Can a living trust protect your assets in bankruptcy? Or, anywhere else?
According to the lawyer advertising and the self-help books, everyone needs a living trust.
The asset protection industry loves irrevocable trusts, another much touted trust. An irrevocable trust gets assets out of your name for all time. Unless of course, they are attacked in court as a fraud.
Living trusts are more common, often as a substitute for a will.
So, do living trusts work in bankruptcy to change the rights of debtors and their creditors?
Not so much.
What’s a living trust
A living trust is another name for a revocable 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?
Living trusts in bankruptcy
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. It becomes property of the bankruptcy estate as though there were no trust.
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 in exchange for 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. A successful challenge to a transfer to trust gives creditors access to trust assets as though it didn’t exist.
Further, state law and the terms of the trust itself will determine the rights of creditors to monies paid out from an irrevocable trust. Developing California law says that creditors can get 25% of distributions from trust, even if there is trust provision to the contrary.
Make sure your expectations about living trusts in bankruptcy align with the law in considering bankruptcy.