Back to Missives
George F. Bearup, J.D. Senior Legal Trust Advisor

15-Oct-18

Irrevocable Life Insurance Trusts

Take-Away: Despite the dramatic increase in the federal estate tax exemption amount it is probably premature to advise an individual to terminate an irrevocable life insurance trust (ILIT) as no longer necessary Tax laws continue to change and a trust provides far greater protection against judgment creditor claims that a trust beneficiary may face.

Background: For decades an ILIT was a staple of many estate plans for wealthier clients. The life insurance death benefit was paid to the irrevocable trust (ILIT), but the death benefit was not included in the insured’s taxable estate, as the insured retained no incidence of ownership over the life insurance policy owned by the trustee. The death benefit paid to the ILIT trustee, which was usually income tax-free, was then available to be loaned to the insured’s estate to enable the estate to timely pay any federal estate tax liability that was due at the insured’s death. As a result, most often an ILIT was viewed as a tool to provide immediate liquidity to pay federal estate taxes on the insured’s death. As such,  with the recent increase in an individual’s federal gift and estate tax exemption amount to $11.18 million, many insureds now consider the abandonment of their ILIT’s as unnecessary as they consider the federal estate tax to no longer be a concern. While that may be true, there are some  points to consider before a life insurance policy held in an ILIT is surrendered or permitted to lapse (usually caused simply by the non-payment of policy premiums) or a petition is filed with the probate court to terminate the ILIT as no longer necessary.

  • Estate Tax Exemption ‘Sunset:’ While we are currently in a period of large federal estate tax exemptions and free access to a deceased spouse’s unused federal estate tax exemption amount (portability), federal  estate taxes are not going away. First, the current federal estate tax exemption amount of $11.18 million per taxpayer is scheduled to drop back to the 2017 transfer tax exemption amount in 2026. While there may be no federal estate tax exposure during the next 6 years, the federal estate tax looms beginning in 2026 for many taxpayers when their federal estate tax exemption amount drops back to 2017 levels (while their taxable estate may have grown substantially in the intervening years.)
  • GST Tax Exemption Not ‘Portable:’ While the opportunity to claim and use a deceased spouse’s unused federal estate tax exemption (portability)  is critically important to avoid federal estate taxes, often overlooked is that the $11.18 million GST tax exemption is not available to be ported and used by a surviving spouse. Consequently, for those estate plans that contemplate a testamentary dynasty-type trust for the benefit of both children and grandchildren, or large outright bequests to grandchildren, the GST tax may still pose a problem, for which immediate liquidity through a life insurance death benefit will continue to be needed.
  • Creditor Protection: Most ILITs contain spendthrift limitations that are designed to protect the assets held in trust from claims asserted by the ILIT beneficiary’s judgment creditors, including the life insurance policy or its cash surrender value. If the ILIT is terminated and ownership of the life insurance policy is returned to the insured, or the insured’s spouse, or to other ILIT beneficiaries,  then the life insurance policy is ‘fair game’ to the policy owner’s judgment creditors. Nothing is more unsettling than the knowledge that the insured/owner’s judgment creditor will reap a financial benefit just as soon as the insured dies. While many states, like Michigan, have insurable interest statutes, most insurable interest statutes do not apply to a subsequent policy owner who takes title to the life insurance policy as a judgment creditor who executes on the judgment debtor’s life insurance policy. In contrast, if the life insurance policy is owned by the ILIT, then the insured has no ownership interest in the insurance policy, and thus a judgment creditor of the insured has no access to the insurance policy, or the policy’s death benefit on the insured’s death. Similarly, the creditors of the ILIT beneficiary cannot access the policy or the death benefit due to the spendthrift limitation usually found in the ILIT instrument.

Life Insurance and Creditors: Some will argue that an ILIT is not necessary to protect life insurance from creditor claims, as life insurance is an exempt asset from creditor claims under a long-standing Michigan statute. However, our courts have had differing conclusions when it comes to the protection that statute affords a life insurance policy, or its cash surrender value, or its death benefit, from judgment creditors.

  • Policy Protection Statute: Michigan’s 1956 statute that protects the cash surrender values and death benefits paid under a life insurance policy is found at MCL 500.2207(1) and (2). An abbreviated summary of parts of the statute follows:

(1);… and the proceeds of any policy of life or endowment insurance, which is payable to the wife, husband or children of the insured or to a trustee for the benefit of the wife, husband or children of the insured, including the cash value thereof, shall be exempt from execution or liability to any creditor of the insured.

