Protection for Life Insurance and Annuities
Vern S. Lazaroff Attorney 570-686-2824
Unlike man, all assets are not created equal-at least from an asset protection planning standpoint. Instead, some assets are favored by statute so as to provide their owner (herein referred to generally as the “debtor) a greater level of protection from the claims of creditors than do other assets. Usually this heightened level of protection, offered under either the federal Bankruptcy Codel or a state’s alternate statutory exemption scheme2 is provided because the asset is considered essential for the debtor and the debtor’s family to maintain at least a minimum level of financial well-being and thereby avoid becoming a burden to the state. The extent of such creditor protection is, of course, tempered by society’s proper concern for the creditor’s competing rights to access the debtor’s property for the satisfaction of legitimate claims.
After the homestead exemption, retirement plans and individual retirement accounts (IRAs) are, perhaps, the most widely recognized and obvious examples of such favored assets since, like the homestead exemption, they help to ensure a debtor’s financial subsistence.2 Since commercial annuities often substitute for or supplement retirement plans and IRAs, it should come as no surprise that, to a greater or lesser extent, they too are generally exempted by statute from the claims of creditors. Life insurance is often similarly favored because it can serve a similar function with regard to the debtor’s spouse and dependents after the “bread winning” debtor’s death. (This discussion assumes that the purchase of the annuity or insurance contract does not constitute a fraudulent transfer under applicable federal or state law since, under that scenario, any protections that would otherwise be afforded are vitiated by the fact of the fraudulent transfer.)
Notwithstanding the foregoing, however, the exemptions afforded to life insurance and annuities are frequently more limited, more widely varied by jurisdiction, and seemingly more subject to the vagaries of the presiding courts than are the exemptions afforded to retirement plans and IRAs. For example, the Supreme Court has ruled, in Patterson v. Shumate,4 that retirement plans that are qualified under ERISA (29 U.S.C. section 1001, et seq.) are exempt from the claims of the employee’s creditors pursuant to 11 U.S.C. section 541(c)(2) as an enforceable spendthrift trust under “applicable non-bankruptcy law.” Furthermore, by association, IRAs established under Internal Revenue Code (IRC) Section 408 (and most likely Roth IRAs established under IRC Section 408A, as well), may be exempt under 11 U.S.C. section 522(d)(10)(E), which exempts “a payment under a stock bonus, pension, profit sharing, annuity, or similar plan or contract on account of illness, disability, death, age, or length of service.. ..” or under state exemption statutes. Seemingly, this reasoning would also extend to commercial annuity products, at least if held for true retirement planning purposes (rather than as they are sometimes marketed-as a tax-favored investment vehicle), but significant issues remain.
Notwithstanding these factors, the potential value of such exemptions to a debtor or potential debtor means that the exemptions warrant a careful and considered review by both asset protection planners and bankruptcy counsel acting in a pre-bankruptcy planning function. (Although foreign life insurance and annuity products may offer more protection from creditors than do their domestic counterparts, such products are beyond the scope of this article.)
Life Insurance
Consideration of the potential creditor protections afforded to life insurance contracts is complicated by the several capacities in which the debtor may have an interest in the policy. For example, the debtor can be the owner of the policy, the insured, or both the owner and the insured. Alternatively the debtor may be the beneficiary of the policy or the owner of a policy that names his or her estate as the beneficiary of the policy. To further complicate matters, since the exemptions afforded to life insurance are intended to further particular public policy goals (i.e., protecting the debtor’s dependents from financial destitution in the event of the debtor’s untimely demise), the relationships between the owner and the insured and between the owner and the beneficiary are often key to determining whether and to what extent the particular life insurance policy at issue may be protected from creditor claims. These additional permutations exponentially increase the complexity of determining whether the life insurance policy may be exempted in any particular circumstance.
