When filing bankruptcy, a debtor must declare all of his/her assets. This is because a debtor can only protect so many assets under the allowed exemption limits, which vary based on the debtors residency status. In a chapter 7 proceeding the debtor is often forced to liquidate the over exempt asset or pay the cash equivalent of the non-exempt amount to retain the asset. In a chapter 13 proceeding, the debtor can keep the non-exempt asset, but might have to pay its unsecured creditors the non-exempt value that it is keeping.
Debtors are often surprised by what some of their assets really are, because they don’t think of them as assets. That car accident you got into 6 months ago and are trying to settle the personal injury claim is an asset. The family corporation you are the 100% owner is also an asset. Your 2010 tax refund you are waiting on, that’s also an asset.
Another asset that debtors often don’t think about as an asset is a potential inheritance, and filing bankruptcy prior to considering the possibilities of receiving an inheritance can prove catastrophic. It is extremely important to remember than an inheritance is treated differently than almost every other asset in a bankruptcy case.
Basically all other assets that are considered assets in a bankruptcy petition are determined by the filing date. In other words, an asset acquired after the filing date is not an asset of the bankruptcy estate. However, an inheritance is treated differently. An inheritance acquired within 180 days of the filing date is considered part of your bankruptcy estate. Furthermore, in a chapter 13 proceeding, the inheritance is part of the estate the whole time the debtor is in the chapter 13, which in some plans is as many as 60 months.
So how to plan for the possibility of receiving an inheritance?
The easiest scenario to address is one where the debtors right to the inheritance exists prior to filing, meaning the testator has already passed. Whether the decedents estate has been probated yet, the right to the inheritance exists at the death. Therefore, if the debtor files bankruptcy after the decedent has passed, the debtors right to the inheritance will pass to the bankruptcy trustee at filing. This is not problematic if the inheritance is small and the debtor has enough exemptions to protect it. But what if the debtor does not have enough exemptions to protect it? The trustee would then liquidate the asset to pay off the debtors creditors, unless the debtor executed a renunciation of the inheritance prior to the debtors bankruptcy filing, so that it is not an asset at the filing of the case.
An experienced estate planning attorney can draw up a renunciation in accordance with federal and state laws; however, there are time limits to the renunciation agreement. Therefore, the debtor who is considering bankruptcy must immediately notify the bankruptcy attorney that the right to an inheritance exists.
If the debtor properly executes the renunciation, the debtor will no longer have rights to that inheritance, since it is a permanent renunciation. The debtors share would then go according to the terms of the will as if the debtor predeceased the testator. Hopefully for the debtors sake, the person who takes in lieu is someone the debtor likes and can be happy is taking in place of the debtor. This person could even later after discharge gift the debtors share back to the debtor, but that would be purely voluntary. This would make the testator happy as well, because the testator would presumably rather anyone but the debtors creditors get the testators hard earned assets, and would probably be happy to see it also go to someone named in the will.
What about the scenario where the debtor knows it is named as a beneficiary of a will, but the testator is still alive? Some people would be surprised to hear that the debtor has no asset at that point, because a will is ambulatory. That means the testator can change the will at any second to write out the debtor as beneficiary.
Still, the testator could die at any moment the debtor is in the bankruptcy, and if that happens within 180 days of the debtors chapter 7 filing or at any point in the debtors chapter 13 filing, that asset would immediately belong to the bankruptcy estate. Remember, the debtor cannot renounce the inheritance once in bankruptcy, because that asset is part of the bankruptcy estate at that point.
So if a debtor knows prior to filing that someone has named him/her as a beneficiary of a will, what are the debtors options? The debtor could notify the testator of the upcoming filing and ask the testator to either remove him/her from the will, or add a clause into the will that if the debtors share would have to be forfeited over to the bankruptcy trustee or any creditors, that the executor should not distribute the funds to the debtor and should give them to someone else named in the will. Then at either discharge or the end of 180 days, the testator can give the inheritance right back to the debtor.
This is all presuming the debtor is comfortable telling the testator of the upcoming bankruptcy. If the debtor is not comfortable having that conversation, then the debtor is taking a gamble that creditors will get their hands on the debtors inheritance. While this will help the debtor avoid an unpleasant phone call, it will ultimately not honor the testators wishes of where and who gets its lifetime of hard earned money.