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Asset Protection

Phil Rupprecht

Phoenix Asset Protection Attorney Phil Rupprecht  

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.

 

AZ CPA magazine, March/April 2017  

This article appeared in the March/April 2017 issue of 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 Paknejad)

 

“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.[1]

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 creditors.[2] If the business failed, Bill and Mary could borrow tax-free against the cash value[3] 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.[4] 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 non-exempt asset.

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 might bring.

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.[5]

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.[6] 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 alternatives.

Simple may not be best; simple could be a disaster. A properly drafted revocable trust should almost always be considered.


[1] This brief article analyzes the options for personally owned life insurance. Corporate (or company) owned life insurance has a distinct set of issues and is not addressed here.

[2] A.R.S. §§ 33-1126(A)(6) and 20-1131(D). Of course, premiums cannot be paid in fraud of creditors.

[3] This assumes the policy is not a modified endowment contract. 26 U.S.C. § 7702A.

[4] A.R.S. § 20-1131

[5] A.R.S. § 44-1009

[6] A.R.S. § 14-10504(D)(2)