How does a trust work in a bankruptcy case?

Those facing bankruptcy sometimes set up a trust to protect certain assets. Because the trust is subsequently the legal "owner" of the assets, the assets no longer belongs to the debtor. Yet the debtor has access to the trust property with certain restrictions. Creditors have a harder time reaching these assets to satisfy outstanding debts.

What Is a Trust?

A trust is a legal instrument or entity that holds property for a beneficiary. The one who creates the trust is generally known as the creator, but is also referred to as the grantor, trustor, donor or settlor. A trustee, either an individual, a group, or an entity, is selected to manage the trust assets and retains legal but not full title to the assets. This limited title allows the trustee to use the assets and any proceeds from the trust property only for the benefit of the trust beneficiary. The beneficiary owns the equitable title to the trust property which allows his or her use of trust assets within the directives of the trust restrictions.

One type of trust that is often established for a debtor/beneficiary is called a spendthrift trust. This particular trust allows the beneficiary limited access through the discretion of the trustee who determines when and how much of the assets the beneficiary may use.

The trust property can include most types of assets, including money, personal property, and real property. Although most trusts are set up as part of an estate plan, those facing bankruptcy may set up a trust to protect certain assets. The debtor may be both grantor and beneficiary, but cannot be the trustee.

Attempt to Defraud?

Since bankruptcy reforms have taken place, it is harder for those facing bankruptcy to set up trusts just before filing. Bankruptcy courts look hard at trusts established within six months prior to bankruptcy. The bankruptcy court may determine that the trust was created to defraud or hide assets from rightful creditors. In this case, the court can attach trust assets for the bankruptcy estate. Additionally, if the debtor is believed to have established the trust in an attempt to defraud, his or her case may be thrown out of court and the debtor may face fraud charges.

Talk with an attorney before taking steps to establish a trust before filing bankruptcy to avoid charges of fraud.