Bankruptcy courts on occasion answer unresolved questions of state probate law. So it was when the Ninth Circuit Bankruptcy Appellate Panel held that the bankruptcy trustee’s interest in a debtor’s interest in a trust cuts off on the debtor’s death.
The chapter 7 debtor was in his 80s. He was a beneficiary of a spendthrift trust established by his parents in the 1970s. The parents were deceased, so the trust was irrevocable. The debtor was entitled to receive income from the trust and, if he were still alive, a distribution of the trust’s assets when the trust terminates.
On the death of the debtor, the trust instrument provided that the debtor’s living issue would receive his distributions “by right of representation.” Evidently, “by right of representation” is the equivalent of “per stirpes.”
Although it was a spendthrift trust, Section 15306.5 of the California Probate Code says that a judgment creditor may execute upon “an amount [not] exceeding 25 percent of the payment that otherwise would be made to, or for the benefit of, the beneficiary.” The debtor and his children conceded that the chapter 7 trustee was entitled to receive 25% of the distributions made by the trust during the debtor’s life.
However, the chapter 7 trustee contended that he could continue collecting 25% of the distributions after the debtor’s death. The bankruptcy court agreed, and the debtor appealed. The BAP reversed in an October 29 opinion by Bankruptcy Judge William J. Lafferty.
Judge Lafferty “found no bankruptcy or California authorities addressing the issue.”
To answer the novel question, Judge Lafferty began with first principles. Under Section 541(a), the bankrupt estate takes “all legal or equitable interests” of the debtor as of the filing date. “Contingent interests, including the right to distributions of property from a trust, are property of the estate,” he said, citing circuit authority.
Judge Lafferty added a caveat: “[T]he estate’s ability to realize upon such interests is subject to whatever limitations existed on the petition date; the estate obtains no greater rights than those held by the debtor before bankruptcy.”
Turning to California probate law, Judge Lafferty said that a beneficiary’s interest in a trust’s income or principal is “neither transferable nor subject to enforcement of a money judgment until it is” paid to the beneficiary. After the death of the debtor, Judge Lafferty said that no distributions will be paid to him. Instead, they will be paid to his living issue.
The bankruptcy trustee conceded as much but argued that the bankrupt estate’s interest in the 25% carveout was fixed on the filing date and could continue even after the debtor’s death.
Judge Lafferty saw no foundation for the argument in the trust instruments. Rather, he said, “a survival contingency is implicit in the provision that when Debtor dies, the distributions that would have gone to him are to go to his living issue.”
Judge Lafferty reversed the bankruptcy court and held that the bankruptcy trustee was not entitled to receive 25% of distributions of income and principal beyond the death of the debtor.
Bankruptcy courts on occasion answer unresolved questions of state probate law. So it was when the Ninth Circuit Bankruptcy Appellate Panel held that the bankruptcy trustee’s interest in a debtor’s interest in a trust cuts off on the debtor’s death.
The chapter 7 debtor was in his 80s. He was a beneficiary of a spendthrift trust established by his parents in the 1970s. The parents were deceased, so the trust was irrevocable. The debtor was entitled to receive income from the trust and, if he were still alive, a distribution of the trust’s assets when the trust terminates.
On the death of the debtor, the trust instrument provided that the debtor’s living issue would receive his distributions “by right of representation.” Evidently, “by right of representation” is the equivalent of “per stirpes.”