Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: If my client is going through bankruptcy and receives a life insurance death benefit from on his father’s life during the proceeding, will the death benefits be protected from creditors?

Answer: It depends on the state. In bankruptcy, the debtor is able to exclude certain assets from his bankruptcy estate (referred to as exemptions). While the bankruptcy code sets forth the federal bankruptcy exemptions, Congress has given the states the choice to create their own exemptions that the state can either require residents to use, or allow residents to use (with the option to instead choose the federal exemptions).

Currently, every state has created its own set of asset protection laws, and 19 states and the District of Columbia have given their residents a choice between the state exemptions and the federal exemptions.

The federal government doesn’t protect the death benefits a debtor receives as a beneficiary unless the debtor is a dependent of the insured, and then they are protected only to the extent necessary for support of the debtor.

For example, consider the recent bankruptcy case In re Sizemore (12/5/13), where a debtor going through bankruptcy received $100,000 from her ex-husband’s life insurance policy. Being a resident of Kentucky, the debtor had the choice of using either federal or state exemptions. The debtor sought to exempt the entire amount under the federal bankruptcy protections, but the bankruptcy court held that life insurance proceeds were part of the bankruptcy estate. Therefore, the life insurance proceeds could not be excluded from the debtor’s bankruptcy estate.

Also consider In re White (5/16/14), a bankruptcy case using Alabama state exemptions. Under Alabama’s bankruptcy exemption laws, death benefits of a life insurance policy are exempted from the estate if the beneficiary is the person who effected the policy in the first place.

In White, a married couple were going through divorce. The wife, who was the insured on a $50,000 life policy, died, and her husband was the beneficiary. The husband claimed that the proceeds from the policy on his wife’s life were protected from his creditors under Alabama exemption laws. He argued that he was the one who effected the policy because (1) she obtained the life insurance through his employer, and (2) he paid the premiums.

The bankruptcy court, however, ruled that because the wife was the owner of the policy, she was the one who effected the policy. Therefore, the death benefits were not protected under Alabama’s exemption laws.

A client going through bankruptcy should check with a local bankruptcy attorney to fully understand his state’s exemption laws that may apply.

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