Losing an Inheritance to Creditors

Take-Away:  Sometimes how an heir receives his or her inheritance dictates if he or she will be able to keep that inheritance if creditors are circling. The Bankruptcy Code provide a ‘bright-line’ approach to what is considered property included in the heir’s bankruptcy estate. The ‘bright-line?’ Avoid passing the decedent’s assets to an heir by bequest, devise or inheritance if bankruptcy might be in the beneficiary’s immediate future. In short, use a trust!

Background: Fortunately few heirs file for bankruptcy, but those parents who are perpetually concerned about their children’s creditworthiness will need to be mindful of how the federal law defines the property of a bankrupt’s estate.

• Bankruptcy Code: The assets subject to the Bankruptcy Court’s exclusive jurisdiction and thus used to pay the debtor’s creditors include: (i) all legal or equitable interests of the debtor in property as of the commencement of the bankruptcy case, including: ‘An 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 of 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 of a death benefit.’ 11 U.S.C. 541(a)(5).
• Bequest or Devise Example: Mom dies leaving a Will. She leaves her entire $1.2 million estate to her three children in separate shares of equal value. Her youngest son is about ready to file for bankruptcy. He files for bankruptcy shortly after Mom’s death. When son files for bankruptcy, he does not own any assets or property as of the date that he filed his petition for bankruptcy. When Mom’s estate is settled and her son receives $400,000 as his share of his late mother’s estate, that amount ($400,000) is included in his bankruptcy estate, thus controlled by the bankruptcy trustee, and ultimately used to pay that child’s creditors. The son’s share of his mother’s estate came to him as a bequest or devise under her Will.
• Intestacy Example: Had Mom died without a Will, i.e. intestate, her son would have shared her probate estate with his 2 siblings, and his share ($400,000) would have passed to him as an inheritance. Again, the bankruptcy trustee would take control of the son’s inheritance and those funds would be used to pay son’s creditors.
• Right, Not Receipt, Controls: In these two scenarios [bequest/devise or inheritance], because the son is entitled to his share of Mom’s estate within 180 days of her death, the assets that pass to him will become part of his bankruptcy estate. The fact that the distribution from Mom’s estate might be delayed well beyond 180 days due to estate administration problems is irrelevant- the son possessed the right to receive his bequest, devise, or inheritance immediately upon Mom’s death, and the right to receive within the 180 day period controls. Williams v. Chenoweth, 132 B.R. (Bankr. S.D. Ill 1991).
• Protective Planning: In light of this hard-and-fast bankruptcy statute that includes ‘inherited’ assets in the debtor’s estate for the benefit of a his/her creditors, including assets that the debtor-beneficiary did not even own on the date that he/she filed  his/her petition for bankruptcy, a few practical estate planning steps can be used to mitigate that risk of losing the inherited assets to the beneficiary’s creditors.
• Use an Intervivos Trust: The terms bequest, devise and inheritance used in the Bankruptcy Code are not defined in the statute. As a result, most Bankruptcy Courts turn to Black’s Law Dictionary to define those statutory terms. Bankruptcy Courts have regularly concluded that a distribution from an intervivos trust is not a bequest, devise or inheritance. Example: The debtor’s interest in his father’s trust was not deemed to be part of his bankruptcy estate, despite the fact that the trust provided that the property the debtor was to receive from the trust would be payable to him immediately upon his father’s death, i.e. no scheduled delays in the trust distribution. The father died within 180 days that the debtor filed for bankruptcy. The Bankruptcy Court found that the terms devise and bequest involve transfers of property by way of a Will. Additionally, an inheritance is property which descends to an heir on the intestate death of another. In this case, the debtor’s rights in the decedent father’s trust were transferred to him intervivos- i.e. not by Will, nor by intestacy. The bankruptcy judge concluded that Section 541(a)(5)(A) does not operate to include interests of property transferred to the debtor by way of intervivos trust. In re Roth, 289 B.R. 161 (Kansas, 2003). Distinguish: Note, however, had the decedent father used a testamentary trust, i.e. the trust was a part of the decedent’s Will,  to distribute the assets, then those assets would have become part of the debtor’s bankruptcy estate as they came to him by bequest or devise.
