Can a trust protect your assets from loss?

According to the lawyer advertising and the self-help books, everyone needs a revocable trust.

The asset protection industry loves irrevocable trusts to get assets out of your name so your creditors can’t reach your wealth.

So, do trusts work in bankruptcy to change the rights of debtors and their creditors?

Not so much.

What’s a revocable trust

A revocable trust is also called a living trust.  It’s created during the lifetime of the person putting their assets in trust.

The settlor, the person creating the trust, can unwind the trust altogether.  Or, the settlor can extract one or more assets from the trust.  It’s revocable.

The appeal of a revocable trust is that assets owned by a trust don’t need to be probated at the settlor’s death.  The terms of the trust determine who gets the trust assets.

I find revocable trusts useful to manage assets of the aging or the incapacitated.

Title to trust assets in a revocable reads:  George Smith, Trustee.  The asset appears to no longer be George’s asset, personally, but the asset of his trust.

Many people would like to think that George’s creditors can’t reach the asset if George doesn’t pay his debts.  Is it so?

Revocable trust and creditors

The very quality that makes a revocable trust appealing, that it can be revoked in whole or in part, is what defeats it as an asset protection tool.

The law says, if the settlor, the person who settles assets on the trustee, can revoke the trust, the settlor is treated as the absolute owner of the assets.

The trust changes nothing as far as the settlor’s exposure to his creditors.

California law puts it this way:

If the settlor retains the power to revoke the trust in whole or in part, the trust property is subject to the claims of creditors of the settlor to the extent of the power of revocation during the lifetime of the settlor.  Ca. Prob. Code § 18200

So when bankruptcy schedules ask for a list of your assets, the property in your revocable trust must be listed.

If the trust is irrevocable

An irrevocable trust is one where the trust can’t be revoked.  Assets that flow into the trust can’t be extracted by the settlor.

With an irrevocable trust, you’ve traded flexibility as to your assets for protection.

So, some see the irrevocable trust as the answer to creditor problems:  put the money in trust, let the trustee pay it out to you, and thumb your nose at creditors.

But there’s this pesky idea called the law against fraudulent transfers.

In this case, the law protects creditors who have a claim at the time the trust is funded.  The theory of law is that you can’t defeat the claims of your creditors by giving your property to a trust without getting back reasonably equivalent value.

If you got nothing for giving away your assets to the trust, it’s a fraudulent transfer.

State law, and bankruptcy law, have rules about how long a fraudulent transfer can be challenged by creditors.

Further, state law and the terms of the trust itself will determine the rights of creditors to monies paid out from an irrevocable trust.

Make sure your expectations about trusts, creditors, and bankruptcy are grounded in law.

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Before you clean your financial house

What you keep through bankruptcy

You can get a Chapter 13 discharge even  without making all the plan payments you promised.

There are hoops to jump through and facts to marshal to get that discharge, but it’s possible.

The Bankruptcy Code provides for a hardship discharge in Chapter 13 to those whose failure to complete their plan is due to circumstances for which they should not be held accountable.

Those circumstances, in my practice, have included illness, job loss, advancing age, and even tax debt arising after the case was filed from the sale of property.

Requirements for hardship discharge

Three conditions have to be met to get a discharge without paying as promised.

1. Unsecured creditors must have received at least as much as they would have if the case had been a Chapter 7.
2. Modification of the plan isn’t possible.
3. The inability to make payments is traceable to events out of the debtor’s control.

The debtor must file a motion for a hardship discharge and provide evidence that shows each of those factors are present in the case.

The motion can be brought anytime after confirmation.

Hardship discharge has limits

Certain debts that would be dischargeable in a fully completed Chapter 13 are not wiped out by the hardship discharge, including priority taxes or debts incurred by fraud, dishonest behavior, or intentional acts.  The complete list is found in §523.

Importantly for lots of debtors is that liens determined to be worthless at the beginning of the case still get stripped.

How lien stripping works

You’ve got to jump through the paper hoops to get the lien voided, but you are entitled to have it wiped out even with a hardship discharge.

Why not just convert?

