Insurance Trust To Protect Death Benefits From Surviving Spouse'...

Several months ago a husband and wife consulted with me about filing Chapter 13 bankruptcy. The husband suffered from a terminal disease. He owned an insurance policy on his own life with a $250,000 death benefit. The beneficiary was his wife. Both spouses worked, but the husband was the primary income earner. After his death, the wife would need to file Chapter 13 bankruptcy to save their home including her stripping off a second mortgage and reducing credit card debt.

The clients were concerned about the impact of the wife’s receipt of the $250,000 death benefit on the planned Chapter 13 case. If the wife filed Chapter 13 bankruptcy with $250,000 cash in her bank after the husbands death the wife’s Chapter 13 bankruptcy would have to pay back all unsecured debt including most of the stripped off mortgage.

I drafted an irrevocable life insurance trust to own the husband’s insurance policy. The wife’s sister was named as trustee. The trust provided that in the event of the husband’s death the trusee would administer the death benefits for the surviving wife’s  health, education, maintenance, and welfare. The trustee (sister) had the sole discretion to distribute money to or for the benefit of the wife provided that no distributions could be made for the benefit of the wife’s creditors. The trust had a spendthrift provision.

The husband died, and the wife filed Chapter 13 bankruptcy in Tampa through another attorney. In Chapter 13 the debtor is required to pay to the unsecured creditors all of his disposable income.  The wife’s interest in the insurance trust is not part of the bankruptcy estate because it is a spendthrift trust. There is no fraudulent transfer issue because the wife did not convey anything to the trust; her deceased husband set up the trust.  If the wife’s income for bankruptcy purposes includes the amount of distributions she receives from the insurance trust she will have to have higher plan payments and pay a higher percentage of unsecured debt.

The bankruptcy attorney called to discuss what effect, if any, trust distributions would have on the wife’s required plan payments. Technically, if the sister distributes trust money to pay the wife’s normal living expenses the wife could not claim the same expenses for purposes of calculating her disposable income, and her plan payments would increase. If the trustee distributed funds to pay extra or luxury expenses for the wife, such as vacations or new purchases, the distributions should not affect disposable income.

As a practical matter, it would be very difficult to track and account for trust distributions during the Chapter 13 case to determine if the trustee is supplementing expenses that the wife claimed on her expense schedules. The safest think would be for the trustee/sister not to make any distributions to the wife, except emergencies, at least until the Chapter 13 plan is confirmed.