The federal bankruptcy exemptions for life insurance policies owned by the debtor are found at 11 U.S.C. sections 522(d)(7) and (8), where their relative importance to the average person is, perhaps, evidenced by their placement between the exemptions for the debtor’s professional books and tools of the trade and the debtor’s professionally prescribed health aids. More specifically, the federal bankruptcy exemptions for life insurance shield unmatured policies owned by the debtor (other than a credit life insurance contract)6 and up to $8,6256 of the debtor’s aggregate interest in any accrued dividend or interest under, or loan value of, an unmatured life insurance contract, provided that the insured is either the debtor or an individual of whom the debtor is a dependent.? Since, however, federal bankruptcy law broadly defines a dependent as including a spouse, regardless of whether the debtor’s spouse is actually dependent on the debtor, the exemption will apply without further inquiry so long as either the debtor or the debtor’s spouse is the insuredY
The effect of the foregoing exemption is to protect the actual insurance element of the policy and little else, since only a minimal portion of the cash surrender value of the policy is afforded any exemption. While the exemption of an unmatured life insurance contract without the exemption of the cash surrender value may prove invaluable in certain limited circumstances (for example, if the debtor has become uninsurable since the life insurance policy was originally purchased), it obviously does not provide significant opportunities for asset protection or pre-bankruptcy planning for the insured.
That the primary intent of the Bankruptcy Code as it relates to the exemption of life insurance is to protect a dependent’s interest in the life insurance policy, rather than the owner’s own interest, is further supported by 11 U.S.C. section 522(d)(11)(C). That section concerns the debtor as the beneficiary of the policy (rather than as the owner of the policy) and exempts the debtor’s entitlement to the proceeds of a life insurance contract, without any specific dollar limitation, to the extent that such proceeds are “reasonably necessary” for the support of the debtor and any dependent of the debtor. For the exemption to apply the debtor has to have been a dependent of the insured at the time of the insured’s death.
Since the federal exemption scheme for life insurance that is owned by the debtor is so parsimonious, if an exemption under an alternative state scheme is provided, it should be carefully considered. Following the model of the federal exemption scheme, some states provide very limited exemptions for the cash surrender value of life insurance. For example, South Carolina offers only a $4,000 exemption for the cash surrender value of life insurance (again, provided that the insured is either the debtor or an individual on whom the debtor is dependent).9 Proceeds payable to the insured’s spouse, children, or dependents are, however, generally fully exempt from the creditors of the insured.-9 Wisconsin also exempts only $4,000 (provided that the insured is either the debtor, a dependent of the debtor, or an individual on whom the debtor is dependent).1 If the debtor is the beneficiary of the life insurance policy, however, and provided that the debtor was dependent on the insured, Wisconsin law exempts payments to the extent reasonably necessary for the support of the debtor and the debtor’s dependents.
Other states, however, have exemption schemes that provide for far greater protection of the cash surrender value of life insurance policies than does the federal exemption scheme. For example, in keeping with its generally pro-debtor stance, Florida specifically exempts the entire cash surrender value of life insurance policies from the reach of creditors13 and the entire death benefit from the creditors of the insured.4 Hawaii similarly specifically exempts the entire death benefit and cash surrender value of life insurance policies from the reach of creditors of the owner of the life insurance policy, provided, however, that the policy is payable to a spouse of the insured, or to a child, parent, or other person dependent on the insured, except as to premiums paid in fraud of creditors.–‘ Louisiana also specifically exempts the entire proceeds (including the full cash surrender value) of life insurance policies from the reach of creditors. The exemption is, however; limited to $35,000 of the cash surrender value if the life
insurance policy was issued within nine months of a bankruptcy Exhibit 1
contains a state-by-state tabulation of the exemptions.
New York’s scheme for the exemption of life insurance is worth noting because it clearly distinguishes between the several permutations which can result depending on whether the debtor is the owner of the policy (referred to under the New York statute as the person “effecting the policy,” and need not be the
person who actually purchased the policy), the insured, the beneficiary, or some combination thereof. More specifically, the New York State exemption scheme for life insurance provides that:
- If the owner of a life insurance policy insures his or her own life for the benefit of another (i.e., a beneficiary other than the owner’s estate), that other person shall be entitled to the proceeds and avails of the policy as against the creditors of the owner. (In other words, the beneficiary’s interest in a life insurance policy owned by another is protected from claims of the policy owner’s creditors, notwithstanding the fact that a power to change the beneficiaries of the life insurance policy has been reserved.)
