Effect of Bankruptcy 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 have declined as the economy has improved, but there were still a whopping 969,397 bankruptcy filings during the period from June 30, 2018 to September 30, 2019. What happens to your estate if you file for bankruptcy protection, but die while still in bankruptcy? What if one of your beneficiaries is in bankruptcy or is likely to be soon?  None of us knows what the future holds, so these are important considerations that you should take into account in your estate planning, 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 who you would like to receive your money and property and how you would like for it to be given away when you die. However, your debts must be paid before your beneficiaries will 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 bankruptcy 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. The bankruptcy trustee will sell your property (including your interest in property you own jointly with your spouse that’s non-exempt, and in community property states, all property acquired during the marriage) to obtain cash that can be used to pay off your creditors (though certain property is exempt because it is necessary for living and working, such as motor vehicles, clothing, household goods, and retirement savings accounts). At the conclusion of the bankruptcy case, any remaining money or property can go through the probate process and be transferred to the beneficiaries of 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 those 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 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

• If you want to protect your savings and property against potential future creditors, you may want to 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 assets in the trust cannot be used to pay off creditors, even if you file for bankruptcy in the future. As a result, your assets will remain available for future distribution to your beneficiaries. But beware that this strategy won’t work if you transfer away savings and property to knowingly avoid debt. It is important to implement this strategy proactively, long before any financial problems leading to bankruptcy arise. This is 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, which is a special type of irrevocable trust that is also a self-settled trust, that is, the person who creates and funds the trust also is a beneficiary of the trust. There are many details that an experienced estate planning attorney should consider in determining whether this type of trust will achieve the goal of protecting your assets if you eventually file for bankruptcy. 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 (except for any exempt property or money) will be added to the amount that the beneficiary has to repay creditors under the repayment plan, i.e., 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 (or may do so) to avoid having your hard-earned money and prized belongings used to pay off creditors rather than be distributed to the beneficiary. Alternatively, you could 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 within the trust.

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. Call our Sioux Falls, Sioux City, or Omaha office 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.