We are picking up the discussion, from our April 30 post, about life insurance payouts and Chapter 7 bankruptcy. The subject came up in a case not from Illinois but from Idaho, a case that shows just how complicated, confusing and, at times, unfair the law can be. Illinois and Idaho are not too far apart in terms of bankruptcy laws: Both require debtors to follow the state’s, not the federal government’s, exemption scheme.

A couple had petitioned for Chapter 7 liquidation bankruptcy just a couple of weeks before the husband’s mother passed away. It turned out that she had named her son as a beneficiary of a life insurance policy, and he received $4,250. He reported the payout to his attorney who, in turn, notified the bankruptcy trustee.

According to the U.S. Bankruptcy Code, if a debtor receives an inheritance within 180 days of the date he or she filed for bankruptcy, the inheritance becomes part of the bankruptcy estate. That means, of course, that the money can be used by the trustee to pay off creditors.

It seems unfair, but Congress apparently wanted to discourage people from declaring bankruptcy in anticipation of a windfall. Say your billionaire mother has been given just weeks to live, and you know you will get a sizeable inheritance from her. You’ve racked up all sorts of debt, though, and you believe that receiving the inheritance will be a great time to start over. You declare bankruptcy on Tuesday, and a couple of days later you receive the first distribution from your trust. Somehow, that doesn’t seem fair to your creditors. They will be taking a portion of what you owe, and you are off to Paris on your private plane.

Now, Illinois law specifically exempts life insurance proceeds (if insured was of immediate family) from bankruptcy. The debtor and his wife would likely have been able to keep the payout.

In Idaho, however, the law is not nearly as straightforward. We’ll get into the details — and the court’s commentary on the state statute governing the matter — in our next post.

Source:  Forbes.com, “The Amazingly Confusing Life Insurance Exemption From Creditor Claims,” Jay Adkisson, April 11, 2015