- If the owner of a life insurance policy insures the life of another for the owner’s own benefit, the owner is entitled to the proceeds and avails of the policy as against the creditors of the insured. (In other words, the interest of an owner of life insurance in the policy is protected from the creditors of the insured).
- If the owner of a life insurance policy insures the life of his or her spouse for the owner’s own benefit, the owner is also entitled to the proceeds and avails of the policy as against his or her own creditors. (In other words, the interest of an owner/beneficiary of life insurance in the policy is protected from the owner/beneficiary’s own creditors if the insured is the owner’s spouse).
- If the owner of a life insurance policy insures the life of another person for the benefit of a third party, the third party is entitled to the proceeds and avails of the policy as against the creditors of both the owner and the insured. (In other words, the beneficiary’s interest in a life insurance policy is protected from claims of the creditors of both the owner of the policy and the insured).
- The owner of a life insurance policy, regardless of the identity of the insured, is entitled to accelerated payment of the death benefit or accelerated payment of a special surrender value permitted under such policy as against the creditors of the owner. (In other words, the owner’s interest in the cash surrender value of a life insurance policy is protected from claims of the owner’s own creditors).
Even the extensive New York exemption statute does not, however, cover all possible permutations. For example, in Dellefield v. Block,n a husband took out two paid-up life insurance policies on his own life with his wife as beneficiary.
Thereafter, both the husband and his wife became debtors of the same judgment creditor. Since the law in effect at that time provided that a life insurance policy insuring the owner’s own life for the benefit of another is protected from the owner’s creditors, but did not then expressly provide that the same life insurance policy is protected from the debtor beneficiary’s own creditors, the novel issue arose as to whether a joint judgment creditor could enforce its judgment against the life insurance policies. Based on a liberal interpretation of legislative intent to the effect that the statutory exemption of the debtor/owner’s interest was intended to protect all cases in which a person invested his or her own money to insure his or her own life for the benefit of another, the Dellefield court held that the life insurance policies could not be reached by the parties’ joint judgment creditor.
Other issues, of course, exist as well. For example, in the New York statute, the phrase “proceeds and avails” is defined to include “. .. death benefits, cash surrender and loan values, premiums waived, and dividends, whether used in reduction of premiums or in whatever manner used or applied, except where the
debtor has, after issuance of the policy, elected to receive the dividends in cash.“20 Unlike New York, however, not all state statutes expressly define which incidents of value of a life insurance policy (i.e., specifically the debtor’s ability to shield the cash surrender value of a life insurance policy versus the debtor’s entitlement to the proceeds of a matured policy on the life of another) are
covered by the exemption scheme at issue. Therefore, the issue may arise as to whether and to what extent the cash surrender value may be exempted when the statute refers only to “monies paid out of a life insurance policy” or similarly ambiguous language. In this regard, in In re Worthington, a bankruptcy court, interpreting a Kentucky exemption statute that provided simply that “[a]ny money or other benefit to be paid or rendered by any assessment or cooperative life or casualty insurance company is exempt from execution or other process’ determined that an unlimited exemption was provided for the cash surrender value of life insurance policies. The Worthington court stated that:
This statute does not restrict ”any money or other benefit to be paid … ” as exemptible only upon death but rather it denotes an exemption extending to the debtor on any monetary value or benefits accruing by virtue of ownership. Thus, the loan values or the cash surrender values by virtue of the enactment of the Kentucky Legislature have been deemed exempt since the term ”any money … to be paid” is not restricted as to time of election and offers no alternative but to include the cash surrender value within its definition…. The Kentucky legislature has, after due deliberation and in its wisdom, determined that any monetary value in life insurance policies owned by its citizens is exempt without monetary limitation. . .
