Using revocable living trusts to avoid probate has become more popular recently. But the impact of such trusts in bankruptcy makes some relatively simple cases much more complex – especially in states that recognize tenancy by the entirety.
A tenancy by the entirety (TBE) is an ancient way of owning property between a married couple. In states which recognize it, it can mean that the property is effectively owned by both spouses and cannot be sold, borrowed against, or put at risk to most creditors — with the notable exception of the IRS — without both spouses effectively agreeing to do so.
This typically means, for example, only creditors who are owed money by both spouses can attach the TBE property to satisfy unpaid debt. And federal law recognizes TBE ownership as a form of exemption of property in a bankruptcy proceeding, if the state law allows it.
A revocable living trust is a type of separate ownership which allows the owners to control property while still passing it on to others without requiring a probate proceeding.
What happens if spouses take their TBE property and put it into a revocable trust? This question confronted Judge Arthur Federman of the Western District of Missouri this year. As the property at issue was worth far more than Missouri would protect through its usual exemptions, the Chapter 7 trustee wanted to liquidate the property to pay creditors. There was no dispute that the debtors were married and had owned the property “by the entireties” before creating the trust. But by transferring it to the trust — a separate entity — the trustee argued that the spouses had destroyed the TBE protection.
Judge Federman disagreed. He concluded that the trust in this case did not actually destroy the TBE ownership interest. The spouses — as trustees of the revocable trust — could not act to lien, sell or otherwise dispose of the property individually, they could only act together. Federal and state tax law effectively ignored the trust and treated the property as still owned by the spouses jointly. The judge reasoned:
…the purpose of entireties property, to protect one spouse from losing marital assets because of the actions of the other spouse, is not in any way affected by this Trust Agreement, since it does not enable either spouse to transfer the property without the consent of the other…. Where, as here, the settlors, trustees, and beneficiaries of a trust such as this one are all the same persons, no purpose is served by treating such assets as being owed by anyone but those persons.
As a practical matter, this decision squares with decisions which hold that the bankruptcy trustee can ignore a trust created by a person with themselves contributing the assets (as “settlor”), acting as the operator of the trust (as “trustee”) and also as the beneficiary of such a trust. Since the law will not ignore the reality of who really owns such assets when it might benefit creditors, it only seems fair that the law should look to the true reality of the ownership if it might benefit the debtors as well.