In re Brandon Clark: Inherited IRA Exempt from Creditors

February 2nd, 2012

In In re Brandon C. Clark,  Case No.  3:11-cv-00482-bbc, the United States District Court for the Western District of Wisconsin reversed the Bankruptcy Court and held that an IRA a debtor inherited from her mother was exempt from the debtor’s creditors.

In August 2000 the debtor’s mother established an Individual Retirement  Account and named her daughter as the sole beneficiary.  The debtor’s mother died a little over a year later.  The debtor established an Inherited IRA account in her name and began taking the required minimum distributions.

In 2010 the debtor and her husband filed  a Chapter 7 bankruptcy petition and listed the Inherited IRA as exempt. At the time the debtor filed bankruptcy the Inherited IRA had an account value of approximately $298,000.00.The trustee objected to the debtor’s claimed exemption of the Inherited IRA.  The bankruptcy court agreed with the trustee and ruled that the Inherited IRA was not exempt.  The debtors appealed to the United States District Court.

The District Court reviewed pertinent provisions of the Bankruptcy Code as well as exemptions afforded the debtor by Wisconsin law.  Quoting from the Bankruptcy Appellate Panel for the Eighth Circuit in In re Nessa, the court noted, “Section 522(d)(12) requires that the account be comprised of retirement funds, but it does not specify that they must be the debtor’s retirement funds.” Looking to the BAP 8th Circuit decision in In re Nessa again, the district court observed, “§ 522(b)(4)(C), which provides that direct transfers of retirement funds from one fund or account exempt from taxation do not cease to qualify for exemption under subsection (d)(12) by reason of such a direct transfer.”

The District Court then analyzed the differences between the majority and minority opinions regarding the exemption of  inherited IRAs, ultimately ruling in favor of the debtor.  This opinion is a detailed map of most if not all of the cases that have addressed the exemption of inherited IRAs.

Full opinion at:  http://goo.gl/7aRyx

In re Bowen: Bankruptcy Trustee Cannot Reach Cash Value of Private ROP Disability Policy

January 26th, 2012

In the Illinois bankruptcy case In re Bowen, No. 11-71289 (C. D. Illinois)(Order entered September 23, 2011) the bankruptcy court held that the cash value of a private disability policy owned by a debtor was exempt from the claims of the debtor’s creditors, not as life insurance, but under the provision of Illinois law exempting the debtor’s right to receive disability payments, even if the debtor was not currently receiving disability payments.

All states exempt certain assets from the claims of creditors.  Many states exempt disability payments to a debtor as part of their statutory exemption scheme.  For example, North Carolina exempts “compensation for personal injury, including compensation from private disability policies or annuities…”  Illinois exempts a “debtor’s right to receive a disability, illness, or unemployment benefit.”

In 1990s disability insurance carriers introduced a return of premium (“ROP”) disability policy.  By paying for a ROP rider, the insured had the potential to receive a portion of the premium back five or ten years down the road, depending on claims experience.  Many of these policies provided that if the insured died without making a claim, the premiums would be returned to the insured’s beneficiary. ROP disability riders were not cheap, typically costing an additional 40% to 60% of the base premium.  Given this increased cost, ROP disability insurance is rarely if ever a wise purchase (you are essentially making an interest free loan to the insurance company of 40% to 60% of the base premium in the hope of getting 50% to 80% back in five to ten years).  As a result,the ROP disability insurance market has all but dried up, with only a couple of carriers offering this type of rider today.

For Steve Bowen, however, this proved to be a wise decision, at least from an asset protection standpoint.  When Mr. Bowen filed bankruptcy he listed not one but two ROP disability policies, which at the time had a combined cash value of $7,777, as exempt.  Illinois is an opt-out state, so Mr. Bowen’s exemptions were based on Illinois’ statutory exemption scheme.

Mr. Bowen claimed the policies were exempt on two grounds.  First, because the policies had a cash value component which could be paid to his beneficiaries if he died without making a claim, the policies were life insurance policies, which were exempt.  Second, because the policies were disability policies, the policies constituted Mr. Bowen’s “right to receive a disability…benefit.”

