Spendthrift Trusts in Bankruptcy: It’s a Question of State Law

by Craig Andresen, Minneapolis, MN, Bankruptcy Attorney

June 29, 2008

If you are the beneficiary of a trust, and are considering filing for bankruptcy, you might be wondering if you will lose your interest in the trust to your creditors. The answer to this question depends, first, on whether the trust is a “spendthrift trust” under the law of the state which governs the trust, and second, if the trust contains no valid spendthrift clause, on whether there is an exemption which can be used to protect your interest in the trust.

The law states that a trust becomes property of the bankruptcy estate, unless the trust contains a spendthrift clause enforceable under state law. If so, section 541(c)(2) of the bankruptcy law excludes the trust from the bankruptcy estate, and therefore it is protected. This means your bankruptcy lawyer will need to carefully examine the terms of the trust to see whether it contains a spendthrift clause.

Next, your lawyer will need to determine which state’s law governs the trust, and whether the trust’s spendthrift clause was properly drafted so as to be enforceable. This may a matter of interpreting complex trust law unique to the state involved. Your bankruptcy lawyer may need to seek an opinion from an experienced trust lawyer in order to answer this question.

If the trust contains a valid spendthrift clause, your worries are over, because your interest in the trust is excluded from the bankruptcy estate and you cannot lose it. However, if there is no spendthrift clause, or if the spendthrift clause is defective in some way so as to render it uneforceable under the law of the state involved, your interest in the trust will be lost unless you can claim it exempt.

The federal bankruptcy exemptions contain a “wild card” exemption in the amount of $11,200 which can be used to protect liquid cash assets such as a trust. If the value of your interest in the trust is less than this amount, the trust will be protected. Note that it is only your interest in the trust which needs to be exempted, rather than the entire amount in the trust, which may be subject to the interest of other persons who are beneficiaries of the trust.

If you elect to use the state law exemptions in your bankruptcy, it is possible, although unlikely, that an exemption law might be available to protect your interest in the trust. Some states have exemptions which protect various forms of income, and some states have “wildcard” exemptions which protect liquid cash assets such as trusts. However, such exemptions are usually quite limited, and due to the amounts involved in most trusts, it is not likely that a state exemption law of this nature would be sufficient to protect a trust.

The most favorable scenario is one in which your interest in a trust is subject to valid spendthrift clause, and therefore the trust does not even need to be claimed exempt, because it is excluded from the bankruptcy estate.

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Craig W. Andresen is a consumer bankruptcy lawyer in Bloomington, Minnesota, with 22 years’ experience in consumer and small business bankruptcy cases. He is the Minnesota chair of the National Association of Consumer Bankruptcy Attorneys, and is a member of the Minnesota State Bar Association’s Bankruptcy Section. Mr. Andresen lectures often on the topic of consumer bankruptcy at local and national legal seminars.

Last modified: June 30, 2008