Converting a Chapter 13 case to Chapter 7 is another alternative when you can’t complete the Chapter 13 plan or modify the plan to one you can complete.  The case remains the same case (no new filing fee, though you need to pay a few bucks to the clerk on conversion).

Three reasons stick out for getting the Chapter 13 discharge rather than converting.

1.   A discharge in the Chapter 7 won’t happen for months;  there’s another first meeting of creditors, and a requirement to amend schedules to bring them up to date.
2.   If you wanted to stay in control of assets or keep a Chapter 7 trustee from messing around in your finances when you first filed, those reasons probably continue.
3.    A Chapter 13 discharge makes you eligible for bankruptcy relief in the future in the shortest time possible.

All good reasons to get a Chapter 13 discharge if you can.

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Keys to Chapter 13 success

Bankruptcy has its own language.  If you are considering filing bankruptcy, it helps to know the language spoken there.

Master just a couple of words and phrases, and input from a bankruptcy lawyer starts to make sense.

So, in our continuing campaign for better understanding of bankruptcy, here’s a dozen phrases from the language of Bankruptcy for your meeting with a bankruptcy lawyer.

Essential bankruptcy terms

Petition – the first paper filed in a bankruptcy case that initiates the case.  It invokes the automatic stay. 

Automatic stay – an injunction against creditors that halts collection and foreclosure just because the petition has been filed. 

Schedules  = the balance of the papers filed after the petition to flesh out your bankruptcy case.  

Trustee  – the individual appointed by the Department of Justice  to oversee your filing and to represent the interests of creditors as a whole. 

U.S. Trustee – an employee of the Department of Justice who supervises trustees and monitors Chapter 11 cases with no creditors committee

Means test – a form and a formula added to consumer bankruptcy cases supposedly to ferret out bankruptcy filers who are really able to pay creditors without bankruptcy.

Discharge – the court order that makes your dischargeable unsecured debts unenforceable

Dischargeable – debts that may be wiped out in bankruptcy  

Non dischargeable  debts that are excluded from the  discharge by the terms of the Bankruptcy Code.

Reaffirm – an agreement made after filing to waive the discharge as to a particular debt.  Reaffirmation requires court approval  

Transfer  – any act that changes ownership or title to an asset, or creates a lien on an asset.

Post petition – events that happen after the petition for bankruptcy is filed.

Add some numbers to your list

Because bankruptcy is based on the Bankruptcy Code, bankruptcy types tend to use the number of some important statutes as shorthand.

341 – Section 341 requires a first meeting of creditors in every bankruptcy case.  We call that the 341 meeting.

523 –  This is the section that lists the debts that are non-dischargeable.  Several subsections require an affected creditor to prove his debt is non dischargeable.

727 – This section sets out the circumstances when a discharge can be denied altogether.  It can be brought by a creditor or the trustee for the benefit of all creditors.

Bankruptcy chapters come next

Different chapters of the Bankruptcy Code provide for different kinds of bankruptcy cases that may be filed.

Chapter 7  – a liquidation bankruptcy case available to individuals and business entities, but not trusts or estates.

Chapter 13  – a reorganization case for individuals with debts under certain limits.

Chapter 11  – a more complex reorganization case for individuals and business entities without debt limits

Chapter 12  – a simplified reorganization proceeding for family farmers

Use your words

Now that you have a working bankruptcy vocabulary, start talking to a bankruptcy lawyer to find out how these concepts work in real life.

Don’t be afraid to ask questions.  There is no reason why you should immediately understand this very specialized area of law.

Even when you understand the concepts, how those concepts apply to your situation, and how they interact with each other is what’s really important.

Make sure you pick a bankruptcy lawyer willing to take your questions and to deliver answers that you can understand.

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Decisions, decisions.

Your bankruptcy filing requires that you state your intentions about reaffirmation right up front.

Translated, that means what are you going to do about the car after bankruptcy.  The car on which you still owe money and need to get to work.

In the midst of all the other information needed to file a Chapter 7, it’s hard to get your head around reaffirmation.

Particularly since reaffirmation got a lot more complicated and unpredictable thanks to Congress and bankruptcy “reform” in 2005.

With my apologies for being dull and dense, here’s my attempt at explaining the issues and the options when deciding whether to reaffirm a car loan.

