How Does Bankruptcy Impact A Trust I Created?

Years ago, you created an estate plan that included a trust. Now, financial difficulties aggravated by the pandemic have left you in a position where bankruptcy is your best way to move forward. You know that your assets are subject to examination and possibly seizure (if you file Chapter 7), but what about the property currently being held in the trust? Are they safe from creditors?

It depends on whether your trust is revocable or irrevocable. The date that it was set up may also be a factor. Let’s take a closer look at these issues and how they determine whether your bankruptcy can impact the trust assets.

Revocable vs. Irrevocable Living Trust

With a revocable trust, the individual setting it up (known as the grantor) maintains complete control over it. They transfer assets into the trust and name a beneficiary who will receive them after they pass away. While they are still alive, the grantor can change the trust, add or remove assets, or even revoke it entirely. The beneficiary has no control until they actually receive their inheritance.

Revocable trusts are not protected in bankruptcy, and their assets can be used to satisfy creditors. With an irrevocable trust, it’s different.

In the case of an irrevocable trust, the grantor is not allowed to access, change, or cancel the arrangement. By placing property into the trust, they surrender any ownership rights to those assets, which are managed by a trustee. Despite not being able to access the assets in the trust, the beneficiary is considered their legal owner.

Although not as flexible as a revocable trust, an irrevocable trust provides the grantor with more protection. Since they are no longer the legal owner of any of the assets in the trust, the bankruptcy court cannot use that property to pay off the grantor’s creditors.

What About Fraudulent Transfers?

Irrevocable trusts are sometimes seen as a way to avoid paying creditors, but it is important to know the laws against fraudulent transfers and preferential payments in bankruptcy. A bankruptcy trustee can void most transfers made within 90 days (possibly even a year) as a preferential payment.

A transfer of property to deter, hinder, or defraud a creditor can be considered a fraudulent transfer, and your bankruptcy trustee can look back two years, meaning that if you established the trust within the last 24 months, its assets may be recoverable. In the case of a self-settled trust, which makes you eligible to receive income from the trust, the lookback period is 10 years.

What If a Trust Beneficiary Declares Bankruptcy?

You created an irrevocable trust for a loved one who is now facing bankruptcy. Can they lose their inheritance?

Not necessarily.

These assets will not be subject to bankruptcy if it is an irrevocable trust that you created for the benefit of the debtor and it contains spendthrift language. Putting spendthrift language into the trust protects assets from being taken by creditors or liquidated in bankruptcy.

Do You Have Questions About Trusts and Bankruptcy?

An irrevocable trust can provide a significant degree of bankruptcy protection, provided it was established in good faith and, ideally, outside the bankruptcy lookback period. If you created a trust and are concerned now about how filing Chapter 7 or Chapter 13 will affect it, talk to an experienced California bankruptcy attorney at Hedtke Law Group. We will provide the right legal advice for your situation, so to schedule a confidential consultation, call us today at (909) 579-2233.