Understanding the Relationship Between Bankruptcy and Estate Planning

Bankruptcy impacts hundreds of people in the United States each year. When bankruptcy impacts an estate plan, it can leave beneficiaries uncertain if they will ever receive their inheritance. People who have been involved with the administration of an estate where bankruptcy is involved often have many questions. The following will review some of the most important issues to consider when it comes to the overlap between estate planning and bankruptcy.

A Quick Overview of Bankruptcy

Bankruptcy is a legal process that exists when a person has so much debt that he or she must petition the United States Bankruptcy Court to erase it. After a court determines that a petitioner is insolvent and no longer able to pay back all of that individual’s debts as they come due, the petitioner can either liquidate assets or create a repayment plan with an economic advisor to pay off these debts. 

There are nine different chapters of bankruptcy. In most cases, an individual claiming bankruptcy will file under either Chapter 7, which relieves debt through the sale of assets, or Chapter 13, in which a person must follow a payment plan that allows them to pay back a creditor over several years. This process can touch several estate planning processes as well as many different types of people who are navigating the estate planning process. 

How can Bankruptcy Impact an Inheritance?

Bankruptcy frequently impacts inheritances provided that the debtor inherits property or money while navigating the bankruptcy process. After a person files for bankruptcy, a bankruptcy estate is established, which is viewed as a temporary legal owner of both the debtor’s assets and property. The ownership of this estate applies to all of the debtor’s assets including anything that the debtor receives while the debtor is still in bankruptcy. 

This applies to inheritances. How an inheritance is impacted by bankruptcy will depend on the chapter of bankruptcy for which the individual has filed. Under Chapter 7, an inheritance will often be lumped into the amount that is used to pay off creditors. Under Chapter 13, the receipt of inheritance often impacts the terms of a person’s debt repayment plan.

Is Inheritance Always Used to Pay Off Bankruptcy Debt?

The timing of inheritance is critical when it comes to the issue of whether the amount will be used to pay off a bankruptcy debt. An inheritance is not always used to pay off a person’s debt if it is received at the correct. For example, in Chapter 7 claims, any inheritances that are received 180 days after filing for bankruptcy remain the property of the person who filed for bankruptcy and does not become part of the bankruptcy estate. 

This narrow window of time, however, is less critical when Chapter 13 bankruptcy is involved. A judge can always decide to consider inheritance and use it to amend a person’s repayment plan. This is because the receipt of an inheritance alters the amount that a person can pay toward each month. Whether an inheritance is used to pay off  debt depends on when the person who left the assets passed away rather than the date that the inheritance is distributed. For example, if Bob files for Chapter 7 bankruptcy on November 1 and his Aunt passes away less than 180 days later, this inheritance will be used to pay off John’s debt. 

What Should You Consider About Bankruptcy When Estate Planning?

If you have already created or are in the process of creating a Last Will and Testament, you are likely planning on leaving specific details about how your assets should be distributed after your death. What exactly will happen to your property and assets depends on the amount of debt that you accrue. Before any beneficiaries receive any inheritance or gifts, your debt must be paid off. 

If you are in the middle of filing for bankruptcy when you pass away, the administrator of your estate as well as your surviving loved ones will often take several steps, which include asking for a case to be dismissed, petitioning for a hardship discharge, and potentially asking to convert the case, if its a Chapter 13 bankruptcy, into a Chapter 7. The final decision of how these matters will be handled falls on the judge who presides over the case. 

How Does Bankruptcy Impact Retirement Assets?

One of the most common things that many people do when money is tight is to reduce or eliminate retirement contributions. These individuals then attempt to make cuts to unsecured debts. In a practical sense, this makes sense because there is no hard and fast requirement to continue to fund a 401(k) or IRA account. In the long run, however, many people end up regretting that they short-changed themselves. Not to mention that paying off debt often becomes much more challenging after retirement, which means that wiping these debts out in advance helps to stretch the savings that a person does have. 

There is a tendency in both federal and California law to favor retirement funding over creditors. A person’s creditors are often barred from taking money out of retirement accounts. Additionally, retirement accounts are not lost if a person navigates Chapter 7 or Chapter 13 bankruptcy. It is still a good idea to check with your bankruptcy attorney to ensure this amount will be protected . Not to mention, an individual can continue making retirement contributions even while navigating the Chapter 7 or Chapter 13 bankruptcy process. 

Are Trusts Protected in Bankruptcy?

An increasingly common type of estate planning tool is the formation of trusts. The question of whether assets in a trust will be protected depends on the type of trust that a person creates. Many people create revocable trusts, which allow the creator or grantor to maintain complete control over the assets in the trusts. 

Revocable trusts are unfortunately not protected by bankruptcy and those assets can be seized to pay off creditors. Irrevocable trusts, however, function differently. In irrevocable trusts, a grantor loses the ability to alter or change a trust. Instead of maintaining control of assets in the trust, the grantor withdraws any rights of ownership over the assets. Assets that are located in an irrevocable trust are incapable of being seized. 

How Does Bankruptcy Impact Payable on Death Accounts?

Payable on death (POD) accounts name a beneficiary for when the account owner passes away. After the account owner’s death, money in the account is transferred to the beneficiary. Many courts have considered whether POD accounts are classified as the property of an estate that is subject to the claims of creditors. 

Courts have generally found that any amount received by a debtor from a payable on death account during the 180 days following a bankruptcy filing is not classified as the property of the estate. As a result, the assets that a beneficiary receives through a POD account are likely not capable of being seized by creditors. If you have received assets through a POD account, it is best to speak with a knowledgeable attorney who can help you determine whether creditors are likely to seize your assets. 

Can Probated Estates File for Bankruptcy?

In most cases, debts that are owed by a person become uncollectible after that individual’s death. If the individual leaves behind an estate, however, that estate is often responsible for resolving the outstanding debt. Accordingly, probated estates often look for ways to eliminate a deceased individual’s debts so the maximum amount of compensation can be transferred to heirs. Rule 1016 of the Federal Rules of Bankruptcy Procedure dictate what happens when a person who owes debt passes away. According to this regulation, a probate estate cannot file for bankruptcy. The reason behind this law is that the fresh start offered by bankruptcy is linked to the person who owes the debt. 

Consequently, if you and your family are navigating the probate process and the deceased individual owned distinct debts, you will have to pursue other options to manage these debts. It is also worth noting that if a person who owes debt passes away after filing for Chapter 7 bankruptcy, the case will continue and the bankruptcy estate will be administered. Sometimes, courts also allow Chapter 13 bankruptcy cases to continue after an individual passes away. Because these are often decided on a case by case basis, it is best to speak with a knowledgeable bankruptcy lawyer about your unique situation. 

Contact an Experienced Estate Planning Lawyer Today

Bankruptcy is a stressful process. When bankruptcy ends up impacting estate planning, it is easy to end up feeling overwhelmed about the entire process. In these situations, one of the best steps that you can take is to retain the assistance of an experienced estate planning lawyer. Contact attorney Melanie Tavare today to schedule a free case evaluation.