The bankruptcy trustee objected on two grounds.  First, the policies were not life insurance policies and, therefore, were not exempt. Second, because Mr. Bowen was not currently receiving disability payments, the cash value of the ROP disability policies was not a “right to receive…disability benefits” as that term is used in the Illinois statute.

The Court agreed with the trustee on the first point, finding that any death benefit was merely “incidental” to the policy.  As a result, the ROP disability policy was not life insurance.  Turning to the second point, the bankruptcy court first observed that exemption statutes, including the one in question, are to be liberally construed in favor of the debtor. If an exemption statute is capable of being read two ways, one that would favor the debtor and one that would not, it should be read to favor the debtor.

The Bowen court went on to rule that even a debtor’s contingent right to receive payment at some uncertain point in the future was also protected. For that reason, the debtor’s “right to receive” disability payments was not limited to benefits being currently received, but extended to include the accumulated cash value in each of the ROP disability policies.  The court went on to note that although the statute in question was silent on this issue, there is no distinction for purposes of the exemption statute, between public disability benefits, such as SSDI, and private disability such as the policies owned by Mr. Bowen.

Are ROP disability policies a wise purchase? Normally no.  Will a ROP disability policy keep the cash value away from the policy owner’s creditors? Yes, at least in Illinois.

Feder and Fujishima: When It Comes to Life Insurance and Taxes, Dot Your I’s and Cross Your T’s

January 21st, 2012

Two recent Tax Court decisions illustrate the danger (and cost) of not paying attention to the details when it comes to life insurance policies and taxes.  In each case the taxpayer failed to dot their i’s and cross their t’s, which created adverse estate tax consequences in one case and adverse income tax consequences in the other.

In the first case, Estate of Dwight T. Fujishima  et al v. Commissioner, TC Memo 2012-6, the decedent was the record owner of three life insurance policies.  The decedent was severely injured after which his mother cared for him in her home.  The decedent’s mother fed him, clothed him, and paid his bills with her own funds.  The Tax Court noted she did this gratuitously, without expectation of payment.

Following the decedent’s death on January 23, 2005 the decedent’s estate filed a Form 706 (United States Estate and Generation Skipping Transfer Tax Return).  On the return the estate listed two of the three policies as owned by the decedent (and therefore includible in the decedent’s estate for federal estate tax purposes), but listed a third policy issued by West Coast Life Insurance Co., with a death benefit of $1,037,973, as “disputed ownership” and did not include it in the value of the decedent’s estate.

At trial the decedent’s mother claimed that because she paid the premiums the policy was really owned by her.  The Tax Court flatly rejected this contention noting that the estate listed two other policies as owned by the decedent despite the fact that the decedent’s mother paid the premiums on those policies as well.  The Tax Court went on to state, “record ownership of the West Coast policy is the most persuasive evidence [of ownership of the policy]”.

Had Mr. Fujishima and his mother simply transferred ownership of the policy to Ms. Fujishima or to an Irrevocable Life Insurance Trust (“ILIT”), the value of the policy, $1,037,973, would NOT have been included in Mr. Fujishima’s estate for federal estate tax purposes.

In the second case, Yulia Feder v. Commissioner, TC Memo 2012-10, the petitioner purchased a Northwestern Mutual life insurance policy with a death benefit of $50,000.00 in 1982.  The policy required quarterly premiums of $73.00.  Petitioner paid the premiums as they became due until November 1987. Shortly afterwards, Ms. Feder sent Northwestern Mutual a letter requesting cancellation of the policy and asked that all future communications be sent to her new address.

Apparently Northwestern Mutual never received the letter.  Instead of cancelling the policy as requested, when Ms. Feder stopped making premium payments the automatic loan provision of the policy went into effect and Northwestern began advancing the premiums from cash value of the policy until the cash value was exhausted.  In 2007, when the cash value was exhausted, the policy lapsed for non-payment of premiums.  Northwestern used the policy’s cash value of $12,654 to pay off the premium loans of the same amount and issued Ms. Feder a 1099-R showing income of $5,625 (Cash value of $12,654 – premiums paid of $7,029 = taxable distribution of $5,625).

