Trust Protected in Bankruptcy in Arizona

Is My Trust Protected in Bankruptcy in Arizona? Debtors are required to list any trusts, equitable or future interests in...

Is My Trust Protected in Bankruptcy in Arizona?

Debtors are required to list any trusts, equitable or future interests in property, and rights and powers exercisable for your benefit and must also list and disclose whether they have transferred any property to a self-settled trust or similar device of which you are a beneficiary within the last 10 years (i.e., asset-protection devices).  So before filing bankruptcy, debtors must determine whether their trust protected in bankruptcy in Arizona.  This is a highly factually intensive inquiry.

Determining creditors’ rights to a trust in general usually turns on the amount of control a debtor has over the trust assets.  There are generally two types of trust – revocable (or inter vivos) and irrevocable.  With a revocable trust, there are generally four situations which may arise: (1) a debtor is solely a beneficiary of a revocable trust; (2) the debtor is both a beneficiary and a trustee of the trust; (3) debtor is solely a trustee of a trust; and (4) the debtor settled the trust prior to filing irrespective of the debtor’s current rights to, or powers over, the trust assets.  And with respect to whether and irrevocable trust protected in bankruptcy in Arizona, the central inquiry is whether it contains a spendthrift clause.

  1. Debtor Has a Beneficial Interest in a Revocable Trust

The majority of the courts hold that this mere expectancy interest that the debtor possesses on the date of filing is not a property interest as required to be included in a bankruptcy estate because the grantor can unilaterally extinguish or revoke the interest at any time.  For example, a debtor’s mother may have settled a revocable trust and named the debtor/daughter as a contingent beneficiary.  If the debtor’s mother is still alive (and competent), the mother could revoke the trust or change the contingent beneficiary designation.  Arizona bankruptcy rulings have seemed to adopt this approach.  Therefore, a bankruptcy trustee would have no right or interest in the trust and the trust protected in bankruptcy in Arizona.  In re Schmitt, 215 B.R. 417 (9th Cir. BAP 1997) (citing a case where the right to renew Phoenix Suns season tickets was not a property right subject to control and disposition by a Chapter 7 trustee).

However, a debtor’s receipt of an inheritance within 180 days after filing a Chapter 7 bankruptcy becomes property of the bankruptcy estate.  In this regard, at least one older Ninth Circuit case ruled that an interest in a revocable inter vivos trust becomes property of the estate where the settlor dies within 180 days of filing bankruptcy.  In Neuton, the debtor’s mother passed about a month after filing and the beneficial interest became irrevocable at that time.  Because Chapter 7 estates include any inheritance received within 180 days of filing, it would appear that Neuton interpreted the vesting of the interest in the trust as an inheritance.  An inheritance is defined as property which descends to an heir on the intestate death of another (i.e., without a will).

A different approach was taken in In re Cook where the Ninth Circuit BAP was asked to resolve a case where the debtor filed with an interest in a revocable inter vivos trust which was later funded through a pour-over will where the debtor’s mother passed within 180 days of the bankruptcy filing.  The debtor’s interest in the trust at the time of the filing was a contingent beneficial interest and not property of the bankruptcy estate.  After the passing of the debtor’s motion, the debtor had a right to share in the trust distributions.  The right was acquired through vesting in the trust, not through bequest, devise, or inheritance and was therefore not included in the estate.  The significance of the pour-over will may have been the deciding factor in that case although they are hard to reconcile.  This seems to be the correct result but the reasoning would seemingly apply to Neutron which held otherwise.

Lastly, this analysis only applies in Chapter 7 cases.  In Chapter 13 bankruptcy, the bankruptcy code provides that property acquired by a Chapter 13 debtor after the petition date (but before closing, dismissal or conversion) of the case becomes property of the estate.  Thus, any interest in a trust acquired during the Chapter 13 process could be used to fund creditor claims.  See 11 U.S.C. § 1306(a).

Debtors should also not overlook the fact that the title of the trust may be misleading and if the settlor of a revocable trust is deceased prior to filing, then the debtor’s interest in the trust is no longer revocable and the bankruptcy estate may have a right to the debtor’s interest subject to any spendthrift provisions.

