Bankruptcy and Being the Beneficiary of a Trust: A Hard Choice?

Are you the beneficiary of a revocable trust?  Many families use revocable trusts for estate planning purposes.  Like so many Americans, let us assume that you are in debt and contemplating the need to file for protection under the bankruptcy code.  What happens if you are the beneficiary of such a trust and your parent or loved one dies suddenly? Must the assets in the trust flow to you and then out to your creditors?

In California, the answer is, "no."  The United States Court of Appeals for the Ninth Circuit decided Gaughan v. Costas in February, 2009.  In that case, the court found that a "pre-petition disclaimer" of the trust assets was valid.

In California, a disclaimer is a procedure whereby a beneficiary can elect to forego an asset. The disclaimer must be in writing.  It must be filed within a reasonable time after the person who is to take assets under a trust learns of the right to take the assets.  Typically, a reasonable time is nine months or less.  Finally, the disclaimer must be filed in the Superior Court in the county in which the estate of the decedent is administered.

One might think that using the California statute allowing one to disclaim trust assets (and thereby causing those assets to flow to family) would be classified as a fraudulent transfer and therefore violate 11 U.S.C. section 548.  To constitute a fraudulent transfer a disclaimer would actually have to transfer "property."  In determining the definition of property, however, the Federal courts look to state law.  A disclaimer is defined as a refusal to accept an interest in property.  One cannot transfer property that one never accepted.

The United States Court of Appeals for the Fifth Circuit recently opted to follow Gaughan v. Costas.  In that decision, Laughlin v. Nouveau Body & Tan, LLC (In re Laughlin), 602 F.3d 417 (5th. Cir., 2010), the court found:

The Ninth Circuit's reasoning is sound: the bankruptcy code defines "transfer," but to effect a transfer there must be "property" or an "interest in property." And the Supreme Court has repeatedly held that "property interests are created and defined by state law" in the absence of a controlling federal interest.

As it currently stands, the law allows a debtor to disclaim assets coming to him or her under a trust, thereby allowing those assets to go to other family members, and then file for bankruptcy protection.