• Delay Testamentary Trust Distributions:  Often the question of whether an inheritance is included in the bankrupt’s estate turns on the right to receive the assets. If a Will or testamentary trust directs that the beneficiary’s right to receive assets is delayed solely to complete estate administration, those assets (whenever received by the debtor-beneficiary) will be included in the bankruptcy estate. In contrast, if the testamentary trust indicates a ‘hold back’ in distributions for a set period of time, e.g. two years, and the beneficiary must be living on that date in order to become entitled to receive that distribution from the testamentary trust, then there is no right held by the debtor-beneficiary to receive that distribution until after the two years have passed- assuming that the beneficiary files for bankruptcy more than 180 days before that identified distribution date. Unfortunately the Bankruptcy Courts are in some disagreement with whether a contingent interest held by the debtor-beneficiary results in estate inclusion under Section 541(a)(5)(A). If the testator’s goal is to protect the debtor-beneficiary’s interest in their estate, it might help to make a gratuitous statement in the testamentary trust that the testator’s intent is that the beneficiary’s interest is ‘not vested’ until the date of distribution to discourage the bankruptcy judge from delving into whether the interest is ‘vested, subject to divestment’ or it is only an ‘expectancy’.
• Use POD and TOD Beneficiary Designations: The receipt of assets upon the death of an account owner through a transfer on death (TOD) or payable on death (POD) results from the contractual arrangement that the account owner established with the investment custodian or financial institution. Thus, the transfer of that wealth by POD or TOD beneficiary designation is not a bequest, devise or inheritance. Example: The money that was received by the debtor from a POD account established by his mother and which was paid directly to him as a result of her death within six months after the debtor filed his bankruptcy petition was not included as property of his bankruptcy estate. The state TOD and POD statutes made it clear that the interest of the named beneficiary did not vest until the death of the account owner. In re Kilstrom, 2011 Bankr. LEXIS 955 (Iowa, March 17, 2011.) Distinguish: While Michigan has not (yet) adopted the Uniform Transfer of Real Estate on Death Act, many other states have, and it is unclear if Bankruptcy Courts will treat a ‘beneficiary deed’ like a TOD or POD ‘contractual’ arrangement. In one case the federal court refused to treat a ‘beneficiary deed’ that functioned like a POD or TOD beneficiary arrangement- the court called it a ‘contingent interest that was held by the debtor when the petition for bankruptcy was filed’ and thus included the real property in the debtor’s bankruptcy estate. In re Neuton, 922 F. 2d 1379 (9^th 1990.)
• IRA Distributions Protected: Like POD and TOD beneficiary designations, an IRA that names a debtor as its beneficiary should be protected, as it is a ‘contractual arrangement’. In one case the Bankruptcy Court found that the debtor-daughter of the deceased IRA owner did not have an interest in the IRA when her father died- it was not property that she received as a bequest or devise. In re Hall, 4441 B.R. 680 (B.A.P. 10^th 2009). Distinguish: This legal conclusion is only with regard to the automatic inclusion of the received IRA proceeds in the debtor’s bankruptcy estate within 180 days after he/she files for bankruptcy. As was indicated by the Supreme Court in 2013 in In re Ramaker, an inherited IRA is not really an IRA but simply a taxable asset, and thus an inherited IRA is an asset that can be included in the debtor-beneficiary’s subsequent bankruptcy proceeding, i.e. a bankruptcy petition filed long after the 180 days of the IRA owner’s death.
