Living Trust and Bankruptcy

We get lots of "living trust and bankruptcy" questions. A common misconception about living trusts is that somehow they can be helpful in protecting assets from creditors in the event of bankruptcy.

Unfortunately, the most common type of living trust (the revocable type) will not do anything to protect your assets from creditors. The creditor can still obtain assets in your trust to satisfy judgments for debts you owe him or her. This makes sense since whether the asset is in a revocable living trust or not, you still control it. So, the idea that a living trust has some kind of bankruptcy advantage is another living trust myth.

However, the less common irrevocable living trust can be used to protect assets from your creditors. As discussed at what is a living trust, there are two distinct types of living trusts: revocable living trusts and irrevocable living trusts.

Anything you put into an irrevocable living trust you are essentially giving away. You no longer own or control that asset once it is placed in the irrevocable trust. Naturally then, if you go bankrupt your creditors can only "get at" what you own. So, if you don't own it, they can't get. Of course the catch is that you have to give the stuff away.

And, there's another catch to think about. Even if your assets are in an irrevocable trust; even if they are simply given away to someone -- a creditor could still go after them if the creditor can show that you transferred the assets to the irrevocable trust (or to any another person or entity for that matter) -- in order to defraud the creditor.

Every state has a fraudulent conveyance statute that governs this. But, essentially, if you transfer assets when you know, or reasonably should know, that you will need those assets to pay a just debt -- then a court could deem that transfer to be fraudulent and the creditor could still recover the asset(s).

Additionally, it is possible, in some states, that you could be found to have the specific intent of defrauding a creditor and have thereby committed a criminal act.

So, the bottom line is this:

1. Revocable living trusts (the most common kind of living trusts) cannot be used to protect assets from creditors in bankruptcy.
2. Irrevocable trusts can possibly be used to keep assets away from creditors. HOWEVER, if the purpose of the transfer of an asset to the irrevocable living trust is to keep the asset from a creditor who you owe a just debt to -- then, the transfer could be revoked and you could have committed a fraudulent conveyance.

Of course, this all comes down to the difficult matter of determining intent which is often objectively determined by looking at timing. If you set up the irrevocable living trust and transfer assets into it as part of a comprehensive estate plan and well before you have any reason to think the assets will be needed to pay off a creditor -- then it likely will be fine and not deemed fraudulent.

On the other hand, if you have a financial setback and believe you will file bankruptcy and then you move your assets to a trust, even an irrevocable one, -- forget it. It's too late. Your creditors will almost certainly be able to recover those assets.

Using timing to determine intent was codified in the 2005 amendments to the Bankruptcy Code that invalidate self-settled trusts (trusts you place your own assets in and act as trustee), created within ten years of bankruptcy filing -- if the trust is intended to "hinder, delay or defraud" creditors.

If you want to use any kind of living trust for the purpose of bankruptcy "protection" or asset protection, you must talk to a competent living trust attorney.

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