Statutory Exemptions: Homestead, Wages, Life Insurance and Annuities

Scope of the chapter. Exemption statutes are the oldest and most widely available form of asset protection. Every state exempts some property from the claims of judgment creditors, and federal law exempts other property and sets the terms on which state exemptions apply in bankruptcy. This chapter examines the principal exemptions: the homestead, wages, life insurance and annuities, together with the miscellaneous exemptions that matter in planning. It then addresses the two planning questions that exemptions raise: whether a client may convert non-exempt assets into exempt form, and whether a client may move to a state with more generous exemptions. Retirement assets, which are protected by a distinct body of federal and state law, are examined in chapter 13 (see infra ch. 13).

Why exemptions matter. An exemption protects an asset without any transfer to a third party, without any trust or entity and, in most cases, without any cost. The client keeps ownership, control and the full benefit of the asset. For many clients, a well-chosen combination of exemptions provides more protection against more creditor classes than any structure a planner could build. It does so with fewer voidable-transfer and tax complications. The planner should consider exemptions before designing any structure, and should design structures to complement them.

The limits of exemptions. Exemptions have three structural limits. First, they are creatures of the law of a single state, and their scope varies enormously from one state to another. Second, they yield to certain creditors: the Internal Revenue Service, support claimants and, for some exemptions, the holder of a lien created by the debtor. Third, the conversion of non-exempt assets into exempt form may be challenged as a voidable transfer and may be limited in bankruptcy. Each limit is examined below.

How to read the chapter. Paragraph 1210 describes the general framework of exemption law in and out of bankruptcy. Paragraphs 1220 through 1260 examine the homestead, wages, life insurance, annuities and other exemptions. Paragraph 1270 addresses the conversion of non-exempt assets, and ¶ 1280 changes of domicile. Paragraph 1290 places exemptions in the Threat Matrix and sets out an exemption review.

Exemptions, exclusions and immunities. Three different legal mechanisms keep property from creditors, and the planner should know which one applies to a given asset. An exemption permits the debtor to withdraw property from the reach of a judgment creditor or from the bankruptcy estate; the property is the debtor's, and the debtor must claim the exemption in the manner the law requires. An exclusion removes the property from the bankruptcy estate altogether, as section 541(c)(2) does for a beneficial interest in a trust subject to an enforceable restriction on transfer and section 541(b)(6) does for certain education savings; the debtor need not claim it and the trustee never administers it. An immunity arises from the nature of the property right itself, as with entireties property in a full-protection state, where the creditor of one spouse has nothing to reach (see supra ¶ 1120.03). The three mechanisms differ in their procedure, in the creditors they bind and in the limits Congress and the states have placed on them.