Is Your Estate Plan Prepared for a Bankrupt Beneficiary?

In these uncertain economic times, many people from all walks of life are turning to bankruptcy to receive the protection they are entitled to under federal law. When planning your estate and drafting a will, one should consider the possibility of a beneficiary declaring bankruptcy. If such a bankruptcy has been filed near in time to your death, your property may go to creditors of a beneficiary instead of your family member, friend, or other beneficiary.

Under the bankruptcy code, the filing of a case creates a bankruptcy estate. This bankruptcy estate is created holding all property of the debtor except that exempted or otherwise excluded or abandoned. An inheritance received would become property of the bankruptcy estate, to be used for the benefit of the bankruptcy debtor's creditors. The exact timing of the death and inheritance controls how the inheritance might become available to the bankruptcy creditors.

In the simplest case, you die and your beneficiary files bankruptcy at some later time. Here, the inheritance has lost its character as an inheritance, and is simply the beneficiary's property, treated like any other property. Of course, the beneficiary has some control in this situation to avoid or delay filing the bankruptcy.

A more complicated situation involves your death occurring shortly after the beneficiary has filed bankruptcy. Under section 541(a)(5) of the bankruptcy code, a bequest, devise, or inheritance received within 180 days after the bankruptcy petition is filed becomes property of the estate. Essentially, the law pretends that the inheritance coming in this 180 day period had been received the moment prior to bankruptcy being filed. A further wrinkle exists if the beneficiary is a debtor under chapter 13, making a series of payments on his or her debt over a period of time. Under section 1306(a), property received during the chapter 13 case is also property of the estate. As in the case of In re Zeitchik, an inheritance received during a chapter 13 case is available for the benefit of the beneficiary's creditors.

Multiple strategies may be available to address this problem. One option is to simply provide the gift fails in the event of an ill-timed bankruptcy. This option is ideal if your concern is keeping the gift within a group of people and away from their creditors. It's not so suitable if it is important that the particular beneficiary receive the gift, and isn't effective if the bankruptcy was filed after your death. Alternatively, you may want to explore the more complex option of creating a spend-thrift trust. Such a trust, properly constituted, is protected from the creditors of its beneficiary.