Trusts and Chapter 7 Bankruptcy
There are two very important things we must know before we evaluate what happens to a trust in Bankruptcy. First, we need to know what kind of trust we are dealing with and second, is the debtor filing for Chapter 7 bankruptcy a beneficiary or a grantor? A beneficiary is a person who has received or will receive benefits from the trust and the grantor is the person who established the trust.
Let’s talk about types of trusts. Trusts generally come in two forms. They are either revokable or irrevocable. This will determine whether the debtor has control over the trust or not.
A revocable trust is a trust that can be changed or even disposed of by the grantor. These trusts are often called a living trust or an inter vivos trust. With these types of trusts the grantor can modify the terms and conditions of the trust at any time.
An irrevocable trust is a trust, once established, that the grantor cannot change. That’s not to say an irrevocable trust cannot be changed but usually changes must be made by a person who is usually neither a grantor nor a beneficiary. The point is though, that the grantor has lost control, and the control lies in the hands of either a third party or the beneficiary.
Now that we know the types of trusts, we must see what happens when the debtor filing for Chapter 7 bankruptcy is the grantor or the beneficiary. If the debtor is a grantor, then in a revocable trust the assets become part of the bankruptcy estate and unless exempted will be liquidated. Why? Because the grantor has complete control over the assets of the trust. However, in an irrevocable trust the grantor no longer has rights to the trust, and it will not be included in the bankruptcy estate.
If the debtor filing for Chapter 7 bankruptcy is a beneficiary of a revocable trust the debtor has no control over the assets of the trust. That is in the hands of the grantor. So, the trust is not included in the bankruptcy estate. However, for an irrevocable trust where the debtor is the beneficiary and has control over changes in the trust; the trust is likely part of the bankruptcy estate and can be liquidated.
I know I said there were two types of trusts but there is a third category that should get some attention. This is a Spendthrift Trust. This is nothing more than a revocable or irrevocable trust that has a provision that the trust assets cannot be used to pay off creditors. So, in an irrevocable trust or a revocable trust where the grantor has passed away the trust may be protected should there be a spendthrift provision.