On occasion I have potential clients who have set up trusts, and want to know if the assets in the trust will be in jeopardy in a Chapter 7 bankruptcy.  My answer has always been:  “It depends.”  And after recently attending a first rate continuing legal education presentation by two erudite colleagues, Mark Jessee and Pat Green, I was happy to see that they echoed my position.

Well, that answer is not very satisfying, is it?  How about a little more detail?

Mark and Pat produced some excellent notes from which I will crib just a bit, using the scholarly exception to copyright infringement, to give you a taste of what is involved.

However:  Caveat Emptor!  This topic is very complicated, and this post just scratches the surface.  If you have a trust, or are planning to set one up, you should consult a competent attorney to discuss the implications — especially if you think bankruptcy is looming on the horizon.

I.          Some Definitions:

It will help to have a few definitions, which I have taken from Mark and Pat’s notes:

Self-Settled Trust:  A self-settled trust is a trust in which the settlor and the beneficiary are the same person.  This is sometimes known as a first-party trust.

Third-Party Trust:  A third-party trust is a trust in which the beneficiary is not the settlor.

Revocable Trust:  A trust which can be revoked by the settlor is a revocable trust.  A trust under California law is presumed to be revocable unless the trust instrument expressly provides otherwise.  This is important because Cal. Prob. Code § 18200 makes the assets of a revocable trust available to creditors as long as the settlor retains the power to revoke the trust.  However, under Cal. Prob. Code § 18201 the settlor is permitted to use the exemptions of Cal. Civ. Proc Code §§ 703.010 et seq. to protect trust assets.  In other words, a revocable trust is a “see through” entity for purposes of the debts of the settlor.

II.        Chapter 7 Bankruptcy Implications

A.        Self-Settled Trusts

If you created a self-settled trust and transferred any assets to the trust during the last ten years, if you cannot exempt those assets then the Chapter 7 Trustee assigned to the case is free to seize and liquidate them for the benefit of your creditors.

Where does the ten-year window come from?  It involves an interplay between fraudulent transfer law and bankruptcy law.  I won’t rehash fraudulent transfer law here, and instead ask you to look at my previous post on the subject.  However, I will draw your attention to 11 U.S.C. § 548(e) (with emphasis added):

[T]he trustee may avoid any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if—

(A)such transfer was made to a self-settled trust or similar device;

(B)such transfer was by the debtor;

(C)the debtor is a beneficiary of such trust or similar device; and

(D)the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

In other words, if you file for Chapter 7 bankruptcy protection and have assets in a self-settled trust, unless you can exempt them you may lose them to the Chapter 7 Trustee’s depredations.

B.        Third-Party Trusts:  Revocable v. Irrevocable Trusts

If you created a third-party trust, then if it is revocable the Chapter 7 Trustee can seize any nonexempt assets in the trust.  If it is irrevocable, then since you can’t get at the contents, neither can the Chapter 7 Trustee.

If you are the third-party beneficiary of a revocable trust, then the Chapter 7 Trustee cannot go after the assets in the trust because your interest as a nonsettlor beneficiary is not a property right under California law.  See, e.g., Burton v. Ulrich, (In re Schmitt), 215 B.R. 417, 422 (9th Cir. B.A.P. 1997) (“We need not determine whether Oregon or California law applies, since we conclude that in either state an interest in a revocable trust is not a property right.”).

III.       Disclaiming An Interest In A Trust

One way to avoid problems is to disclaim any interest in the trust.  If you do so, then you forever waive any right to reclaim any of the trust’s assets.  The concept of disclaimer is found in Cal. Prob. Code §§260-295.  Some of the key elements are as follows (with a further acknowledgment to Mark and Pat):

A disclaimer is a legal fiction in which the beneficiary is presumed to have predeceased the decedent.

  • The disclaimant has no say on where the disclaimed assets go.
  • The beneficiary renounces any interest that he or she would otherwise have been entitled to upon the death of the trustor.
  • The disclaimant must disclaim the interest no later than 9 months after the trustor’s death.
  • A disclaimer is irrevocable.
  • A disclaimer is not allowed after the beneficiary accepts an interest in the trust.
  • A valid disclaimer is not a fraudulent transfer.

In sum, if you have a trust, or are the beneficiary of a trust, and are considering filing for Chapter 7 protection, do not go to a bankruptcy mill where a paralegal will do the work.  Paralegals are not permitted to give legal advice, and if they do they not only violate the law, but mislead the people they are counseling.

Instead, contact a highly skilled bankruptcy attorney to discuss the potential pitfalls in your case.  In the long run it is cheaper hiring a superlative bankruptcy attorney who will help you in your prebankruptcy planning, then to have to hire such an attorney to do potentially very expensive repair work.