joint judgment creditor.
As shall be seen, the liberal application of statutory creditor exemptions for life insurance policies appears to be the prevailing practice among our nation’s judiciary. One example of this phenomenon exists in connection with the court’s interpretation of the phrase “proceeds and avails” of an insurance policy pursuant to a statutory exemption. As a baseline, it might be noted that the phrase “proceeds and avails” as used in the New York statute, for example, is defi ned to include “death benefi ts, cash surrender and loan values, premiums waived, and dividends, whether used in reduction of premiums or in whatever manner used or applied, except where the debtor has, after issuance of the policy, elected to receive the dividends in cash.”23 Unlike New York, however, not all state statutes expressly defi ne which incidents of value of a life insurance policy (that is, specifi cally, the debtor’s ability to shield the cash surrender value of a life insurance policy versus the debtor’s entitlement to the proceeds of a matured policy which insured the life of another) are covered by the exemption scheme at issue. Therefore, the issue has frequently arisen as to whether and to what extent the cash surrender value should be exempted when the statute refers only to “monies paid out of a life insurance policy” or similarly ambiguous language.
In the matter of In re Worthington,24 the Bankruptcy Court, interpreting a Kentucky exemption statute which provided simply that “any money or other benefi t to be paid or rendered by any assessment or cooperative life or casualty insurance company is exempt from execution or other process,”25 determined that an unlimited exemption was provided for the cash surrender value of life insurance policies. The Worthington court stated that:
This statute does not restrict “any money or other benefi t to be paid” as exemptible only upon death, but rather it denotes an exemption extending to the debtor on any monetary value or benefi ts accruing by virtue of ownership. Thus, the loan values or the cash surrender values by virtue of the enactment of the Kentucky legislature have been deemed exempt since the term “any money . . . to be paid” is not restricted as to time of election and offers no alternative but to include the cash surrender value within its defi nition. The Kentucky legislature has, after due deliberation and in its wisdom, determined that any monetary value in life insurance policies owned by its citizens is exempt without monetary limitation.26
Similarly, it has generally been held that when reference is made to the “proceeds and avails” of a life insurance policy, such reference comprehends the protection of cash surrender values and other values built up during the life of the policy as well as the protection of its death benefi t even if not expressly so provided by statute. The rationale behind such holdings is made clear in the matter of In re Beckman,27 in which the court stated:
The legislature well knew that an insured would probably have creditors during his lifetime and no doubt fully realized that if the cash surrender value could be reached by creditors of the insured while he was living, there would not be in many cases any “proceeds and avails” to exempt or safeguard after death. Nowhere in the statute do we fi nd a single word or expression indicating that the exemption is only to be effective after the death of the insured.28
Moreover, the unlimited exemption for the cash surrender value of life insurance that exists in some state can be roundly abused by dishonest debtors and has been considered by the courts and disregarded as a basis for judicially recasting the liberally interpreted import of the exemption statutes. For example, in the matter of In re White,29 the court rejected the bankruptcy trustee’s objection to an unlimited exemption for the “proceeds and avails” of life insurance. The bankruptcy trustee’s objection, rejected by the court, was that to exempt the cash surrender value of the debtor’s life insurance policy would provide a debtor with an avenue for depositing his funds in unlimited amounts in a species of property that would place it beyond the reach of his creditors but not beyond his own reach after his discharge in bankruptcy. 3
Similarly, the court in In re Beckman31 was not compelled by the bankruptcy trustee’s argument that to hold the cash surrender value of the debtor’s life insurance policy exempt would be to make an insurance policy “a refuge for fraud.”32 In each case, the court responded to the creditor’s argument by stating that such argument overlooks the fact that the exemption statute expressly provides that premiums paid in fraud of creditors would, nevertheless, inure to the benefi t of creditors. Finally, it has been said that in any event “if abuses to enacted exemptions are deemed to exist, the remedy is by other than judicial legislation.”33
Therefore, for the residents of certain states, at least, valuable asset protection and prebankruptcy planning opportunities exist using life insurance policies, provided, as always, that the conversion of nonexempt assets into exempt assets (be they cash surrender value life insurance policies or otherwise) is not made with the intent to hinder, delay, or defraud creditors.34
Insurance Trusts
Whether or not there exists in any particular jurisdiction a signifi cant creditor exemption for life insurance policies, however, the greatest creditor protection will always be achieved through the use of trusts. For example, a policy may be transferred to an irrevocable spendthrift trust (or even better, an irrevocable spendthrift trust can acquire the life insurance policy in the fi rst instance), thereby protecting the value of the life insurance policy not only from future creditors of the settlor and creditors of the trust benefi ciaries but from taxation in the settlor’s estate as well.35 At the same time, there is little doubt that Section 541(c)(2) of the Bankruptcy Code would also exclude the trust property from the settlor/debtor’s bankruptcy estate as a spendthrift trust enforceable under applicable nonbankruptcy law. The use of a trust also avoids a potential creditor argument that, notwithstanding the existence of a statutory exemption, such exemption was never intended to extend to PPLI policies with cash value and a death benefi t far in excess of what might be required for the subsistence of the debtor and/or his or her dependents.
