Bankruptcy When You Have a Living Trust

Financial problems can strike anyone, and bankruptcy can be a useful tool when debts pile up. But if you are one of the many Connecticut residents who manages their money through a trust, you might wonder how the two will intersect. Here’s what happens in a bankruptcy when you have a living trust.

Types of Living Trusts

A living trust is a trust that you create and use while you are still alive, as opposed to in your will or estate plan. There are two kinds of living trusts:

• Revocable living trusts can be funded and the funds withdrawn by the grantor (you, the person who created the trust) at your discretion. Grantors maintain complete control over revocable living trusts. They can be modified at any time, and the interest and principal can both be used to pay for the grantor’s living expenses. By the same token, a revocable living trust offers no protection from creditors. It is mainly a device to minimize probate administration after you pass. Although it is very valuable in that regard, during your lifetime creditors can execute on the trust assets just as surely as if they were still titled in your name.
• Irrevocable trusts hand over control of the trust assets to the trustee, who has a fiduciary obligation to the beneficiaries. As his or her title implies, the trustee should be someone you trust, since he or she will have complete control of the trust assets and a wide range of powers as to what to do with them.

Are Trusts Protected from Bankruptcy?

The effect of bankruptcy when you have a living trust depends on the nature of that trust. Because revocable living trusts can be reached by creditors, a bankruptcy trustee may “stand in their shoes” and reach the trust assets to satisfy your debts. On the other hand, irrevocable trusts can offer some protection from the bankruptcy process.

Irrevocable Trusts and Chapter 7 Liquidations

A Chapter 7 bankruptcy is also called a “liquidation” bankruptcy. In it, the bankruptcy trustee sells off the debtor’s non-exempt property and distributes the proceeds to his or her creditors according to their security interests and the priority of their debts. This means that the lowest priority “unsecured” creditors – like credit cards and medical bill collectors – often get paid far less than their full balance. Still, when the Chapter 7 bankruptcy is over, anything unpaid is discharged and can no longer be collected.

But that raises the question: can property in a trust be seized as part of a Chapter 7 bankruptcy? Once you transfer funds into an irrevocable trust, they belong to the trust, not you. The trust is a separate legal entity, so its assets are generally not considered yours for bankruptcy purposes.

The only exception is when you create the trust too close to the start of your bankruptcy. In general, grantors should avoid “fraudulent transfers” made to avoid paying creditors and “preferential payments.” The “look back” period for these transactions depends on the circumstances and type of payment made. However, under Connecticut’s Fraudulent Conveyance Act, a bankruptcy court can look back up to 4 years to recover assets that should be paid to creditors. If they exist, the bankruptcy trustee can reverse the trust, restoring the assets into your name, so that they can be liquidated in a Chapter 7 bankruptcy proceeding.

Altogether, this means you can’t use an irrevocable trust to shield your assets from creditors or to distance yourself from your property once you are already considering bankruptcy. But assets transferred to an irrevocable trust more than four years before filing may escape the bankruptcy process. Chapter 13 Repayment Plans and Trust Fund Payments

Under a Chapter 13 bankruptcy, debtors with reliable sources of income can pay off their debts over the course of three to five years. However, the debtor needs to be prepared to put all their disposable income to reduce their credit balances during that time, and cannot generally take on new debt while the bankruptcy is pending. If you regularly receive trust fund distributions, either from your own revocable living trust or as a beneficiary to a deceased relative’s trust, those funds will likely be included in your Chapter 13 repayment plan.

Can a Trust File Bankruptcy?

In most cases, a revocable living trust or irrevocable trust created by an individual (rather than a business) cannot file for bankruptcy. This is because the grantor of a personal trust remains the debtor for any funds borrowed or owed. However, a business trust is an entirely separate legal entity, which can take on its own debts, and as a result, can file a Chapter 11 bankruptcy independent of the people who formed it.

Get Help Navigating Trust Bankruptcy Questions from an Experienced Connecticut Bankruptcy and Estate Planning Attorney

Understanding bankruptcy when you have a living trust can be challenging. If you are considering creating a trust to manage your assets, or are worried your trust will be invaded to pay off your creditors, you need to work with an attorney who understands both bankruptcy and estate planning law. At Lawrence & Jurkiewicz, we focus our practice on helping people. We can advise you on your estate planning options, and be there for you when you decide to file for bankruptcy. Please contact us or call 860-264-1551 for a free consultation.