The answer is found at the intersection of trust and bankruptcy law. At the start, I want to define terms. A trust is a legal entity that can own and control assets including real and personal property. Practically speaking, a trust is little more than a folder of papers, but in the eyes of the law those papers create a legal entity. Bankruptcy law can forgive many debts but requires a showing of financial hardship. Financial hardship for bankruptcy purposes considers a person’s monthly income as well as their assets. Too much income, or too many assets, and bankruptcy may not be an option. People considering bankruptcy often ask, “Can I avoid bankruptcy by creating a trust to protect my assets from creditors?” To answer requires a brief description of the two major types of trusts: revocable and irrevocable.
A revocable living trust (“RLT”) is the most common type of trust. Many people have created RLTs with the help of lawyers, paralegals or even do-it-yourself kits. The typical RLT gives you (as settlor or trustmaker) unfettered control of the trust and all assets. In fact, as the name implies, the trust is revocable which means you can cancel it. For these reasons, the law will view assets in an RLT as your assets for debt collection purposes. Said another way, an RLT is essentially invisible during your life and does not protect assets from creditor claims.
The other type of trust is an irrevocable trust (“IRT”) which is generally created with the assistance of an attorney. This trust transfers assets permanently out of your name, meaning you have no ownership or control of the assets transferred. Your creditors are limited to seeking payment from you and your assets, and once an asset is transferred using an IRT it no longer belongs to you. Unfortunately, there are several “look back” periods so you cannot transfer your assets to an IRT once you are in financial straits as a means to dodge creditors. A couple examples will illustrate the point.
Amanda has substantial financial resources, pays all her bills on time and is employed. She decides she would like to help her niece, Betty, by establishing an IRT for Betty’s benefit. She funds the trust by transferring money to the trust. Shortly thereafter, Amanda’s fortunes wane. She loses her job and depletes her savings, and in time she amasses vast debts. Her debts arose after creation of the IRT and she has no right or access to the assets in the trust. Her creditors will have no claim to assets in the trust. Note: there can be gift taxes associated with funding an irrevocable trust.
Carson owns a house but has not been able to pay his credit cards since he lost his job last year. He has bill collectors calling and is concerned he might get sued by one of his creditors. He creates an RLT and funds the trust by transferring his house and other assets to the trust. The trust will not limit the rights of his creditors to pursue Carson or his assets. Note: the exemptions laws protect many assets from creditor claims.
Now back to the original question, can a person avoid bankruptcy by creating a trust to protect assets? The answer is no. Only an irrevocable trust can protect assets, and an irrevocable trust must be created prior to a person becoming unable to pay their debts when due.
At the Law Office of Michael Primus we have helped thousands of clients get out of debt, stop wage garnishments, and start fresh through bankruptcy. If you live in Contra Costa, Alameda or Solano counties and have debt problems, contact us for a free in-office consultation. We have offices in Walnut Creek, Antioch, and Hercules.