Similarly, it has been held that when reference is made to the “proceeds and avails” of a life insurance policy, such reference comprehends the protection of cash surrender values and other values built up during the life of the policy as well as the protection of its death benefit, even if not expressly so provided by statute.
Notwithstanding the express unlimited exemption that exists in some states, however, the actual use of such an exemption may have the unintended effect of reducing the debtor’s general exemption for personal property.
The fact that the unlimited exemption for the cash surrender value of life insurance that exists in some states can be abused by dishonest debtors has been considered by the bankruptcy court and appropriately disregarded as a basis for judicially recasting the import of the exemption statutes. For example, in In re White, the bankruptcy trustee, objecting to the debtor’s argument that the cash surrender value of his life insurance policy should be exempted as part of the unlimited exemption for the “proceeds and avails” of life insurance referred to under West Virginia’s exemption statute, poignantly argued that to hold the cash surrender value exempt would:
… provide a debtor with an avenue for depositing his funds, in unlimited amounts, in a species of property which would place it beyond the reach of his creditors, but not beyond his own reach after his discharge in bankruptcy.
Similarly in In re Beckman,26 the bankruptcy trustee argued that to hold the cash surrender value of the debtor’s life insurance policy exempt would be to make an insurance policy “a refuge for fraud.” In each case, however, the bankruptcy court responded by stating that such an argument overlooks the fact that the exemption statute expressly provides that premiums paid in fraud of creditors would, nevertheless, inure to the benefit of creditors. In any event, “. .. [i]f abuses to enacted exemptions are deemed to exist, the remedy is by other than judicial legislation.” Such reasoning would seem to exempt even single premium policies purchased as a safe harbor for otherwise non-exempt funds; provided, however, that it cannot be proven that the single premium payment constituted a fraudulent transfer.
Therefore, for the residents of certain states at least, valuable asset protection and pre-bankruptcy planning opportunities exist using life insurance policies; provided, as always, that the conversion of non-exempt assets into exempt assets (be they cash surrender value life insurance policies or otherwise) is not made with the intent to hinder, delay, or defraud creditors. (The reorganization of a debtor’s holdings into exempt assets prior to bankruptcy for the purpose of shielding such assets from creditors is generally held to be acceptable pre-bankruptcy planning rather than transfers fraudulent as to creditors.)
Notwithstanding the foregoing, however, the greatest protection for life insurance exists irrespective of the exemptions afforded by applicable law, relying instead on traditional (and not so traditional) estate planning techniques. For example, the owner of the policy (the settlor) may transfer his or her policies to an irrevocable spendthrift trust (or even better, the settlor can create an irrevocable spendthrift trust to acquire the life insurance policy in the first instance), thereby protecting the value of the life insurance policy not only from creditors (both those of the settlor and those of the trust beneficiaries, and regardless of their relationship to each other or to the insured), but from taxation in the settlor’s estate as well under IRC Section 2042. IRC Section 2035(a)(2), however, includes in the settlor’s gross estate the proceeds of any life insurance policies that were transferred within the three-year period ending on the date of the settlor’s death. At the same time, there is little doubt that section 541(c)(2) of the Bankruptcy Code would also serve to exclude the trust property from the settlor/debtor’s bankruptcy estate as a spendthrift trust enforceable under applicable non-bankruptcy law.