• Pay Life Insurance to Trust: If the decedent’s life is insured and the death benefit is paid to the decedent’s children, the beneficiary’s direct receipt of the death benefit (or his/her share of the death benefit) will be included in the debtor-beneficiary’s bankruptcy estate within the 180 day period. Section 541(a)(5)(C).  In re Hall, 441 B.R. 680 (B.A.P. 10^th 2009). In re Hodge, 2014 Bankr. LEXIS 1073 W.D. Mich., 2014). If, however, the owner’s trust is named as the policy’s primary beneficiary, the life insurance death benefit will be paid directly to the trustee of the decedent’s intervivos trust. The trust then directs that all of its assets (including the life insurance death benefit received) are to be distributed to the decedent’s children in shares of equal value from the trust (not as life insurance primary beneficiaries.) Thus, the policy’s death benefit is converted to a trust distribution and consequently it avoids the reach of Section 541(a)(5)(C.) Example: Parent creates a lifetime trust for child. On parent’s death, the deceased parent’s Will pours over the deceased parent’s assets to the preexisting trust for child, which then distributes all trust assets to child. The bankruptcy trustee argue that the addition of the parent’s assets to the trust on the parent’s death [like life insurance proceeds] converted the intervivos trust to a testamentary trust for purposes of Section 541(a)(5)(A). The Bankruptcy Court rejected that argument and said that the addition of assets to the preexisting trust did not alter the character of the trust or the assets held in that trust- thus, the distribution of all assets from the trust were property characterized as intervivos trust distributions. In re Blount, 438 B.R. 98 (Bankr. E.D. Tex, 2010.)
• Include Survivorship Language in Ladybird Deed: Lots of parents are now using ‘ladybird deeds’ as a way to convey title to real estate on the parents’ deaths to their children while avoiding probate and complying with the byzantine real property tax ‘uncapping’ rules. With such a deed, parents convey title to their real estate to their children, but the parents reserve in the conveyance deed a retained life estate. Upon the parents’ deaths the children record the parents’ death certificates, and thus they perfect title to the real estate in their names, all the while avoiding probate with its publicity, delays and expenses. The question then is what is the interest held by the child in the ‘ladybird deed?’ Does the child who is named in the deed hold a vested interest, or only a contingent interest. In one reported case the bankruptcy trustee discharged the debtor-child’s case, but later learned that the debtor-child held what was called a ‘contingent remainder interest’ in certain real property. Apparently the child’s parents had executed what they called a ‘life estate deed’ which the debtor-child was unaware of at the time the petition for bankruptcy was filed by him. The child’s interest vested one year after he filed his petition for bankruptcy, but before the trustee’s discharge of the bankruptcy. The debtor-child claimed that he only held a ‘mere expectancy’ in the real estate. Despite the both the debtor and the trustee referring to it as a ‘contingent remainder interest’ the Bankruptcy Court found that the debtor-child held a ‘vested remainder interest’ because there was no language in the ‘life estate deed’ that required the survivorship of the debtor-child. In re Amaral, 550 B.R. (Bankr.D. Mass. 2016.) It is unclear if what is called in Michigan an ‘enhanced life estate’ retained by the parents in a ‘ladybird’ deed, i.e. the parents retain not only a life estate but also a general power of appointment to transfer title to the real estate, whether the result would be different, or the child’s interest would still be viewed as being vested, and thus an equitable property interest held at the time of filing a petition for bankruptcy. Thus, it again might be helpful to specify that the child’s interest under a ‘ladybird’ deed is not vested until the life estate holders’ deaths; I am not sure if that works, but it may go a long way for a bankruptcy judge to find that no property interest was held in the ladybird deed until after the parents’ deaths.

Conclusion: While normally parents do not contemplate that the named beneficiaries of their estates might have filed for bankruptcy prior to their deaths. But most parents express concerns about children losing their inheritance, more often in a divorce than to conventional creditors. If the parents  express concerns of a child’s debts or outstanding creditors, it would be wise to spend a little time discussing with them the Bankruptcy Code’s 180 day ‘rule of inclusion’ and how that rule can be circumvented with a bit of planning