Beneficiary’s Lost Inheritance in Bankruptcy – The ‘Throw-Back’ Rule

Take-Away: Normally when a person files for bankruptcy what is included in the debtor’s estate are assets owned by that person on the date that he/she filed for bankruptcy. That is frequently called the snapshot rule, i.e. a snapshot is taken of all assets owned by the debtor on that date and they are then subject to the control of the bankruptcy court. Did you know that assets that are inherited by the debtor after that snapshot date can also be reeled back into the bankrupt’s estate and used to pay his/her creditors?

Background: Normally those assets listed on the schedules attached to a debtor’s petition for bankruptcy are liquidated by the bankruptcy trustee in a Chapter 7 Bankruptcy proceeding, and the proceeds from those assets are then used to pay the debtor’s listed creditors. Most assets or property interests acquired after that bankruptcy filing, called post-petition, are excluded from the debtor’s estate. Generally speaking, those assets are not available to pay the creditor’s whose debts are listed on the schedules. Those ‘new’ post-petition assets are intended to give the debtor his/her fresh start, which is the underlying principle behind bankruptcy and the relief from creditors that it affords.

Inheritance Exception: But one major exception to the snapshot rule are inheritances. While Bankruptcy Section 541(a) includes in the debtor’s estate ‘all legal or equitable interests of the debtor in property as of the commencement of the case,’ if within 180 days after filing for bankruptcy the debtor acquires or becomes entitled to acquire an inheritance, the property that is  inherited is treated as if it was the debtor’s personal property at the time that he/she filed for bankruptcy.

Specifically,  11 U.S. Code 541(a)(5) includes as part of the property of the debtor’s estate in bankruptcy:

Any interest in property that would have been property of the estate if such interest had been an interest of the debtor on the date of filing of the petition, and that the debtor acquires or becomes entitled to acquire within 180 days after such date- (A) by bequest, devise or inheritance; (B) as a result of a property settlement agreement with the debtor’s spouse, or of an interlocutory or final divorce decree; or (C) as a beneficiary of a life insurance policy or a death benefit plan.  

One Hundred and Eighty Day ‘Throw-Back’ Rule: This 180 day throw-back rule applies to assets that are acquired by the debtor as a bequest or a devise in either a will or a distribution under a trust. It also applies if the debtor receives a portion of the decedent’s estate through intestacy. And it applies if the debtor is the beneficiary of a life insurance policy or the designated recipient under a death benefit plan. This 180 day throw-back rule also applies to a bequest if it is fixed. Example: Child is beneficiary of a credit shelter trust established by deceased father The trust is primarily created for mother’s lifetime support, i.e. income and principal are available for her support. However, the same trust provides that upon tenth anniversary of father’s death, the trustee of the credit shelter trust is directed to pay to child $50,000 from trust principal. That $50,000 distribution would be a fixed, albeit delayed, bequest to child, subject to the 180 day throw-back rule. [How that fixed bequest is ultimately valued is another matter entirely. It is possible for some bankruptcy estates to remain open, on the petition of the bankruptcy, awaiting a subsequent distribution from a trust many years later in time, e.g. awaiting a residuary distribution from a marital trust, after the death of the surviving spouse life estate holder.  Note, too, that the bankruptcy trustee could abandon this interest in the trust as being too remote to be of much value in paying the debtor’s existing creditors.]

Expectancies: If the testator or trust settlor are still alive, and thus they are able to change their testamentary instrument, all the debtor possesses under that will or trust is an expectancy. An expectancy is not included within this 180 day throw-back rule since the testator or settlor are free to change their testamentary plan at any time up until their death.

Disclaimer: The debtor cannot avoid the application of the 180 day throw-back rule by timely filing a qualified disclaimer of the inheritance, bequest or devise that is directed to them. The assets subject to the disclaimer will still be treated as a pre-petition asset available to the debtor.

Inherited IRAs: You will recall that 5 years ago in the Ramaker case Supreme Court decision it held that an inherited IRA is not an exempt asset in bankruptcy (it is not the debtor’s exempt IRA), so that if the beneficiary of the inherited IRA later files for bankruptcy, whether or not within the 180 days after the IRA owner’s death, those inherited IRA assets will still be available to satisfy the debtor’s  creditors in the debtor’s bankruptcy proceeding. As noted in the past, this treatment of inherited IRAs might be one reason to name an irrevocable trust as the beneficiary of the IRA (a trust that contains a spendthrift provision) to remove the inherited IRA from the debtor-beneficiary’s bankruptcy estate.

Strained Implications of the ‘fixed’ 180 day Throw-Back Rule?: Example: Son files for bankruptcy. Son also holds his mother’s durable power of attorney for health care. Mother’s is failing; she is lingering in a coma. Son is named as a beneficiary of mother’s will, along with his siblings. Other siblings want the son to exercise their mother’s durable power of attorney for health care to formally withdraw their mother’s life support to stop the emotional trauma of their bed-side vigil (and incidentally to also stop incurring excessive medical bills while their mother is hospitalized in a vegetative state, which indirectly depletes their expected inheritances.) Son ignores his siblings’ wishes (and arguably he ignores mother’s medical directive which expressly gives him the authority to withhold life support if she is in a persistent vegetative state) and he directs the health care providers to not withdraw mother’s life support….. at least not until 180 days after he has filed for bankruptcy so he is then entitled to keep his share of his mother’ residuary estate as part of his fresh start. Is this what his mother wanted? Obviously this is not what the  siblings want, especially when the delay to withdraw their mother’s  life support will reduce the ultimate size of their mother’s estate which they will inherit.

Conclusion: If there is a real risk of an estate or trust beneficiary (debtor) becoming insolvent or having to file for bankruptcy, the testamentary instrument should direct that the assets to be inherited be held in trust, post-death, and not distributed to the beneficiary for an extended period of time, making the bequest contingent for at least 180 days. More to the point, rather than give specific distribution or withdrawal rights to the beneficiary (debtor), a discretionary trust should be used for an express period of time, like the following: ‘two years following my death the trustee may pay to or for the benefit of the trust beneficiary such amounts, or none, of the income or principal from this trust as the trustee deems advisable; after that two year period the trustee shall pay trust income to the beneficiary who is entitled to the income as a matter of right.’  In this situation, the trust beneficiary (debtor) has no rights to either income or principal for two years, and the Michigan Trust Code makes it very clear that the trust beneficiary (debtor) has no property interest in the trust for that duration [MCL 700.7815(1) and MCL 700.7505], so that the debtor’s beneficial interest in the trust cannot be taken by the bankruptcy trustee. When you listen to clients express their anxiety about their children financial insolvency or spendthrift tendencies, you will  probably want to mention the 180 day throw-back rule and the benefit of using a discretionary trust, at least for a couple of years after the client dies, before that inheritance is received by their child. Not only will that protect the inheritance from a future bankruptcy within 180 days of filing the petition for bankruptcy, but it will give the trustee time to mentor that child regarding the responsible management of that inheritance.