Bankruptcy affects hundreds of thousands of Americans every year. In 2017, the United States Courts reported that there were 796,037 bankruptcies filed in that fiscal year—only a 2.8% decrease from the total reported in 2016 (819,159).
With bankruptcy being such a common occurrence, it leaves many Americans a little shaken and concerned about how major debt can affect many aspects of their lives including their estate plans.
In this post, we’ll break down some basics of bankruptcy and explain how it affects inheritances and estate planning.
What is Bankruptcy?
Bankruptcy is a financial and legal term that refers to when an individual, business, or municipality has so much debt that they must petition the United States Bankruptcy Court to erase their debt. The court rules the petitioner as insolvent (which means they are unable to pay back creditors because their debts or liabilities exceed their assets), and then the petitioner will either liquidate their assets or create a repayment plan with an economic advisor to pay off their debts.
Bankruptcy is governed by federal law, and the cases are filed in the United States Bankruptcy Court. However, state law is usually applied to issues involving property rights, so many systems can be at play.
When someone is declaring bankruptcy, a petition is filed under one of the chapters of the Bankruptcy Code, which acts as a framework for providing economic relief and determining how the claimant’s debts are settled.
There are nine chapters of the Bankruptcy Code (although they are not numbered 1 through 9). Typically, an individual claiming bankruptcy (also known as a debtor) will file under:
- Chapter 7 of the Bankruptcy Code, which relieves the debtor through liquidation (the sale) of their assets to pay back creditors
- Or Chapter 13 of the Bankruptcy Code, which provides relief through adjusted debts (usually allowing a debtor to keep some property) and a payment plan that allows the debtor to pay back creditors over 3 to 5 years
When the debtor meets all the requirements of their bankruptcy filing, they will receive a court-ordered bankruptcy discharge that relieves them from their obligation to pay their debts. Having debts discharged prevents creditors from continuing collection actions on those specific debts again (this includes calls, letters, and civil suits).
Does Bankruptcy Affect Inheritances?
Bankruptcy can, and often does, affect inheritances as long as the debtor inherits property or money while they are in bankruptcy.
When an individual files for bankruptcy, a bankruptcy estate is created. The estate (under the control and protection of the Bankruptcy Court and an appointed bankruptcy trustee who acts as an administrator for the estate) is considered the temporary legal owner of the debtor’s assets and property. The bankruptcy estate’s ownership over the debtor’s assets can extend to any additional assets the debtor receives while he or she remains in bankruptcy, including inheritances.
How inheritances are affected can depend on which chapter of bankruptcy the individual has filed under. Since many people file under Chapter 7, where their assets are sold off to pay back creditors, the inheritance is usually lumped into that process.
For example, if a debtor receives $30,000 from the residue of their parent’s estate, it will act as a lump-sum payment to be subtracted from the debtor’s total debt. Likewise, if the debtor was left valuable property like a car, it would be liquidated for cash and then paid to creditors.
Will an Inheritance Always Be Used to Pay Off Bankruptcy Debt?
The timing of an inheritance is very important when it comes to whether or not it will be used to pay off a bankruptcy debt. An inheritance might not always be claimed by the bankruptcy trustee to pay off the insolvent’s debts. In a Chapter 7 claim, any inheritances received 180 days after filing will remain the property of the debtor and not the property of the bankruptcy estate.
In a Chapter 13 filing, the time elapsed after filing might not matter, as the judge can choose to take your inheritance into account to amend your repayment plan. This is because a large inheritance could be considered a significant increase of income thereby increasing your ability to make higher payments.
It should be noted, however, that whether or not an inheritance is used to pay off someone’s bankruptcy debt is dependant on when the decedent (the person who named the debtor as an heir in their Last Will and Testament) passed away, not the date the inheritances are distributed. To be specific, if the person leaving the inheritance dies within 180 days of the debtor filing for bankruptcy, the bankruptcy estate will replace the debtor as the beneficiary in the Last Will.
For example, if John claims Chapter 7 bankruptcy on January 1, and his aunt (who’s leaving him her $150,000 home as an inheritance) dies on June 30 (exactly 180 days later), John’s $150,000 home inheritance will be liquidated for cash and used to pay off his debts. Even if his aunt’s Last Will is tied up in probate court for over a year and he gets his inheritance after, the money will still go to the bankruptcy estate because his aunt died within the 180-day limit.
How Does Bankruptcy Affect My Estate Plan?
If you’ve created a Last Will and Testament as part of your estate plan, you will have left specific instructions as to how your assets will be distributed (and to whom) once you pass away. Of course, what happens to your property and assets upon your death depends on how much debt you’ve accrued.
Your debts will always be paid first before your beneficiaries receive any inheritances or gifts. That means that if you pass away in the midst of a pending Chapter 7 filing, your assets will be liquidated until your creditors are paid off. Only then will your beneficiaries see any inheritances from what’s left of your assets (known as the residue of your estate).
If you’ve filed under Chapter 13, however, things can get a little complicated because the debtor must actively participate in the proceedings by making payments for 3 to 5 years. Usually, if the debtor dies, the survivors and the estate trustee will decide what to do and petition the court for a course of action.
Typically, the courses of action that the administrator and survivors can take after a bankrupt debtor dies are:
- Asking for the case to be dismissed
- Petitioning for a hardship discharge (where the court discharges the debtor since they’ve passed away)
- Asking to convert the case to a Chapter 7 filing (and then liquidating the estate until the bankruptcy terms are satisfied)
- Continuing the case as normal
Keep in mind that these are requests of the court and the final decision will be left to the judge presiding over the case. The judge will approve the course of action that operates in the best interest of all parties.
When Navigating Bankruptcy, Use the Resources at Your Disposal
Declaring bankruptcy can be a stressful time for anyone, especially when it affects the possibility of future income from inheritances or the livelihood of your beneficiaries. Try to remember that you are not alone in the process.
The main thing you can do in the midst of bankruptcy is keep yourself informed about how your assets and future income might be affected. Don’t be afraid to ask your bankruptcy estate trustee for advice and try to keep in mind that you and your trustee are a team as you go through this tough time.
Have you dealt with bankruptcy or major debt before? What was your experience?