Society has long recognized the individual’s obligations to provide for his or her family. Insurance was developed to protect against contingencies that might destroy or diminish one’s ability to meet those obligations.
To aid this objective, every state and the federal government sets limits to the rights of creditors to insurance where the debtor has not sought to use this approach merely to avoid payment of debts. Because insurance, particularly life insurance, has expanded beyond its social origins to become an important planning tool, financial planners need to be aware of these rules. The federal government has the right to collect unpaid policy-owner income taxes from life insurance policies. The government can also collect from disability payments, annuity contracts, joint returns and community property.
1. Federal Tax Lien
Section 6321 of the Internal Revenue Code imposes a tax lien “upon all property and rights to property, whether real or personal,” belonging to a taxpayer, if he or she neglects or refuses to pay any taxes, including cash surrender values of insurance policies. The lien arises when an assessment is made (IRC Section 6322) and even attaches to after-acquired property. Section 6334 exempts several classes of property from the government’s tax levy and provides that property not listed is exempt may be levied. The cash values of life insurance are not specified as exempt property, and are maybe subject to a levy.
The lien can be attached to property that ordinarily is not accessible to private creditors, such as funds payable under a spendthrift trust. Furthermore, state exemption laws are ineffective against it. Moreover, a lien on a life insurance policy will survive the insured’s death, even subjecting the beneficiary to liability as a transferee under Section 6901 of the Internal Revenue Code. However, since delinquent tax is not a partnership debt, the lien cannot reach the cash values of partnership-owned insurance policies.
Because government liens apply to all policy-owner taxpayer rights, they apply to a policy with no cash surrender values. The government can demand that the policy be sold and the proceeds applied to the tax claim.
2. Government Collection Methods
Once the government has established its lien against a taxpayer’s life insurance policies, it can foreclose in either of two ways.
Section 6332(b) of the internal Revenue Code permits the government to impose a levy for the cash loan value of a delinquent taxpayer’s life insurance policies directly on an insurer. Within 90 days of the levy notice, the insurance company is required to pay the government an amount equal to the lien or the cash loan value, whichever is less. After this payment, the insurance company is discharged from further liability to the owner or beneficiary of the policy.
Section 7403 authorizes the government to enforce the lien through a civil action in a federal district court. All persons having liens upon or who claim an interest in the policy must be joined, including the insured, the beneficiaries and the insurance company, as well as the assignees if the policy has been assigned. [IRC Section 7403(b)]. The government’s recovery is limited to the extent of its tax lien — the amount a taxpayer owes (including interest and costs). If the taxpayer has no interest in a policy, a lien cannot be attached to it.
If a beneficiary (or policy-owner) is the insured’s spouse and the tax liability is of a joint nature, the tax lien gives the government access to either or both of their rights to the policy [IRC Section 6013(d)(3)].
3. When Lien Attaches to Policy or Automatic Premium Loans
An automatic premium loan provision is agreed to by most life insurance policyholders when they acquire their policies. Because this is a contractual provision between the insurer and the policyholder, the insurer is required to comply with the contract when premiums are not paid. IRC Section 6323(b)(9) recognizes this responsibility by providing that the government’s lien is not valid against an insurance company’s policy loan:
when granted before it has actual notice of the lien;
after actual notice if there is a contractual requirement for an automatic premium loan; or
after satisfying a tax levy on the policy unless the government gives prior notice of any new tax lien.
This means that with respect to such loans, the insurance company has superpriority status, or priority over the government.
4. Right to Disability Payments
In proceedings against an insurance company under IRC Section 6332 with a policy-owner as the defendant, the government can claim all monthly income disability payments due the insured-taxpayer to cover unpaid taxes.
Under the Social Security Act, disability benefits are also subject to government claims for unpaid income taxes.
5. Right to Annuities
The government, acting under IRC Section 7403, can enforce a lien against a taxpayer’s annuity contracts. In one case in which both the taxpayer and the insurance company appeared before the court, the insurance company was directed to make annuity payments to the government.
The court ruled that the company was to pay the policy’s cash surrender value to the government if all three parties agreed on an amount. On the other hand, if only the company and government agreed on a surrender value, while the taxpayer dissented, the contracts were to be sold at public auction.
6. Spousal Liability
When a tax deficiency is found on a joint return, each spouse is jointly and separately liable for the tax under IRC Section 6013(d)(3). Thus, the government can obtain and enforce its lien against policies owned by either spouse.
In a case involving a life insurance policy which gave the beneficiary unlimited power to withdraw the policies from the insurance trust, the husband and wife had filed joint tax returns that were found to be deficient. The court ruled that the government’s tax lien was valid against the trust.
In a community property state, each spouse is liable for half of the tax on community income. When separate returns are filed, the government can foreclose a tax lien on the interest each spouse has in any policy, to the extent of the respective spouse’s tax liability.
7. Right to Income Taxes from Death Proceeds When the Government Has a Lien
If the government has a lien for income tax deficiencies against a taxpayer, it is good only against the cash surrender value of the taxpayer’s insurance policies, calculated as of the date of death. The amount at risk (excess over cash surrender value) is beyond the government’s reach if state law exempts the insurance proceeds from creditors` claims. But state law will not prevent the government from collecting the tax from a beneficiary-spouse if he or she and the deceased spouse file a joint return for the period of the deficiency—under Section 6013(d)(3) both joint and separate liability are imposed upon husband and wife when a joint return is filed.
The equitable doctrine known as “marshalling” of assets will not be practiced to satisfy a federal tax lien accompanying cash surrender values of life insurance policies if it would require ignoring a state statute that exempts insurance proceeds from the claims of creditors. An example of marshalling— the equitable arrangement of creditors’ assets— is demonstrated by the following: one creditor is secured by two funds while another creditor is secured by only one of those funds; therefore, equity will compel the twice-secured creditor to extinguish first the fund that is not security for the other creditor.
8. Right to Income Taxes from Death Proceeds When the Government Has No Lien
After a taxpayer’s death, if the government determines a tax deficiency exists, it will have no lien. Also, it will have no recourse, under IRC Section 6901, against life insurance proceeds payable to named beneficiaries if state law exempts such proceeds from creditors.
State law will generally not exempt life insurance proceeds from creditors if the proceeds are payable to an individual’s estate, his or her executor or administrator, or a trust for the benefit of the estate or a named beneficiary who agrees to use the proceeds for the benefit of the estate. The government’s claim against the estate is usually a higher priority than that of general unsecured creditors.
—Read Follow the RMD and Your Clients Won’t Go Broke in Retirement on ThinkAdvisor.