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.