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Palm Desert Trust Attorney Explains the Pitfalls of Bankruptcy on Trusts

Bankruptcy can disrupt your estate plan. We previously discussed here the problem bankruptcy creates if you have assets in joint tenancy with a bankruptcy debtor. However, bankruptcy can also effect your estate plan for your beneficiaries if certain precautions are not followed. A recent case, Frealy v. Reynolds, highlights this problem. A Trust beneficiary was part of bankruptcy and the bankruptcy Trustee attempted to get all of the beneficiary’s interest in a Trust to pay off creditors. The Ninth Circuit ruled that a bankruptcy trustee’s recovery was limited to 25% pursuant to the Probate Code. However, 25% is still a large amount.

Imagine the situation of leaving your entire trust estate to two children outright and free of trust. You think this is fair and equitable. However, if one of them is in a bankruptcy, his share will be greatly reduced after the bankruptcy court takes 25% to pay off your child’s creditors. Your intention of providing equally for your children has now been disrupted.

A more effective approach would leave the bankrupt child’s assets to a spendthrift Trust or keep the assets retained in Trust with spendthrift provisions. The Trustee could have the discretion to distribute to the child but not if the money will be used to pay creditors. The Trustee would not be obligated to make payments and therefore the beneficiary is not considered the owner of the assets. Since the beneficiary is not the owner the bankruptcy court cannot compel the distributions which would go to the creditors. Instead, the Trustee may wait until the bankruptcy proceedings are over to make any distributions to the beneficiary.

If any of your beneficiaries have considerable debts it might make sense to utilize a spendthrift trust or spendthrift provisions in your estate plan.