Using the Bankruptcy Code and Life Insurance for Asset Protection

Going into Bankruptcy

When clients are slowly sliding into bankruptcy, they are typically of the mindset that any liquid wealth they have will be lost and will ultimately be divided among various creditors (which is usually the case).

Interestingly, the bankruptcy laws, §522(d)(8) allow a client to keep $10,775 of any unmatured life insurance contract owned by the debtor under which the insured is the debtor or an individual of whom the debtor is a dependent.

I believe there are some interesting planning opportunities to use the bankruptcy statute with the new no-cash value policies in the marketplace.

Let’s look at an example:

You have a client, Mr. Green, age 45, who sees the writing on the wall and knows that it is only a matter of time before his creditors close in on him and force him to file bankruptcy.  It’s not that Mr. Green is illiquid, it’s that his debts are significantly more than his assets and in the near future he will have to file bankruptcy to get out from under the growing debt.

Let’s assume Mr. Green has $50,000 of liquid wealth in a brokerage account or in a bank account.  Under the bankruptcy laws, he could take that $25,000 and pay a simple premium payment into what I call a no cash value UL single premium policy with a guaranteed death benefit of let’s say $400,000.

What will be the cash surrender value of the policy in year one?  Certainly less than $10,755.  What does that mean for the family?  It means that $50,000 that would have otherwise gone to creditors in a bankruptcy proceeding ended up providing a guaranteed $250,000 paid-up life insurance policy that becomes an asset of the family for life (or until death or until the client turns 65 and then sells his policy to a life settlement company).

While this is not the best solution in the world, would your client rather give their money to a creditor or guarantee a lifetime benefit for the family?

One question that will arise is, does the use of pouring money into a cash-value life insurance violates the fraudulent conveyance laws. It shouldn’t. First of all, it’s not a conveyance.  The person transferring money from a bank account to a life insurance policy is not transferring ownership.  The same person who owned money in the bank account also owns the life insurance policy.

You may be wondering how this is fair; it seems to be contrary to the creditor’s rights and is preserving assets due to a creditor for the debtor’s use later on.  Creditors feel the same way, yet there are cases out there where the bankruptcy trustee has argued unsuccessfully that using life insurance as a pre-bankruptcy asset protection tool puts the creditors at a disadvantage by defeating the creditor’s chances of getting what is owed to them by the debtor yet saving the money for future use by the debtor after the bankruptcy has been discharged.  The courts were forced to weigh the debtor’s rights and public policy concerns v. creditor’s rights; and, so far the debtors have prevailed.

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Side note: What about the proceeds of a life insurance policy?:

Many clients have their children as beneficiaries or contingent beneficiaries of life insurance policies.  What happens if the children are candidates for bankruptcy and then mom and or dad die thereby leaving the children $100,000-$250,000+ in tax-free death benefit proceeds?

What’s a creditor going to want the children to do with such proceeds?  Sure. Pay off the debts.

522(d)(11)(C) of the bankruptcy code states that a payment under a life insurance contract that insured the life of an individual of whom the debtor was a dependent on the date of the individual’s death, may be exempted from the extent reasonably necessary for the support of the debtor and any dependent of the debtor.  For the exemption to apply the debtor has to have been a dependent of the insured at the time of the insured’s death.

What if the child is not a dependent?  Then the proceeds would be subject to seizure.  That’s not good planning which is why it is vitally important for clients to use Irrevocable Life Insurance Trusts (ILITs) for life insurance policies that will ultimately be paid to their heirs. When the proceeds are paid to an ILIT, the trust can have to spend thrift-type language that will prevent the trust from giving money to a beneficiary if that money is to be used to pay a creditor (of any kind (the IRS included)).

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Life Insurance and Asset Protection

As many of you are aware, in states like TX, FL, OK, and some others, cash value life insurance is protected from creditors.  You can surf the APS website to determine if your state asset protects life insurance.

While many states do asset protect life insurance from creditors many do not.  That means if a client is funding tens of thousands of dollars into a cash-building life insurance policy to build a tax-favorable retirement vehicle, the cash is subject to loss from creditors.