Furthermore, the transfer of life insurance policies to an irrevocable life insurance trust need not have the effect of placing the potential use and enjoyment of the cash value beyond the settlor’s reach. Provided that the settlor is married, the spouse may be named as a discretionary benefi ciary of the trust. Therefore, to the extent that the trustees are amenable to making a distribution of property out of the trust to the settlor’s spouse, the settlor can have an indirect benefi t from the trust property for as long as the settlor’s spouse is living and the parties have not separated or divorced. Where the settlor is concerned with the possibility of the spouse predeceasing or, alternatively, where the settlor is concerned with the possibility of a divorce, a so-called fl oating spouse clause may be appropriate. A fl oating spouse clause would defi ne the spouse of the settlor as the person to whom the settlor is married at the time in question; therefore, if the settlor and the settlor’s current spouse should divorce, or the settlor’s spouse should predecease the settlor, the settlor could again have access to the trust fund provided only that the settlor remarry.
A less traditional alternative would have the settlor establish the trust under the laws of Alaska, Delaware, Missouri, Nevada, Oklahoma, Rhode Island, or Utah, since the law in each of those states provides that the owner of property (including the owner of a life insurance policy) may create a discretionary trust for his or her own benefi t without leaving the transferred property subject to the claims of his or her future creditors (a so-called self-settled trust). Such trusts are frequently also called domestic asset protection trusts. A number of foreign jurisdictions, including Bermuda, the Bahamas, the Cayman Islands, and the Cook Islands, have similar laws regarding the use of self-settled trusts to protect against potential future creditor claims. Such trusts are frequently called foreign asset protection trusts and are generally considered to be more protective because they are not subject to potential “full faith and credit” and “federalism” attacks under U.S. constitutional law.36
A transfer to an asset-protection trust settled under the law of one of the aforementioned jurisdictions, wherein the settler retains no rights (other than those of a discretionary benefi ciary), would be deemed a completed gift for U.S. gift-tax purposes because of the interplay between the Internal Revenue Code and the applicable law governing creditors’ rights. Furthermore, such a trust should cause the proceeds payable on death to be excluded from the settlor’s estate for transfer-tax purposes, irrespective of the fact that the settlor may benefi t from the cash value of the policy (albeit at the trustee’s discretion) during the settlor’s lifetime.37
The use of PPLI policies can actually enhance the asset protection afforded by such trusts. This is so because the tax benefi ts that are expected to inure from the PPLI policy provide a rationale other than the hindrance, delay, or fraud of creditors (a so-called fraudulent transfer) in connection with the settlor’s transfer of property to the trust in connection with its funding. As has been discussed in other chapters, the relatively large premium commitment required in connection with PPLI policies frequently warrants that the insurance trust crafted to hold them be established in a jurisdiction like Alaska, which imposes no state premium tax (generally 2 to 3 percent of each premium payment) or, at a minimum, a relatively low state premium tax.38 An offshore asset-protection trust might be further justifi ed by the fact that an offshore PPLI policy, which may be owned only by a non-U.S. person (such as a foreign asset-protection trust), can invest in foreign securities, which are not otherwise open for investment to U.S. persons because of Securities and Exchange Commission regulation. Moreover, offshore investment opportunities may provide greater flexibility and, perhaps, economies, again because of the absence of regulation over such investments by the SEC.
It’s also important to note that similar to the state statutory exemptions discussed earlier, certain foreign jurisdictions with substantial life insurance industries have statutory law exempting life insurance from the reach of creditors. For example, Bermuda’s Insurance Act of 1978 provides that:
1 Where a benefi ciary is designated, the insurance money, from the time of the happening of the event upon which the insurance money becomes payable, is not part of the estate of the insured and is not subject to the claims of the creditors of the insured.
2 While a designation in favor of a child or grandchild . . . or a spouse or parent of a person whose life is insured, or any of them, is in effect, the rights and interests of the insured in the insurance money and in the contract are exempt from execution or seizure.39
In a similar vein, in Barbados the interest of a policyholder is not liable to be applied to or made available in payment of the debts of the policyholder by any judgment, order, or process of any court.40 The Bahamas has similarly protective legislation.41
In contrast to Bermuda, Barbados, and the Bahamas, however, the governing insurance law in the Cayman Islands (which is another relatively substantial offshore insurance jurisdiction) does not specifi cally address whether there are any special creditor protections for policy values. The law of the Cayman Islands does, however, require that insurers keep separate accounts on behalf of its clients from which no payment can be made “directly or indirectly for any purpose other than those of the insurer’s long-term business.”42 This obviously presents a potentially powerful argument that the claims of creditors of a policy owner, insured, or benefi ciary cannot be paid out of the cash value of a life insurance policy held with a Cayman insurer.43
Therefore, the investment in a PPLI policy, whether domestic or foreign, might provide a concerned individual not only with the potential for tax-free income, but also with an asset that will be protected against even the most aggressive creditor claims. For many individuals, the exemption from creditor claim that is generally afforded to life insurance policies will provide a compelling argument in favor of life insurance as an investment. Even in jurisdictions that have generous exemptions for the cash surrender value of life insurance, however, the use of a properly structured “life insurance” trust to hold the policy remains important. This is especially true in light of the fact that through advanced planning, the use of an irrevocable life insurance trust need not have the effect of placing the potential use and enjoyment of the cash surrender value beyond the settlor’s reach.