Parents who have saved and invested prudently for many years often expect to be able to leave their adult children a substantial inheritance.   They hope this will fund their children’s retirement savings, grandchildren’s college tuition, or other goal of financial security.  But what if an adult child has filed for bankruptcy when a parent dies? 

Although a bankruptcy is often an intelligent choice for an individual to “get a fresh start” when medical bills, business failure, or a divorce devastate his or her finances, many grown children are embarrassed and ashamed to tell friends and family about their situation.  This can cause further problems when parents make their estate plans assuming their children are not and will never be in bankruptcy.

Personal Bankruptcy Proceedings

A personal bankruptcy proceeding can be either a “Chapter 7” in which much of the debtor’s assets are liquidated and paid to a bankruptcy trustee to pay creditors, or a “Chapter 13” which allows a debtor to keep many assets while paying all available income (after reasonable living expenses) to a bankruptcy trustee to pay creditors.  Chapter 13 is usually requested by debtors who have a steady source of income and own their residence.  While a Chapter 7 bankruptcy may be discharged in less than six months from the filing of a petition, a Chapter 13 bankruptcy proceeding usually lasts three to five years. Any funds inherited by the debtor from a parent or other individual who dies during the bankruptcy proceeding will likely be paid over to the bankruptcy trustee to the extent that the debt is satisfied.

Common scenarios involving estate planning and a grown child’s bankruptcy:

• Mary’s will left all her assets to her son Bill, and if Bill was not living at the time of Mary’s death, to Bill’s son John.  Bill had filed for bankruptcy just before Mary’s death, but did not want Mary to know about his financial problems.  Because Mary’s death would be the date the inheritance was “vested” in Bill, the inheritance was subject to the bankruptcy proceeding, and would have to be paid to the bankruptcy trustee to be paid out to Bill’s creditors.  Meanwhile, Bill’s son John had no significant debt and had just been accepted to medical school.  While an estate beneficiary is often free to “disclaim” an inheritance (which generally causes this share of the estate to be distributed as if the beneficiary had predeceased the decedent), doing so after filing a bankruptcy petition is likely to be viewed as a fraudulent transfer.  Bill could not disclaim the inheritance so that it could be used for John’s tuition.

• Frank’s adult daughter, Deborah, told him that she had just filed a bankruptcy petition and that her bankruptcy attorney had advised her that any inheritance during the bankruptcy would be available to pay Deborah’s creditors.  Frank immediately went to his estate planning attorney and executed a new estate plan naming Deborah’s son Greg as the beneficiary of what had been Deborah’s share of Frank’s estate.  Shortly thereafter, Frank died.  Because Frank was free to leave his estate to anyone he liked, Greg was able to inherit from Frank without interference from Deborah’s bankruptcy proceedings.

• Molly and Felix had substantial assets and were worried that their child, Chris, could have creditor problems in the future.  Their estate planning attorney advised them to incorporate a lifetime trust for Chris into their estate plan with “spendthrift” provisions.  This would allow an independent trustee discretion to distribute funds to Chris.  If properly drafted, this trust would shelter funds from Chris’ creditors if Chris were to file for bankruptcy.  The trust could also protect the funds from Chris’ ex-spouse in the event of a divorce.  Incorporating such a trust into Molly and Felix’s estate plan now would provide security against creditor problems that Chris might have in the future.

Although bankruptcy is a federal proceeding, the laws of the state where the debtor resides vary in determining which assets are available to creditors.  If you are concerned about protecting your legacy from your child’s possible bankruptcy, you should discuss options with your estate planning attorney.

The estate planning attorneys of the Wilchins Cosentino & Novins, LLP Trust & Estates Group provide high net worth individuals with legal and tax planning advice for their estates, trusts, business activities, investments and insurance. At the core of these private client law firm services is a close, confidential relationship with our clients through which we learn and understand their goals and objectives for transferring wealth to future generations. This wealth transfer takes place either outright or via managed trusts, preserving wealth by minimizing income, estate, gift and generation skipping transfer taxes, and directing the disposition of assets during life and after death, while protecting assets from creditors.

To learn more about the Private Client Services at WCN, click here. To learn more about Attorney Marjory Selig, click here.

This article does not create, and should not be construed as creating, an attorney-client relationship.