  1. Debtor is Both Beneficiary and Trustee of a Revocable Trust

Any powers which a debtor has in a trust is property of the estate, including the power to amend the trust and the power to revoke a revocable trust and recover the remaining funds in the trust for the benefit of creditors.  Therefore, even if the debtor is only a contingent beneficiary of a revocable trust which is not property of the estate, the bankruptcy trustee may look to the powers a trustee can exercise for his own benefit to seek a recovery for the bankruptcy estate.  See In re Cutter, 398 B.R. 6, 18-19 (9th Cir. BAP 2008) (“powers that a debtor who is trustee of a trust may exercise for his or her own benefit become property of the estate.”).

  1. Debtor is Solely a Trustee of the Trust

Where a debtor is solely the trustee of a trust with no rights to income or principal, Section 541(b)(1) provides excludes such interest from the estate (“any power that the debtor may exercise solely for the benefit of an entity (i.e., trust) of than the debtor.”).  If, however, the trust provides certain discretionary powers to the trustee such as “reasonable compensation for serving as trustee,” then this income can be considered wages as part of qualifying for Chapter 7 or for purposes of funding a Chapter 13 or Chapter 11 plan.  Likewise, if one is merely designated a trustee but permitted to invade the principal at his discretion, such powers become property of the estate.  But generally the trust would not be property of the estate and should not be an issue in this scenario.

  1. Debtor Settled a Trust Pre-Petition

Where the debtor settled a trust prior to filing bankruptcy, it could be viewed as a fraudulent transfer by the Chapter 7 trustee.  If settled within four years of filing bankruptcy, the trustee has a right to seek to set aside the funding of the trust as a fraudulent transfer.  Debtors should disclose to their bankruptcy counsel the circumstances in the funding of the trust.  If done in response to increased creditor activity or unsustainable debts, it would likely be challenged by a Chapter 7 trustee and may be lost to the bankruptcy estate.

Irrevocable Trusts and Spendthrift Clauses in Arizona

Where the debtor is a beneficiary of an irrevocable trust (or a revocable trust where the grantor is deceased), the Chapter 7 trustee has the right to any trust income or principal that can be compelled by the trustee under the terms of the trust.  This is where the terms of the trust need to be examined carefully.

But determining a bankruptcy trustee’s rights to an irrevocable trust generally turn on whether the irrevocable trust contains a “spendthrift clause” which prohibit compelled contributions by creditors (or a Chapter 7 trustee).  If a trustee of a trust cannot be compelled to make such distributions for the benefit of creditors, the trustee of the bankruptcy estate similarly cannot compel the trustee of the trust to make such distributions for the benefit of the estate.  Bankruptcy law generally honors “spendthrift provisions” that bar creditors from obtaining the assets of a trust.  11 U.S.C. § 541(c)(2) provides that “[a] restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.”  Spendthrift protections may be limited, however, if the debtor settled the trust.

Self-Settled Spendthrift Trusts in Arizona

In some circumstances, debtors have tried to settle irrevocable trusts for their own benefit.  Under the old Arizona trust code, self-settled trusts were not permitted as an asset protection device for the settlor.  The new Arizona Trust Code still provides that property of a revocable trust is subject to the claims of the settlor’s creditors during the lifetime of the settlor  and upon death A.R.S. § 14-10505(a)(1), (A)(3).

However, Arizona has now adopted the Uniform Trust Code which seems to permit the some spendthrift protections for self-settled irrevocable trusts.  Under the new Arizona Trust Code, A.R.S. § 14-10505(A)(2) states that “with respect to an irrevocable trust, a creditor or assignee of the settlor may reach the maximum amount that can be distributed to or for the settlor’s benefit.”  This seemingly means that a debtor could settle an irrevocable trust and if the settlor’s rights to the trust are limited to a fixed amount per month or just the income from the principal, the remaining trust principal is outside the reach of creditors.

The bottom line is that determining whether your trust is protected in bankruptcy in Arizona is a complex and highly factual inquiry that should only be assessed after consulting with experienced bankruptcy counsel.




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