Liquidation of trusts in a Chapter 7 bankruptcy: What you need to know?

In a Chapter 7 bankruptcy, known as liquidation bankruptcy, consumers are able to erase certain debt and start over on a fresh financial footing. During the bankruptcy, the trustee generally gathers all of the consumer's assets and determines which ones qualify for liquidation. Once liquidated, the proceeds go to pay off the consumer's creditors. However, determining which assets qualify for liquidation gets tricky.

Trusts and bankruptcy

One particular asset involves a consumer filing for Chapter 7 bankruptcy who also is a beneficiary of a trust. When a consumer is filing for bankruptcy and he or she is a potential beneficiary of a trust that has considerable assets, there are issues that need to be resolved before deciding whether it's likely the assets of the trust will be included in the bankruptcy liquidation.

First, it must be determined whether the consumer has control over the trust. A way to determine this is by looking at whether the trust is revocable or irrevocable.

A revocable trust in bankruptcy

A revocable trust is essentially a trust that can be revoked, or taken away, by the grantor (the person granting the trust to another).

With a revocable trust, the grantor has complete control over the assets until his or her death. As a result, the consumer (or trust beneficiary) doesn't have any legal claim to the trust assets.

So, generally, a revocable trust is not considered an asset a consumer controls that can be acquired and liquidated by a trustee in a Chapter 7 bankruptcy proceeding.

Consumer as maker of revocable trust

However, the situation becomes a bit more complex when the consumer is the grantor and the trust beneficiary.

In this situation, since the consumer has control over the trust (being the grantor), it's likely the revocable trust will be reached by the trustee.

An irrevocable trust in bankruptcy

An irrevocable trust is essentially a trust in which assets have been permanently transferred to a trust with designated beneficiaries.

With an irrevocable trust, the grantor has removed his or her rights to the assets of the trust and only the beneficiaries can change or modify the trust. Since the consumer has control over the assets as a trust beneficiary in an irrevocable trust, the assets are at risk of becoming liquidated.

Consumer as maker of irrevocable trust

However, just like the situation described above, if the consumer filing for bankruptcy is also the grantor, the situation changes. A consumer as grantor of an irrevocable trust in which the consumer is giving away assets, the consumer giver no longer has rights to the trust and will not be included in the bankruptcy.

Spendthrift provision

However, simply because the assets are at risk doesn't mean they automatically will be liquidated.

For instance, the bankruptcy laws provide for "spendthrift provisions" that bar creditors from obtaining the proceeds of assets in an irrevocable trust, or a revocable trust in which the grantor has passed away, to pay off debt. Additionally, there could be problems with liquidating the trust in a Chapter 7 bankruptcy when there are multiple beneficiaries of an irrevocable trust.

Consulting with a bankruptcy attorney

When there are issues such as trusts involved in a bankruptcy, the process becomes more complex. Consulting with an experienced bankruptcy attorney who knows the law and can offer the best advice prior to filing is advised. A lawyer can offer advice on the best route to take that will result in the best possible financial outcome.