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A living trust can be an effective means of passing property to loved ones upon death. Many Californians use living trusts to bypass the probate process and ensure a more seamless transition, giving loved ones access to the benefits of that property earlier.
But, living trusts aren’t, and aren’t intended to be, asset protection trusts. There is some confusion about this, as many people believe that property placed in trust is “safe.” Generally, if you’ve placed property in a living trust, that property is considered part of your bankruptcy estate. Any non-exempt property will typically be available for liquidation for the benefit of creditors.
Here’s how it works, and why.
What is a Living Trust?
A living trust is a trust created for estate planning purposes. The person creating the trust, called the grantor, transfers some or all of their assets into the trust. Technically, the trust now owns that property. But, during their lifetime, the grantor is also the trustee and the beneficiary. Since the grantor is managing the property for their own benefit, there is little practical difference between property the grantor owns and property held in the living trust. For example, a vehicle title might be transferred to the trust, but the grantor would continue to use the vehicle, and could sell it or give it away if they chose.
When the grantor passes away, a new trustee would take over and manage the trust for the benefit of successor beneficiaries–people chosen by the grantor when the trust was created. Depending on the terms of the trust, all assets might be distributed to beneficiaries and the trust terminated. Or, the trustee might continue to manage the assets for the beneficiaries, paying out distributions according to a pre-set timeline or when certain trigger events occurred.
The fact that the grantor is the beneficiary of the trust is one reason trust property is accessible by the bankruptcy trustee if the grantor files during their lifetime. But, it’s not the only one. The other reason is that a living trust is a revocable trust. In other words, the grantor can end the trust and take back the property any time they want.
The bottom line is that property placed in a living trust by someone who later files for bankruptcy generally enjoys no protection, and any non-exempt assets in the trust will be available for distribution to creditors.
Other Trusts in Bankruptcy
Other revocable trusts are generally treated the same as a living trust in bankruptcy. If the bankruptcy petitioner controls the assets and has the right to take them back at any time, then the property becomes part of the bankruptcy estate. For example, if a grandparent set up a revocable trust to provide for their grandchildren and transferred property into it, and then the grandparent files for bankruptcy, that property would typically still be available to the bankruptcy trustee, since the grandparent had the right to reclaim the property at will.
But, not all trusts are revocable.
Irrevocable Trusts in Bankruptcy
An irrevocable trust is different from a living trust or other revocable trust in one very important way: when someone creates an irrevocable trust, that person loses the right to reclaim the property. The property has been given away, just as if it had been given to another person. The grantor no longer has any control over the property, and no longer has any right to benefit from the property. That means a bankruptcy petitioner who has created an irrevocable trust generally isn’t considered the owner of the trust property and that property is not included in the bankruptcy estate.
It’s important to note, though, that the transfer of that property will be scrutinized like any other transfer of property prior to a bankruptcy filing. Creating an irrevocable trust for the purpose of putting those assets outside the reach of the bankruptcy court is fraud, just as any other effort to hide or give away assets in anticipation of bankruptcy would be.
What If The Bankruptcy Petitioner is the Beneficiary of a Trust?
Generally, funds a trust beneficiary is entitled to receive are fair game for the bankruptcy trustee. The grantor can build in some protections to ensure that trust assets go for the good of the beneficiary and cannot be seized by creditors. But, a few years ago, the U.S. Court of Appeals for the 9th Circuit, which includes California, limited the reach of those protections.
Now, creditors (and the bankruptcy trustee on behalf of creditors) can generally intercept 100% of any sums remaining in the trust that the bankruptcy filing beneficiary is already owed, along with 25% of distributions moving forward. The exception is when the terms of the trust provide specifically for education and support, and the beneficiary needs the funds for those purposes.
The Bottom Line on Trusts and Bankruptcy
While some types of trust provide some asset protection for the beneficiaries, those protections must be explicitly built into the trust terms, and are limited by law. Many common types of trusts, including living trusts, offer no protection at all in bankruptcy. And, the transfer of assets to an irrevocable trust to put those assets out of reach of the bankruptcy trustee may be considered a fraudulent transfer.
If you have created a trust or are the beneficiary of a trust and are considering bankruptcy, it’s important to talk with an attorney before taking any action. To schedule an appointment with one of the experienced California bankruptcy and debt resolution attorneys at Borowitz & Clark, call 877-439-9717 or fill out the contact form on this page. The initial consultation is free.