Bankruptcy and its Effects on Estate Planning
Bankruptcy may be one of the last things on your mind when you are creating an estate plan. Fortunately, the number of bankruptcy filings has declined over the past several years, but there were still a whopping 544,463 bankruptcy filings in 2020. What happens to your estate if you file for protection but die while still in bankruptcy? What if one of your beneficiaries is in bankruptcy or is soon likely to be? None of us knows what the future holds, so you should consider these important issues in your estate plan, even if the possibility of bankruptcy seems far-fetched right now.
What happens to my estate if I am in bankruptcy when I die?
A will enables you to leave specific instructions about whom you would like to receive your money and property and how you would like for it to be distributed when you die. However, in general, your debts must be paid before your beneficiaries can receive a dime. As a result, if you are in bankruptcy when you pass away, your beneficiaries will receive only what is left of your life savings and property when the case concludes.
Individual 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 of an interruption because your direct participation is very limited after the meeting of creditors. The bankruptcy trustee will sell your property (including your interest in nonexempt property you own jointly with your spouse and, in community property states, all property acquired during the marriage) to obtain cash to pay off your creditors. However, certain property, such as motor vehicles, clothing, household goods, and retirement savings accounts, is exempt because it is necessary for living and working. When the case concludes, any remaining money or property can go through the probate process and be transferred to the beneficiaries named in your will.
A chapter 13 bankruptcy involves a repayment plan that typically lasts from three to five years, so you, as the debtor, must actively participate in the plan by making the payments. If you are in the midst of a chapter 13 bankruptcy when you pass away, your bankruptcy trustee and your survivors usually must petition the court for instructions about what to do next. Typically, there are several possible 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 that the case 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 the survivors can request a certain course of action, the court will ultimately decide what is in the best interest of all the parties involved.
- If you want to protect your savings and property against potential future creditors, consider transferring them to an irrevocable trust. You will not be able to easily 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 accounts and property in the trust generally cannot be used to pay off creditors, even if you file for bankruptcy in the future. As a result, your money and property will remain available for future distribution to your beneficiaries. But beware that this strategy will not work if you knowingly transfer money and property to avoid debt. It is important to implement this strategy proactively, long before any financial problems leading to bankruptcy arise, because you must disclose to the bankruptcy trustee any transfers made within two years before filing, and the trustee will review the transfer to evaluate whether it should be undone, making that property or money available to your creditors.
- Some states allow an asset protection trust, a special type of irrevocable trust that is self-settled, that is, the person who creates and funds the trust is also a trust beneficiary. There are numerous details that an experienced estate planning attorney should consider when determining whether this type of trust will protect your money and property if you eventually file for bankruptcy. Transfers of money or property to this type of trust made within ten years prior to the bankruptcy filing are 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, they 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 (except for any exempt property or money) will be added to the amount available to the beneficiary for repaying creditors under the repayment plan, i.e., it will increase the amount of the payments your beneficiary must make.
- You are free to amend your will to eliminate all gifts to a beneficiary who has filed (or may file) bankruptcy to avoid having your hard-earned money and prized belongings used to pay off creditors rather than being distributed to the beneficiary. Many people dislike this option, however, because they do not want to effectively disinherit someone (often, their child) whom 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 your money or property to the trust and retain complete control over and enjoyment of your property during your lifetime. Because the trust (and not the beneficiary) owns the property and because 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, the property 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 their 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, and maintenance. However, any amounts distributed prior to bankruptcy or within 180 days after the bankruptcy petition has been filed can become part of the beneficiary’s bankruptcy estate and used to pay off creditors.
- A standalone retirement trust that is drafted as an accumulation trust, rather than a conduit trust, can be used to protect the funds held in your individual retirement account (IRA) or other retirement account, such as a 401(k), from being taken by creditors if your beneficiary files for bankruptcy after your death. Because inherited IRAs, in contrast to the debtor’s IRA, are not protected in bankruptcy proceedings, it is necessary to provide additional protection by using a trust. The trust is funded from your retirement account upon your death. Because the trust is irrevocable, those funds are protected from the beneficiary’s creditors.
We Can Help You Plan Ahead
It is impossible to know what the future holds. Those who are prospering today may encounter financial problems tomorrow. Do not wait until you or your loved ones are experiencing money troubles, or even the prospect of bankruptcy, to take action to protect the life savings, heirlooms, and property that you have worked so hard to accumulate. We can design an estate plan that will help protect your property and money—and your loved ones’ inheritances. Call 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 ever files for bankruptcy.
 11 U.S.C. § 548(a).