On August 14, 2014, Michael and Laura Gutke filed for Chapter 7 bankruptcy. This was not the end to their problems, for just a few weeks later, on September 15, Michael's mother passed away.
Soon thereafter, the Gutkes learned that Michael's mother had a life insurance policy, wherein Michael was named as a beneficiary -- leaving him a whopping $4,250. The Gutkes didn't try to hide this, but instead did the right thing and told their bankruptcy counsel, who then advised the Trustee and filed an amended schedules B and C to disclose the life insurance to the Bankruptcy Court and also claim it as exempt under Idaho law.
The Trustee, however, objected to the Gutkes' claim of exemption, which lead to the Bankruptcy Court's Opinion which I shall now relate.
When a Chapter 7 bankruptcy petition is filed, the totality of the debtor's property -- both legal and equitable in nature -- immediately passes from the debtor and into the instantly-created "debtor's estate" under Bankruptcy Code section 541(a)(1).
But additional property can come into the debtor's estate as well, such as, under 541(a)(5)(c), a debtor's right to life insurance proceeds to which the debtor becomes entitled within the next 180 days after the bankruptcy petition is filed.
However, under section 522, a debtor may seek to exempt certain property from the bankruptcy estate, either under federal law (if the state where the debtor is a resident at the time of the filing allows it), or under state law. Idaho, where the Gutkes lived, have "opted out" of the federal exemptions, and thus only Idaho exemption law applies.
Thus, the Bankruptcy Court undertook and examination of Idaho law as it relates to whether a beneficiary's interest in a life insurance policy is exempt.
The Bankruptcy Court first noted that, as in nearly all states, Idaho requires that its exemption statutes be liberally construed in favor of the debtor, i.e., if the statute is less than clear, the debtor gets the benefit of the doubt. This general rule become important in this case because of the somewhat confused drafting of the Idaho life insurance exemption statute, Idaho Code sec. 41-1833(1), which provides:
If a policy of insurance, whether heretofore or hereafter issued, is effected by any person on his own life, or on another life, in favor of a person other than himself, or, except in cases of transfer with intent to defraud creditors, if a policy of life insurance is assigned or in any way made payable to any such person, the lawful beneficiary or assignee thereof, other than the insured or the person so effecting such insurance or executors or administrators of such insured or the person so effecting such insurance, shall be entitled to its proceeds and avails against the creditors and representatives of the insured and of the person effecting the same, whether or not the right to change the beneficiary is reserved or permitted, and whether or not the policy is made payable to the person whose life is insured if the beneficiary or assignee shall predecease such person, and such proceeds and avails shall be exempt from all liability for any debt of the beneficiary existing at the time the policy is made available for his use: provided, that subject to the statute of limitations, the amount of any premiums for such insurance paid with intent to defraud creditors, with interest thereon, shall inure to their benefit from the proceeds of the policy; but the insurer issuing the policy shall be discharged of all liability thereon by payment of its proceeds in accordance with its terms, unless, before such payment, the insurer shall have received written notice at its home office, by or in behalf of a creditor, of a claim to recover for transfer made or premiums paid with intent to defraud creditors, with specification of the amount claimed.
Good luck figuring that out on the first try, or the second, or maybe even the third. Even the learned Judge who deals with exemptions on a daily basis was frustrated by the almost cryptic wording of this statute:
It is fair to observe that this statute, originally enacted in 1961, and amended only once since, is not a model of clarity. Indeed, this provision seemingly attempts to make up through confusion for what it lacks in punctuation. Moreover, its legislative history provides no insight as to its proper interpretation, and the Court and parties have been unable to uncover any reported decisions construing this statute rendered during the fifty-four years since its enactment. Acknowledging their frustration, when Trustee and Debtors' counsel appeared before the Court, they both candidly admitted that they could not fully understand this statute. It is against this backdrop that the Court must attempt to parse the statutory language and to decide whether the insurance proceeds paid to Michael are exempt.
Nonetheless, the Court was able to parse the statute to conclude that the life insurance proceeds were -- isolating the key phrase in the statute -- "exempt from all liability for any debt of the beneficiary existing at the time the policy is made available for his use". In English, the money that Michael received from his mother's life insurance policy was exempt as to Michael.
The Court also looked to identical in Delaware, Kentucky and Vermont, and the few cases decided under those statutes, to bolster this conclusion, and as well as a "nearly identical" statute in Washington state where a court reached the same conclusion after liberally construing the statute in favor of the debtor.
Thus, the Court held that the life insurance proceeds payable to Michael were exempt under Idaho law.
ANALYSIS
Possibly nowhere is the law relating to exemptions more confusing than that relating to life insurance proceeds. There are many reasons for this, not the least of which is that the statutes are antiquated, verbose, and utterly fail to clearly set out just what claims and whose creditors the exemption protects against. Some state protect life insurance proceeds entirely, some partially, some against creditors of the owner, some against creditors of the beneficiary, some none at all, some with dollar limits, and some we really don't know exactly what they protect if anything.
Life insurance exemption statutes also do not typically take into account the workings of modern insurance policies, thus leaving up in the air the issues of what happens to the cash value of policies. Happily, that was not an issue in this case.
Even more happily, this case did not involve any conflict issues since there is hardly any uniformity amongst the states regarding exemptions for life insurance. The various state laws on life insurance exemptions are about as diverse as one can find. While the law that would usually apply will be that (as here) of the debtor's residence, that's not necessarily always the case.
The varying state laws create an awful nightmare for life insurance planners, since they can't predict where the owner of the policy will be with he or she passes, or where the beneficiaries will be living at that time. About the best that planners can do is to plan for the here and now under the laws of the state where the owner is resident, and hope for the best.
All of which brings me to the point of this article: The only way that a planner can bring any certainty to the issue of whether life insurance will be protected from the creditors of the owner or the creditors of the beneficiaries is to have the life insurance owned by an appropriate trust.
As to the owner, having the life insurance owned by an irrevocable trust keeps the life insurance proceeds out of the owner's estate for creditor purposes. Likewise, having the life insurance proceeds paid to a discretionary spendthrift trust instead of to beneficiaries directly, keeps those proceeds from becoming available to the beneficiaries' creditors.
Had Michael's mother directed the life insurance proceeds paid to a discretionary spendthrift trust to Michael, then those proceeds would not have been available to Michael's creditors or the Trustee of his bankruptcy estate. This whole futzing around with whether or not an almost indecipherable exemption statute applies would have been avoided, and that positive result for Michael would have been the result in all 50 states.
This is not to suggest that trusts for life insurance are any panacea, and the selection of the type of trust and its drafting are critical -- for instance, a revocable "living trust" will not protect life insurance proceeds from the creditors of the owner in many states. Trusts are sometimes expensive to draft correctly, and create difficulties and expenses of their own.
But what I am suggesting is that where life insurance is involved, and creditors of the owner or a beneficiary are a reasonable possibility, then at the very least the use of a trust should be considered to avoid the myriad problems that arise with life insurance exemptions.
You can trust me on this one.
CITE AS
In re Gutke, Bk.D.Idaho No. 14-40963-JDP (April 2, 2015). Full opinion at http://goo.gl/XZNZCX
This article at http://onforb.es/1D7FsJh and http://goo.gl/JJsmMJ
