Bankruptcy and Your Estate Plan

Gabriel Katzner - January 6, 2020 - Estate Planning

During the period from June 30, 2018 to September 30, 2019, the country experienced 969,397 bankruptcy filings, a large number by any standard. Most of those who prepared estate plans during that time probably weren’t factoring bankruptcy into their equations. What happens to your estate if you file for bankruptcy protection, but die before you have emerged from bankruptcy? What if one of your beneficiaries declares bankruptcy or is likely to do so soon?  We don’t know what the future holds, so we need to take these possibilities into account during the estate planning process, even if the idea of bankruptcy seems far-fetched right now.

What Happens to My Estate If I Pass Away While I’m in Bankruptcy?

A will or revocable living trust provides specific instructions about who you would like your money and property to be given to when you die. However, your debts must be paid before your beneficiaries will receive anything that you leave for them. If you die while in bankruptcy, your beneficiaries will receive only what is left of your life savings and property when the bankruptcy case concludes.

Debtors typically file for Chapter 7 (liquidation) or Chapter 13 (repayment plan) bankruptcy. If you pass away during a Chapter 7 bankruptcy, the bankruptcy case will proceed without much interruption because your direct participation is very limited. The bankruptcy trustee will sell your property (including your share of property you own jointly with your spouse that’s non-exempt, and in community property states, all property acquired during the marriage). The sale will obtain cash that can be used to pay off your creditors. At the conclusion of the bankruptcy case, any remaining money or property will go through the probate process and be transferred to the beneficiaries of your will.

A Chapter 13 bankruptcy involves a repayment plan that may last between three and five years, so you must actively participate in the plan by making those payments. If you are involved in a Chapter 13 bankruptcy when you pass away, your bankruptcy trustee and your survivors must petition the court for instructions about what to do next. They may face several courses of action. They can: (1) request that the case be dismissed, enabling your creditors to seek repayment of debts in a probate proceeding; (2) petition for a hardship discharge, eliminating the obligation to continue to repay the debt even though the repayment plan was not completed; (3) request the case to be converted to a Chapter 7 bankruptcy filing so the estate can be liquidated (converted to cash) until the debts are discharged; or (4) continue the case as a Chapter 13 bankruptcy, with your heirs attempting to complete the repayment plan.  Although the bankruptcy trustee and survivors can request a certain course of action, the court will ultimately decide what is in the best interests of all the parties involved.

Solutions

  • To protect your savings and property against creditors, you can transfer them to an irrevocable trust. It will not be easy to amend or cancel the trust, but because you no longer own any of the property or money in the trust and have no right to change its terms, the assets in the trust cannot be used to pay off creditors, even if you file for bankruptcy in the future. This means your assets will remain available for your beneficiaries later on. But this strategy won’t work if you transfer savings and property to knowingly avoid debt. If you implement this strategy, do so long before any financial problems occur that could lead to bankruptcy. This is because you must disclose to the bankruptcy trustee any transfers made within two years before filing. Your trustee will review the transfer to evaluate whether it should be undone and that property should be made available to your creditors.
  • Some states allow an self-settled asset protection trust, which is a special type of irrevocable trust that is also a self-settled trust, This means the person who creates and funds the trust also is a beneficiary of the trust. For this type of trust, transfers of money or property made within 10 years prior to the bankruptcy filing will be vulnerable to being undone by the bankruptcy trustee.

What Happens If One of My Beneficiaries Is in Bankruptcy When I Die?

If you die within 180 days after your beneficiary files for bankruptcy, your beneficiary must disclose the inheritance to the bankruptcy trustee. In a Chapter 7 bankruptcy case, unless the property is exempt, the trustee is free to take the inheritance to pay off your beneficiary’s creditors. If the beneficiary has filed a Chapter 13 bankruptcy, the value of the inheritance will be added to the amount that the beneficiary has to repay creditors under the repayment plan, which means it will be used to increase the amount of the payments your beneficiary must make under the repayment plan.

Solutions 

  • You are free to amend your will to revoke all gifts to a beneficiary who has filed bankruptcy to avoid having your hard-earned money used to pay off creditors rather than be distributed to the beneficiary. You can also include a provision in the will stating that no part of your estate is to be used to benefit a creditor of any beneficiary. Many people dislike this option, however, because they do not want to effectively disinherit someone (often a child) they want to benefit from their estate.
  • One of the best ways to prevent your life savings and property from being used to pay off a beneficiary’s creditors is to create a revocable living trust. You can transfer ownership of the money or property to the trust and retain complete control and enjoyment over your property during your lifetime. Because the trust owns the property, not the beneficiary, and the beneficiary has no legal claim to the trust assets during your life because the trust can be revoked at any time prior to your death, it will not be considered part of the beneficiary’s bankruptcy estate.
  • In addition, money and property held in a trust with a valid spendthrift provision specifying that the beneficiary cannot transfer his or her interest in the trust and has no control over it typically cannot be used to pay off the beneficiary’s creditors in bankruptcy. After your death, your beneficiary can receive distributions, i.e., gifts from the trust, according to the terms of the trust, as long as they are purely at the trustee’s discretion or for certain specific purposes, such as health, education, support, or maintenance. However, any amounts that are distributed prior to bankruptcy or within 180 days after the bankruptcy petition is filed can become part of the beneficiary’s bankruptcy estate and used to pay off creditors.
  • A standalone retirement trust can be used to protect the funds held in your Individual Retirement Account (IRA) from being taken by creditors if your beneficiary files for bankruptcy after your death. Because inherited IRAs are not protected in bankruptcy proceedings like the IRA of the debtor, it is necessary to provide additional protection through the use of a trust. The trust is funded from your IRA upon your death. Because the trust is irrevocable, those funds are protected from the beneficiary’s creditors. A bonus is that the IRA assets will continue to grow tax-deferred.

We Can Help You Plan Ahead

It is impossible to know what the future holds: Those who are prospering today may encounter severe money problems tomorrow. It is crucial not to wait until you or your family members or loved ones are experiencing financial troubles, or even the prospect of bankruptcy, to take action to protect your life savings, heirlooms, and other property you have worked so hard to accumulate. We can design an estate plan that will help protect your property and money —and your children or loved ones’ inheritance. Contact us today to create or update your estate plan to ensure that your property is protected from creditors’ claims—whether or not you or a loved one eventually files for bankruptcy.

You can use the link below to schedule a call with Gabriel Katzner, or just call us at 855.528.9637 to learn more about how best to plan today to protect those most important to you




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