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How Will Filing for Bankruptcy Affect My Estate Plan?

What happens to your estate if you file for bankruptcy protection but die while in bankruptcy? What effect does it have on you if one of your beneficiaries files for bankruptcy?

Bankruptcy may not be something you're thinking about when creating an estate plan. And while the number of bankruptcy filings has been on the decline for several years, there were still more than 540,000 bankruptcy filings in 2020. None of us know what the future holds, so you should consider these important issues in your estate plan, even if the possibility of bankruptcy seems far-fetched at the current moment.

What happens to my estate if I am in bankruptcy when I die?

The purpose of a will is to provide specific instructions about whom you would like to receive your money and property when you die. But in general, your debts must be paid before your beneficiaries can receive anything. Therefore, if you're in bankruptcy at the time of your passing, your beneficiaries will receive what's left of your life savings and property when the bankruptcy case concludes.

You will typically file for chapter 7 (liquidation) or chapter 13 (repayment plan) bankruptcy if you're an individual debtor. If you die during a chapter 7 bankruptcy, the case will proceed without much interruption as your direct participation is 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 are exempt because they are necessary to live and work. When the bankruptcy case concludes, any remaining money or property can go through the probate process and be transferred to the beneficiaries named in your will.

On the other hand, a chapter 13 bankruptcy involves a repayment plan typically lasting 3-5 years. So you (the debtor) are actively participating in the plan by making the payments. If you're 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. There are often 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 you did not complete the repayment plan;

  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.

What can I do?

An irrevocable trust is one possible solution to making sure money and property will be available for your loved ones despite bankruptcy. An irrevocable trust can be a great way to protect your savings and property against potential future creditors. You won't be able to easily amend or cancel the trust if you need to. However, 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.

That means your money and property will remain available for future distribution to your beneficiaries. But be careful: this strategy won't work if you knowingly transfer money and property to avoid debt. You must implement this strategy proactively before any financial problems leading to bankruptcy arise because you must disclose to the bankruptcy trustee any transfers made within two years before filing. The trustee will evaluate the transfer and determine whether it should be undone, making that property or money available to your creditors.

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, the trustee is free to take the inheritance to pay off your beneficiary's creditors unless the property is exempt. Suppose the beneficiary has filed a chapter 13 bankruptcy. In that case, 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.

What can I do?

You are, of course, free to amend your will to eliminate all gifts to a beneficiary who has filed (or may file) bankruptcy to avoid having your money and belongings used to pay off creditors instead of being distributed to your beneficiary. However, this isn't a valid option for many people because they don't want to effectively disinherit someone (often their own child) whom they want to benefit from their estate.

Another option is protecting your life savings and property in a revocable living trust. You can transfer ownership of your money and property to the trust and retain complete control over and enjoyment of your property during your lifetime. Because the trust (not your 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 won't be considered part of the beneficiary's bankrupt estate.

Additionally, 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.

Lastly, 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 retirement account (IRA), 401(k), or other retirement account 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.

Santaella Legal Group can help you plan ahead

If the COVID-19 pandemic taught us anything, it's that it's impossible to know what the future holds. Sometimes we don't know if or when we'll experience financial problems - which is why it's best to make a plan. Don't wait until you or your loved ones are experiencing money troubles or even the idea of bankruptcy to take action to protect your life savings, heirlooms, and property.

We can design an estate plan to help protect your property, money, and loved ones' inheritances. Call us today for a consultation - Santaella Legal Group, serving San Ramon, Danville, Dublin, Pleasanton & the Tri-Valley area, at (925) 831-4840.

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