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When a family member or friend passes away and leaves you money or property, it is generally because they want you to benefit from the bequeathment. However, for individuals who have filed for bankruptcy or are considering bankruptcy, receiving an inheritance may be stressful and concerning. They often wonder whether the inheritance will disqualify them from bankruptcy or whether the bankruptcy trustee will lay claim to the inheritance. Some individuals even try to conceal the fact that they inherited money or property, which can result is serious consequences. The following is an overview of how inheritances are handled during the bankruptcy process and whether you will have to relinquish the inheritance.

Chapter 7 bankruptcy1 is commonly known as “liquidation bankruptcy.” If you are approved, the bankruptcy court will discharge all of your qualifying debts without expecting you to engage in any type of repayment plan. However, the law acknowledges that creditors deserve to be paid as much as possible and, therefore, in exchange for the discharge, the bankruptcy trustee will seize assets and property that you own to liquidate and repay your creditors.

When examining how an inheritance is handled in bankruptcy, we must look at the date on which the death and the inheritance occurred.

If you receive an inheritance, you cannot protect it by simply making large purchases. However, you may spend the money you inherited on basic needs, such as mortgage or rent payments, car payments, food or clothing, and similar necessities. You will have to report how you spent the funds to the court, however, at least you will receive the benefits of the money instead of your creditors.

If you know you are going to file for bankruptcy and you predict that you may receive an inheritance within a short period of time, you may request that the benefactor create a trust account with you named as a beneficiary. It is important that you are not named as the successor trustee of the trust, as the bankruptcy trustee may have the power to exercise your powers as trustee to amend trust terms, to order distributions of trust assets, or even to revoke the trust.

However, not all assets in every kind of trust will be protected from a bankruptcy trustee. Instead, your situation should be carefully evaluated when determining which type of trust account will bet protect your inheritance. In most situations, the creator of the trust can add a spendthrift clause to your designation as a beneficiary. This puts limitations on your access to the trust assets and generally protects the trust assets from your creditors, as well as bankruptcy trustees. There are other types of trusts, such as family trusts, that may also work to protect an inheritance. However, protection of your assets by a spendthrift or family trust is not infallible and, depending on the terms of the trust, the bankruptcy trustee may be able to reach these assets.

For instance, if the trust allows you to take a lump sum, the bankruptcy trustee will then be able to seize those assets. Additionally, if the trust provides for substantial draws or distributions, those assets will likely become vulnerable to your creditors in bankruptcy as you receive the funds. Some trusts set out that you must wait a certain period of time before receiving the whole trust amount. With these trusts, your success at protecting those assets often depends on the mandatory waiting period. If it is a relatively short period of time, the bankruptcy trustee may keep your case open until that time period is up in order to then seize the assets. If you must wait several years, however, it is less likely the trustee will keep your case open long enough to wait.

Trusts that distribute a small amount of regular income each month to provide for your basic needs and survival generally survive bankruptcy better than other types of distribution provisions. However, situations can vary, so you should never assume that your inheritance is safe in a trust. Instead, you should always thoroughly discuss the best trust structure with an experienced attorney who can advise you on the chances of survival in bankruptcy.

If your spouse has filed for bankruptcy and you receive an individual inheritance, the inheritance will generally be considered to be separate property in new York with some exceptions. For example, if you comingle the inheritance funds with your spouse’s money by depositing in your joint checking account, the inheritance may then be converted to marital property and will be subject to liquidation in your spouse’s bankruptcy. Additionally, you should avoid using the inheritance to purchase gifts for your spouse that then may be seized.

The case of Clark v. Rameker6 went before the Supreme Court of the United States (SCOTUS) in 2013 with the legal question of whether an inherited Individual Retirement Account (IRA) is exempt from seizure in bankruptcy. In the case, Heidi Clark had inherited an IRA from her mother worth about $300,000 and argued that the account should be exempt from seizure in her subsequent bankruptcy because it constituted “retirement funds” under the law. § 522(b)(3)(C) states that the following is exempt: “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under [seven listed sections] of the Internal Revenue Code.” The bankruptcy trustee, on the other hand, argued that the funds constituted an inheritance and not retirement funds for various reasons, including that Clark did not herself save the money for her retirement years.

In a unanimous decision, SCOTUS held that Clark must relinquish the funds, as an inherited IRA did not fit Congress’s intended definition of “retirement funds” when it designed that particular exemption. Unlike initial account holders, individuals who inherit IRA accounts do not have to wait until they stop working to withdraw and use the funds as they wish. In fact, they must receive at least minimum distributions upon inheritance and they have the opportunity to withdraw the total balance if they so choose. The Court reminded us that the bankruptcy exemptions are intended to provide for the filer’s basic needs and not to give them a “free pass,” as held in a previous SCOTUS case, Schwab v. Reilly.7 For this reason, the IRA funds were used to pay creditors as part of Clark’s bankruptcy. 

This case demonstrates how an inheritance can be at jeopardy in a bankruptcy case. An experienced bankruptcy attorney can devise skillful legal maneuvers to protect your inherited assets or property whenever possible. In addition, you may simply choose not to accept the inheritance at the time it is presented. Though the funds or property will go to someone else, you will not have to see your deceased loved one’s valued property be liquidated by the bankruptcy court. 

If you have received an inheritance and are considering bankruptcy, you need a skilled bankruptcy lawyer on your side who can use New York and federal bankruptcy laws to your advantage whenever possible and who can provide valuable advice on how to protect your inheritance. Call the office of Ronald D. Weiss at 631-479-2455 today to discuss your case.