How Do I Protect Assets That May Reach A Beneficiary Involved In Bankruptcy?

August 27th, 2014

A financial advisor contacted me with the issue that one of his clients was to receive an inheritance; however, the client was also in the midst of bankruptcy proceedings. The question is whether the client could receive the inheritance, without having to risk paying creditors the proceeds from any inheritance. The answer is, that it depends. It depends whether there is control by the beneficiary in directing where the inheritance goes at the time of death. The general rule is that where a beneficiary controls where the inheritance goes, the more likely a bankruptcy trustee may gain access to those funds. It always pays to plan ahead, especially where gifts or inheritances may be left to beneficiaries with creditors. It does matter whether the inheritance or gifts are made in cash, through an estate, through qualified retirement accounts, etc.

One solution to protect an inheritance from potential creditors of beneficiaries (or beneficiaries that may be in, or may go through bankruptcy), is the use of a revocable (living) trust. The trust must maintain certain spendthrift clauses. These clauses are provisions in which money set aside for the beneficiary (through the trust), cannot be transferred by the beneficiary (even to himself or herself), thus prohibiting creditors from attaching the beneficiary’s interest to the assets. The trustee is the layer of protection that is required to protect the asset(s) from creditors. If there are no spendthrift clauses, then a bankruptcy trustee can access those assets on behalf of creditors.

Although spendthrift clauses are enforceable, care must be given in drafting trusts. If the trust has other language that derogates or weakens the spendthrift clause, then the spendthrift clause may be useless. The attorney drafting the trust must remember the main purpose or goal. If the sole reason for drafting the trust is to avoid a beneficiary’s creditors, then broad language requiring that monies go to the beneficiary for lots of reasons, the goal may fail. It becomes much easier to enforce spendthrift trusts if carefully drafted with that goal in mind.

Moreover, care must be given to the self-settled trust, meaning that if the beneficiary is also the trustmaker or the grantor of the trust. Courts have occasionally invalided spendthrift provisions if there is not a “buffer” that prevents the beneficiary from having absolute access to the trust property. Again, careful drafting is key. Contact our office if you have concerns that money may reach a beneficiary that has creditors, either by gift or inheritance. Proper planning is vital in ensuring money reaches the intended beneficiary, without subjecting that money to creditors or bankruptcy courts.