Furthermore, the transfer of life insurance policies to an irrevocable life insurance trust need not place the potential benefit of the cash surrender value of such policies beyond the settlor’s reach. A married settlor can name his or her spouse as a discretionary beneficiary of the trust and, therefore, to the extent that the trustees are amenable to making a distribution of property out of the trust to the spouse of the settlor, the settlor can attain an indirect benefit from the trust property for so long as the spouse survives. If, however, the settlor is unmarried, or if the settlor is concerned with the possibility that his or her spouse may be the
first of the pair to die, the settlor can establish the trust under the laws of Alaska or Delaware (or, alternatively, under the law of certain, select, off-shore jurisdictions such as the Cook Islands), since the law of each of those jurisdictions provides that the owner of property (including life insurance policies) can create a discretionary trust for his or her own benefit without leaving the transferred property subject to the claims of his or her creditors. (There may, however, be a risk of creditor attachment in such a self-settled trust if the assets are within the U.S. court’s jurisdiction.) Through the interaction between Chapters 11, 12, and 13 of the IRC and local law governing creditors’ rights, the death benefit of the life insurance policy will most likely be excluded from the settlor’s gross estate for transfer tax purposes, notwithstanding the fact that the settlor can benefit from the cash surrender value of the policy during the settlor’s
Annuities
The federal bankruptcy exemption for annuity payments is found at 11 U.S.C. section 522(d)(10)(E). Like the federal exemption for the cash surrender value of life insurance policies, the exemption for the right to receive an annuity is not overly generous and does not lend itself to asset protection or pre-bankruptcy planning. Specifically, the federal exemption for the right to receive an annuity provides that payments may be exempted only if payable by reason of “… illness, disability, death, age, or length of service … ” and even then, only to the extent “reasonably necessary” for the support of the debtor and any dependent of the debtor. Therefore, planning opportunities under the federal exemption for the right to receive an annuity are limited because of the requirement that the annuitant be ill, aged, dead, or have performed a certain length of service. Even if the debtor was the beneficiary of such a fortuitously placed annuity, the exemption of the payments to be received by the debtor would most likely be subject to litigation to resolve whether they are in an amount required under the exemption’s “reasonably necessary’ standard. While the “reasonably necessary” standard is sensitive to the debtor’s particular situation, the courts have generally proven extremely spare in applying the exemption under such standard. In Warren v. Taff, the court stated that “[t]he reasonably necessary standard requires that the court take into account other income and exempt property of the debtor, present and anticipated … the appropriate amount to be set aside for the debtor ought to be sufficient to sustain basic needs, not related to [the debtor’s] former status in society or the lifestyle to which [the debtor] is accustomed. …” In In re Hunsucker, for example, a 57-year-old teacher’s aide was allowed to exempt a commercial annuity when her anticipated teacher’s retirement benefits were only $50 per month.
State law exemptions for the right to receive an annuity, on the other hand, vary greatly from one state to another, but generally align with the state’s exemption for the cash value of life insurance policies. Florida, for example, exempts the proceeds of annuity contracts without limitation. In contrast to Florida, Pennsylvania generally permits the exemption of only $100 per month of the
proceeds of an annuity,30 and North Carolina does not appear to permit the exemption of the proceeds of an annuity to any extent. Still other states, such as Missouri, follow the federal scheme and exempt only so much of an annuity as may be “reasonably necessary” for the support of the debtor and the debtor’s dependents. New York’s exemption for annuities at first seems to follow that of the Florida model in that it initially provides that “[t]he benefits, rights, privileges and options which, under any annuity contract are due or prospectively due the annuitant, who paid the consideration for the annuity contract, shall not be subject to execution.“33 Unfortunately the New York exemption statute goes on to provide that:
… the court may order the annuitant to pay to a judgment creditor or apply on the judgment in installments, a portion of such benefits that appears just and proper to the court, with due regard for the reasonable requirements of the judgment debtor and his family, if dependent upon him…
Moreover, the New York exemption for the right to receive an annuity is further qualified by New York Debtor and Creditor Law § 283(1), which generally provides that the exemption for annuity contracts initially purchased by the debtor within six months of the debtor’s bankruptcy filing are capped at $5,000, irrespective of the reasonable income requirements of the debtor and his or her dependents. The intent of this latter section of the statute, according to the bankruptcy court in In re Moore,4 is to “. .. limit the debtor’s ability to deliberately ‘load up’ on exempt property” Exhibit 1 contains a state-by-state tabulation of the exemptions.