At trial the Tax Court noted that Ms. Feder failed to introduce a copy of the policy at issue.  Had she done so the court may have found that she complied with the notice provisions of the policy and given effect to the cancellation that Northwestern said it never received.

When it comes to life insurance and taxes,  pay attention to the details.  Life insurance is afforded generous income and estate tax treatment when handled in the right manner.  Further, a number of states protect the cash value  and  death benefits of life insurance policies from the claims of various creditors –if structured properly. In each case had those involved simply dotted their i’s and crossed their t’s, these issues would have never arisen.

-Scott Tippett

Designation of Client’s Living Trust as Beneficiary of Life Insurance Policy Forfeits Exemption

January 15th, 2012

In North Carolina a creditor cannot reach the cash value or death benefit of a debtor’s life insurance policy on his or her own life provided the debtor’s spouse, children, or both are the beneficiaries of the policy.  This right is guaranteed under Article X, Section 5 of the North Carolina Constitution and is also found in under the state’s statutory exemption scheme at N.C. Gen. Stat. Sec. 1C-1601(a)(6). Because North Carolina is an opt-out state for bankruptcy purposes, which means a debtor filing bankruptcy in North Carolina must use the exemptions granted under North Carolina law.

A recent bankruptcy case from the Eastern District of North Carolina, In re: Shawn Foster and Nancy Foster, United States Bankruptcy Court, Eastern District of North Carolina; Case No. 11-02711-8-JRL, illustrates the danger of a common estate planning technique of designating a client’s revocable trust as the beneficiary of the client’s life insurance policy.  In Foster the debtor owned several life insurance policies, each of which had accumulated some cash value.  Several years prior to filing bankruptcy Mr. and Mrs. Foster executed estate planning documents that included a revocable living trust (“RLT”).  The Fosters’ RLTs were designated as the beneficiary of various life insurance policies the Fosters owned.  As is common with many estate plans, the surviving spouse and children were the beneficiaries of the RLTs. Likewise as with many RLTs, the trust authorized the trustee to pay the Fosters’ burial expenses, death taxes, and unsecured creditors of their estates.

When they filed bankruptcy the Fosters listed the life insurance policies as exempt assets, relying on the provisions of the North Carolina Constitution and North Carolina’s exemption statutes.  The bankruptcy trustee objected to the exemption for the life insurance policies arguing that because the trusts, not the spouse and children, were the beneficiaries of the life insurance polices, the exemption did not apply even though the surviving spouse and children were the beneficiaries of the trust.  The bankruptcy trustee also argued that even if the court could look through the trust to see the real beneficiaries, i.e. the surviving spouse and children, because the trust permitted the trustee to pay the Fosters’ burial expenses, death taxes, and creditors of their estates, the life insurance policies were not for the sole benefit of the surviving spouse and children as required by North Carolina’s constitution.

The court ruled that naming the trust as a beneficiary instead of the spouse and children did not “categorically violate the terms of Article X, Section  5, so long as the trust complies with the purposes of the underlying exemption.” The court went on to hold, “where a trust authorizes payments to unsecured creditors of the decedent…such a trust exceeds the boundaries of “sole use and benefit” contemplated by” Article X, Section 5 of the North Carolina Constitution.” As a result, the Fosters lost approximately $32,000.00 to creditors in bankruptcy that they would otherwise been able to keep except for the faulty trust language.

In light of the Foster decision, advisors should review their current RLT provisions and modify the language to crave out life insurance from those assets that could be used to pay estate expenses.  Better yet,  create an Irrevocable Life Insurance Trust (“ILIT”), which is a type of trust specifically designed to hold life insurance policies.  Had the Fosters done so, they would not have lost $32,000.00 to their creditors.

-Scott Tippett