In addition to serving his own high net worth clients,
Phil Rupprecht is a valuable
resource for other attorneys, financial planners and tax professionals in
shielding their clients' accumulated wealth from avoidable risk through the
innovative use of domestic and offshore planning strategies.
This article appeared in the March/April 2017 issue
AZ CPA magazine, published
by the Arizona Society of Certified Public Accountants.
Life Insurance and Creditors: A Complicated Story
Life insurance can have wonderful benefits, including asset protection, if properly structured. This article discusses some of the nuances that need to be taken into account by clients, CPAs and financial planners to receive maximum asset protection for life insurance proceeds.
By Phil Rupprecht
(Aiken Schenk) and
Phil Glasscock (Smith
“Oh, by the way, we’re buying some life insurance. Who should we
name as the beneficiary?”
Sounds simple, doesn’t it? Obviously, the beneficiary should be
the surviving spouse or, in some cases, the children. If credit claims are, or
could be, an issue, the simple answer might be the wrong answer.
There are many good reasons to own life insurance. As anybody
who has wandered into the life insurance market recently can tell you, life
insurance, particularly cash value life insurance, is an extremely complicated
product. The beneficiary designation, while initially obvious, is complicated if
current or future creditor claims are considered.
Clients buy life insurance for a variety of reasons – income
replacement, tax efficiency, transfer tax mitigation and others. Since at least
2005, buyers have been told that some portions of the cash value and death
benefit are exempt from creditor claims. The creditor exemption question turns,
in part, on the beneficiary designation, thus complicating the choice. If the
purchaser has, or could have, creditor issues in their future, then designating
a beneficiary without considering the effect of later creditor claims could lead
to the loss of the insurance proceeds to creditors.
For example, Bill and Mary own a small struggling business.
They’ve guaranteed the company’s multi-year lease and substantial bank debt. At
age 45, Mary dies. She is the owner of a policy, purchased in 2000, with a $1
million death benefit and a $250,000 cash value. Bill is the sole beneficiary.
Before Mary’s passing, the cash value was exempt from the claims of the couple’s
If the business failed, Bill and Mary could borrow tax-free against the cash
and can pay their bills without creditor interference. This $250,000 asset could
be critical to the couple’s financial security.
If Mary dies while Bill is the sole beneficiary, her passing
could be doubly catastrophic. Presumably, Mary is insured because she plays a
significant role in the company’s business and its prospects will be materially
harmed by her passing. In addition, her passing could have the unintended and
unexpected consequence of converting an exempt asset free from creditor claims
into a non-exempt asset subject to creditor claims.
It is clear law in Arizona that if Mary bought the policy on her
life for Bill’s benefit, Bill receives the death benefit free and clear of any
of the claims of Mary’s creditors.
Unresolved, however, is whether the proceeds of Mary’s policy are exempt
in Bill’s hands. Bill has substantial leasehold and guarantee liability. A
creditor could argue that, although Bill receives the death benefit free and
clear of Mary’s creditors, he does not receive the policy proceeds from
the claims of his creditors – even though they share largely the same
creditors. Arizona case law has yet to squarely address this issue. Unless the
proceeds are exempt in Bill’s hands, they would be subject to garnishment by
Bill’s creditors converting that $250,000 exempt asset into a $1 million
Even if Mary and Bill are not financially struggling today, they
face everyday risks (auto accidents, slip and falls, etc.). While elderly
clients are less susceptible to certain types of risks, they are in a higher
risk category with respect to others. No one is immune from catastrophic risk.
Even if Bill and Mary do not see themselves as high risk, they
ought to consider beneficiary designation alternatives that preserve creditor
protection. Preserving a $1 million exemption for Bill’s life expectancy of 40
years (or more) could have considerable value. All other things being equal,
Bill is financially more secure if the $1 million left by Mary is locked in a
creditor-protected structure because, quite simply, he cannot know what life
Irrevocable Life Insurance Trust (ILIT)
Bill and Mary have several options. First, the simplest and the
clearest option is an irrevocable life insurance trust (ILIT). Bill and Mary can
either purchase replacement insurance or transfer their policy to an ILIT,
depending on their concern for transfer tax exposure. The transfer tax
considerations are simpler if Bill and Mary never own the policy. The cash value
of an ILIT on the policy is not exposed to claims of Bill and Mary's creditors
because Bill and Mary do not own the policy and, hopefully, the settlor is not a
beneficiary. The death benefit is not exposed to the claims of either of their
creditors because the death benefit is payable to the ILIT trustee. The one risk
of a conventional ILIT (i.e., in which only the children are beneficiaries) is
that Bill and Mary are making a gift and therefore subject to fraudulent
transfer considerations subject to, at least, a four-year lookback.
Bill and Mary may not want an ILIT for a variety of reasons.
ILITs can be costly to settle, the death benefit may be relatively small, and
they generally require a third-party trustee. Bill and Mary may be unwilling or
unable to send the Crummey notices. They may want unimpeded access to the
cash value for the survivor.
Other Options and Considerations
There is another option for couples of even modest means and at
lower death benefit thresholds. Bill and Mary can, and probably should, name
their revocable living trust as the beneficiary. If they do, however, they need
to pay careful attention to their treatment of those proceeds under the terms of
the trust agreement. First, if an insurance policy is exempt when payable to an
individual beneficiary, then the policy (or cash value) is also exempt if it is
paid to a trust for the benefit of that individual.
So, at first pass, it is important that Bill and Mary's revocable living trust
clearly makes the members of the protected class (spouse, children, other
dependents) the ultimate beneficiaries of the life insurance proceeds.
Second, Bill and Mary should pay attention to how their trust is
drafted, particularly with respect to community property issues, closing off any
back doors to the benefit they seek to protect.
In general, a carefully drafted revocable trust can protect
policy proceeds for the benefit of the surviving spouse’s life. The surviving
spouse, or the children, can enjoy the proceeds free and clear from not only the
creditors of the decedent, but also their own creditors.
Therefore, if either the cash value or the death benefit is a
material part of a client’s financial security, then the client is well advised
to pay close attention to the beneficiary designation and consider the
Simple may not be best; simple could be a disaster. A properly
drafted revocable trust should almost always be considered.