The vulnerability of life insurance benefits to the Internal Revenue Service depends on the nature of the debt, and who holds it. Generally, the law exempts life insurance death benefits from attachment by the creditors of the deceased. If someone died owing money to the IRS, they IRS cannot intercept the death benefit on a life insurance policy to pay the debt. However, if the beneficiary is the party that owes the IRS, then the death benefit becomes an asset of the debtor and is subject to collection
Life Insurance and Creditors Overview
Life insurance is a contract in which a policy owner contributes a sum of money, called premium, to an insurance company in exchange for a promise to pay a larger sum of money in the event of the death of the insured. Until that point, the premium is not held in a segregated account, but is mingled in the general account of the insurance company. This is an important point to understand - because the assets are not segregated, they are, in fact, the insurance company's assets, and not the insured's. This provides a layer of creditor protection in most states, and restricts the ability of the IRS to seize the cash value of life insurance policies.
Contract Versus Probate Law
Probate is the legal process of the orderly unwinding of a deceased individual's affairs, ensuring that creditors are satisfied as much as possible. Assets are then distributed among the decedent's heirs according to a valid will, or under state intestate laws if there is no will that governs their distribution. Unless the policy owner named his own estate as the beneficiary of a life insurance policy, life insurance death benefits are not subject to probate. Instead, the death benefit bypasses probate and goes directly to the beneficiary via contract law. The claims of creditors against the deceased are not considered in this process - the full death benefit passes directly to the beneficiary.
Liability of the Beneficiary
Normally, the beneficiary has no liability for the debts of the deceased. One exception, however, occurs when a surviving spouse has cosigned on a mortgage or other outstanding debt. In this case, the life insurance proceeds flow directly to the surviving spouse as a beneficiary, but the beneficiary herself is still subject to the debt. In the case of tax debt, a surviving spouse may still be liable to the IRS for any debts arising from a joint return, unless she files for and obtains innocent spouse relief.
If the claims of creditors against a beneficiary are a serious concern, the policy owner has a couple of options: He can direct the insurance company to pay the death benefit in a series of installments, rather than as a single lump sum. Until the beneficiary actually receives the funds, creditors cannot seize them. You can also name a trust as the life insurance beneficiary, and your intended ultimate beneficiary as the beneficiary of the life insurance trust. The life insurance company sends the money to the trust, but the beneficiary does not control the trust assets. Instead, an independent trustee controls the money, protecting it against a claim by the IRS or any other creditor against the beneficiary of the trust.
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