In states where the exemption for the right to receive an annuity is unlimited, litigation has centered around the issue of whether the interest held by the debtor is, in fact, an annuity under the exemption statute at hand. In Florida, at least, the courts have broadly construed the scope of the term to maintain the breadth of the exemption. For example, in In re McColIam,3F the court held that under the Florida exemption scheme, an annuity received by the debtor pursuant to a structured settlement of her deceased father’s wrongful death claim was exempt as an annuity rather than non-exempt as the equivalent of an account receivable by the debtor. The court was expressly cognizant of the fact that a literal interpretation of the exemption statute would permit the debtor to conceal her award as an asset, but stated that “. .. had the legislature intended to limit the exemption to particular annuity contracts, it would have included such restrictive language when the statute was amended to include annuity contracts.” In contrast, however, the bankruptcy court in In re Pizzi held that the annual payment of a debtor’s lottery winnings through a commercial annuity purchased by the state for the purpose of ensuring payment of the debtor’s lottery winnings was not exempt from the bankruptcy estate as an annuity under Florida law. Seemingly the Pizzi court allowed form to prevail over substance since the defining feature of the case to the Pizzi court was the fact that the state was named the beneficiary of the annuity contract for the purpose of ensuring the payment of the lottery winnings to the debtor over time rather than the debtor
having been named individually on the annuity contract. Interestingly the court noted, in dicta, that under Florida law “… the purpose and nature of an annuity is irrelevant if the contract fits within the broad definition of an annuity contract,” and then went on to state that had the state named the debtor as the beneficiary of the annuity contract, the payments would have fallen within the purview of the Florida exemption statute and been exempt. The court in Solomon v. Guardian Life Insurance Co. of Arnerica, declined to follow the bankruptcy court’s reasoning of In re PizzO and held that “. .. not only annuities in the nature of retirement instruments can be exempted under § 222.14 but also debts structured as annuities.” Holding that the debtor could not exempt her stream of payments under an equitable distribution arrangement, the court in In re Conner stated, “[t]he critical distinction between this case and the cases cited by the parties is that the contract in those cases is identified as an annuity within the four corners of the contract.”
In re Mart took the broad definition of an annuity under Florida’s exemption scheme one step further. Here, the debtor’s daughter-in-law established an irrevocable trust for the benefit of seven children, nieces and nephews of the debtor, and minimally funded the trust with $2,000. The debtor’s daughter was appointed as trustee of the trust. The day after the trust was created, the debtor and his spouse entered into an annuity agreement with their daughter as trustee. In furtherance of the annuity agreement, the debtor and his spouse transferred $350,000 to the trust in exchange for a return stream of annuity payments of $3,000 per month. Thirteen months later, the debtor filed bankruptcy and claimed that the annuity was exempt under Fla. Stat. § 222.14. Substantively identical to the arguments made with regard to the unlimited exemption of the cash surrender value of life insurance by the creditors in In re White,ithe objecting creditors argued that:
… if (the debtor’s income stream from the transfer of this property is an Annuity, any debtor can go to his cousin and give him all of his property in return for a promised stream of income. That debtor need only pull out his big rubber stamp with the word Annuity on it and label the agreement from his cousin to pay the money.
Notwithstanding the piquancy of this argument, and like its predecessor in In re White, the bankruptcy court in In re Mart dismissed this argument to find in favor of the debtor. In re Mart, however, gave more of an explanation of its reasoning than did In re White, stating that:
I agree that this statutory exemption, perhaps like all exemptions, invites abuse. I also agree that the debtor’s relationship with the .. . trustee, her evident willingness to accept her father’s proposals, and the fact that this is a completely private arrangement are grounds for careful scrutiny…. I reject the argument and the objections, however, because, (1) . . . the statutory exemption is not restricted to annuities provided by completely unrelated, public entities, and (2) I find no intent to defraud creditors in this debtor’s conversion of his non-exempt assets to exempt assets through the establishment of this annuity contract.
In contrast, the court in In re Gefen,41 determined that the debtor’s conversion of a non-exempt individual retirement account to an annuity with an intent to defraud creditors was a fraudulent transfer voidable under the Florida statute.