Liens not discharged

The entire reaffirmation issue comes up because the bankruptcy discharge wipes out your personal liability for your car loan.  But the lender’s lien on the car survives bankruptcy.

After your Chapter 7 is over, the car lender can’t sue you for the unpaid balance of the car loan, but it can repo the car to enforce its lien.

As bankruptcy lawyers say, the lien “rides through” the bankruptcy.

If you keep paying

Before 2005, a provision of the Bankruptcy Code said that if you kept payments current on a loan after filing, you were not in default.

Put another way, just filing bankruptcy and discharging your personal liability didn’t breach the contract for the car loan as long as you paid as agreed.

That provision was wiped out in bankruptcy “reform”.  Now, even if you are current on the car loan payments, just having filed bankruptcy puts you in default.  You are now at risk of having your car repossessed.

You can eliminate the risk of repossession by reaffirming the car loan.

Effect of reaffirmation

If you “reaffirm” the original loan deal, your bankruptcy is no longer a breach of the contract.  You give up the benefits of your bankruptcy discharge as to the car loan.  So, the car lender emerges from your bankruptcy in the same position that it was when you filed.

You, however, are once again at risk of not only repossession of the car, but also a lawsuit for any deficiency if you can’t pay in the future.

The greater the spread  between what you owe on the car and what it’s worth, the greater the risk to your pocketbook in the future.

What the car lenders got from Congress

The car finance industry was one of the big winners when Congress amended the Bankruptcy Code.  They got the right to intimidate debtors with the loss of their wheels if they didn’t give up the benefits of bankruptcy as to this one creditor.

And the fear factor of losing your car, even if you’re paying, is huge.

As it has played out since 2005, most car lenders have elected not to automatically repossess cars when the loan isn’t reaffirmed.  They decided that they’d rather have the stream of income that post bankruptcy payments provide than get the used car worth less than the loan balance.

Ford Motors is the exception.  Ford has aggressively repoed cars where the debtor didn’t reaffirm the debt.

Reaffirmation is voluntary

You get a choice about reaffirming a car loan.  You don’t have to reaffirm.

In fact, the form that you file with your bankruptcy papers allows you to elect to surrender the car.

Surrender may be the best thing if the car is simply too expensive or isn’t reliable.

You can choose to keep the car and continue paying without reaffirming.  You take your chances that the lender will repossess the car, but you also keep the benefits of the bankruptcy discharge.

Getting reaff approved

Because reaffirmation presents risks, the required form for reaffirming lays out the value of the collateral, the amount owed on the loan, and the interest rate.  The facts get laid out in black and white.

A form I reviewed recently made clear that while the debt to be reaffirmed was $22,000, the value of the car involved was only $11,000.  You had to ask whether it was a good deal to pay $22,000 for something worth half of that.

Sometimes, the lender will reduce the interest rate or extend the payments as part of the reaffirmation.

The form also calls for the debtor to lay out his income and his other expenses.  The question is:  can the debtor really afford to keep paying on the car.

Often, there isn’t enough income to pay the expected costs of living and pay the car.  The form contains no way to express the fact that some living expenses are essential, and get paid even if other expenses are deferred.

Because the issue is so fraught with risks and uncertainties, the reaffirmation agreement has to be approved by the bankruptcy judge.

The judge is tasked with assessing whether the debtor understands the risks, and can pay the reaffirmed loan without hardship.

And the question the law doesn’t address is what can the debtor do if he loses the car.

In my experience, lawyers hate having to advise clients about their “options” when the options are so unappealing.  Judges, too,  hate trying to predict the debtor’s future, with or without the car.

Does ride-through survive?

Out of this cauldron of uncertain and bad options, a line of court decisions has developed that may provide a middle course.

Some courts have held that a debtor who attempts to reaffirm a car loan and has the judge deny approval is still protected from repossession.

Those courts read the law to say that all that is required to preserve the right to “keep and pay” is the willingness to reaffirm.  So, even if the judge withholds approval of the reaff, the lender can’t repossess as long as the payments are kept current.

In my view, all of this is enough to end our love affair with cars.  But there are your choices.

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