(2)  If a policy of insurance, or a contract of annuity (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 such person, the lawful beneficiary or assignee thereof (other than the insured or the person so effecting such insurance, or his executors or administrators) shall be entitled to the proceeds and avails (including the cash value thereof) against the creditors and representatives of the insured.

  • [Not the easiest statute to read, sorry to say, and I even skipped the really wordy parts!] The effect of this Michigan statute [MCL 500.2207(1) and (2)] is that the proceeds of any life insurance policy payable to a wife, husband, or children of the insured, or to a trust for their benefit, including cash surrender values in those policies, is exempt from claims of the insured’s creditors.  That is what most people assume to be the case and why they often feel that they no longer need the protection provided by an ILIT- the policy itself is statutorily protected.
  • Courts: Despite the language of MCL 500.2207(1) and (2) courts decisions are not always consistent with regard to the scope and protection provided by the Michigan statute with regard to life insurance death benefits and any cash surrender values associated with such life insurance policies:
  • Public Policy Statement: “In regards to life insurance contracts, the general public policy is to protect the insurance taken out by a person for the maintenance and support of the person’s spouse and children from the claims of creditors after the person’s death” and that “evidence of the Legislature’s intent as to this public policy can be found in MCL 500.2207(1).” Baltrusalitis v. Cook, 174 Mich. App 180 (1988).
  • Protected Against Judgment Creditors:  In a 2017 decision the Court of Appeals found that the phrase ‘including the cash value thereof’ used in the statute meant that the cash value of a life insurance policy is considered part of its death benefit proceeds, and therefore the cash surrender value is exempt from garnishment by a judgment creditor. The Court found that the cash surrender value of the policy is necessary for policy to be preserved in order to pay the death benefit to the insured’s spouse or children at death. DC MEX Holdings, LLC v. Affordable Land, LLC (Docket 332489, 2017). A universal life insurance policy with a $73,000 cash value was thus not subject to garnishment by the insured’s judgment creditor.
  • Protected in Bankruptcy: The cash surrender value of a life insurance policy was protected in a Chapter 7 bankruptcy proceeding filed by the insured. In re Johnson, 274 B.R. 473 (2002).
  • Not Protected Against Judgment Creditors: Creditors of a deceased insured contested the life insurance proceeds that were paid to the decedent’s children. The policy ownership had been transferred from the insured to his children just before the insured committed suicide, and while he was insolvent. The designated beneficiary of the policy proceeds was the insured’s estate. The Court held that the policy was ‘property’ to which the insured’s creditors could look to satisfaction, finding the transfer of ownership of the policy to be a fraudulent transfer. But the Court limited the creditors’ rights to the recovery of the cash surrender value of the policy at the time of the transfer of the policy to the children, not the full death benefit. Equitable life Assur. Society v. Hitchcock, 270 Mich 72 (1935.) There may have been a different result if the designated beneficiary had been the insured’s spouse or children, rather than the insured’s estate.
  • No Exemption: In Schenck Boncher & Prasher v. Vanderlaan, 2003 Mich App LEXIS 2082 (2003), litigation where Northwestern Mutual refused to turn over the cash surrender values in  the life insurance policies since the owner did not formally surrender the policies or borrow against the policies, the Court, in compelling Northwestern to turn over the cash surrender values to the judgment creditor, observed in footnote one of its decision: “Life insurance proceeds are not exempt under any statute.” Of course, no mention was made by the Court of MCL 500.2207(1) and (2). This was the same result in Chrysler First Business Credit Corporation v. Rotenberg v. John Hancock Mutual Life Insurance Company, 789 F. Supp 870 (1992) where the garnishment of cash surrender values was permitted with, again, no mention of MCL 500.2207 (1) or (2).
  • Not Protected In Beneficiary’s Bankruptcy: Life insurance death benefits that are paid to the designated beneficiary will be included in the designated beneficiary’s bankruptcy estate if the death benefit is received within 180 days of the beneficiary’s filing for bankruptcy.  [11 U.S.C. 541(a)(5).]

Conclusion: With the change in the federal estate tax exemption amount, there may no longer be the immediate need for liquidity on the insured’s death provided by an ILIT. But there are other uses for life insurance beyond the payment of federal estate taxes, such as the payment of outstanding mortgages, the need to hire employees to replace the ‘key man’ who just died in a closely held business owned by the family, or to provide investible assets to generate income to support survivors. Not to be overlooked, either, is the advantage of having the life insurance policy owned by the ILIT trustee, with the death benefit paid to that trustee rather than outright to  individual beneficiaries to protect the death benefit from predators or creditors.