Like life insurance, the exemption for the right to receive an annuity is provided under applicable federal and state law for a particular purpose; to allow persons to ensure their retirement savings through vehicles peculiarly structured to provide an income stream during retirement (i.e., the minimum distributions required for ERISA qualified plans and IRAs, or the delayed lifetime income stream provided by the traditional annuity). In the past, annuity contracts were generally held by government workers and the employees of not-for-profit institutions (for example, the Teachers’ Insurance and Annuity Association (TIAA-CREF), which is one of the country’s largest providers of annuities) for whom other retirement plans were unavailable, as well as by those retirees who chose to receive distributions from other retirement plans in the form of an annuity rather than via a “roll-over” into an IRA. More recently however, commercial annuities (such as variable annuity contracts) are being purchased by individuals purely as a tax-favored investment vehicle without any view towards the annuity’s traditional use for retirement savings. Such products were most likely never intended to be exempt and a colorable argument can be made by creditors to the effect that such products should not be held exempt, notwithstanding that they are, in fact, annuities.
A similar issue arises when a debtor converts non-exempt assets into an exempt annuity shortly prior to bankruptcy since the purpose of such conversion is likely less to provide for retirement needs than to “avoid” creditors (although not necessarily with any noisome connotation). In In re Johnson, the debtor, a physician, personally guaranteed $19 million of the obligations of a corporation of which he was a 2% share-holder. Following the corporation’s default on the obligations, judgments were entered against the debtor on his guarantees. Thereafter, on the advice of counsel, and in furtherance of what the bankruptcy court termed “bankruptcy estate planning with a vengeance,” the debtor liquidated most of his non-exempt assets and purchased, inter alia, an annuity with a face value approximating $250,000. In finding that the debtor’s specific intent to put all of his rather substantial personal wealth beyond the reach of his business creditors pursuant to the Minnesota exemption scheme did not void the exemption of the debtor’s annuity interests, the Johnson court recognized that “[t]he gut level difficulty with the case at bar stems both from the massive amounts of money involved and from debtor’s status as an affluent physician enjoying sound professional status, excellent current income, and unlimited future earning potential.” Nevertheless, the Johnson court denied the bankruptcy trustee’s motion to deny the debtor a discharge. According to the court:
… what is truly blame-worthy about a debtor’s intentional resort to ”bankruptcy estate planning,” standing alone? From a purely legal perspective, and only in the context of an objection to discharge, the answer is ”nothing”-at least where the debtor has not perpetrated actual fraud on a creditor, creditors, receiver, trustee, or other party in
interest during the process…. The case law in this Circuit has long recognized the principle noted in the legislative history-that the pre-petition conversion of non-exempt assets to an exempt form is not fraudulent per se. . .
Therefore, annuities need not necessarily further retirement purposes to fall within the current exemption schemes, although obviously a more moving argument can be made for the exemption of such an asset where it does so.
Conclusion
Even in those states that have generous exemptions for the cash surrender value of life insurance or the right to receive an annuity, the efficacy of any asset protection planning and pre-bankruptcy planning will likely turn on the court’s perception of the debtor’s purpose in holding the life insurance or annuity contract, even if the acquisition of such an asset did not constitute a fraudulent conveyance. While the law governing the extent to which pre-bankruptcy or asset protection planning is a permissible exercise of simple prudence is outside the scope of this article, consideration should be given to the gulf between the typical no-consideration transfer and planning for the conversion of non-exempt assets into cash surrender value life insurance and annuities. Since there are numerous reasons for effecting the latter that have nothing to do with avoiding an individual’s creditors, the finding of an intent to hinder, delay or defeat creditors is probably unlikely except in the most egregious transactions. Moreover, even where the ultimate resolution of whether a life insurance policy or annuity
contract remains in doubt, such conversions may in the end, provide a debtor with the additional leverage he or she needs to force a settlement with his or her creditors at something less than the full value of their claims.
Vern S. Lazaroff Attorney 570-686-2824