How Does the Bankruptcy of a Trustee Affect the Trust?

A trustee's declaration of bankruptcy can harm the interests of trust beneficiaries if the trust instrument empowers the trustee to self-direct unlimited and unrestricted distributions from the trust. Such broad powers expose the trust assets to the reach of the trustee's creditors in a bankruptcy case, depleting the amount of distributions available to named beneficiaries.

Generally, all of a bankruptcy debtor’s non-exempt property and powers belong to the bankruptcy estate, except for property that the debtor holds in trust for another person and trustee powers the debtor may exercise solely for the benefit of other persons or entities. However, if the trust instrument grants discretionary powers to the trustee-debtor to withdraw trust assets for his own benefit, those powers belong to the bankruptcy estate. This holds true even if the trustee-debtor is not a named beneficiary of the trust and has no right to amend, revoke or terminate the trust. Consequently, for the purpose of satisfying creditors, the bankruptcy trustee can exercise the debtor's trustee powers to take the maximum amount the trustee-debtor is allowed to withdraw from the trust in accordance with the trust's terms. This result could leave the named trust beneficiaries with little or nothing.

Read More: Definition of Trust Agreement

The 2008 bankruptcy case In re Cutter illustrates this point. A California debtor created a living trust and made himself the trustee. The trust beneficiaries were the debtor's surviving descendants. He neither named himself as a beneficiary nor reserved the right to revoke the trust. However, the trust document gave the debtor the power to make distributions to himself from either the trust principal or income to support his standard of living.

The Bankruptcy Appellate Panel for the 9th Circuit stated that "[w]hile assets transferred to a trust do not ordinarily become property of the bankruptcy estate of the trust's trustee, powers that a debtor - who is also the trustee of a trust - may exercise for his or her own benefit become property of the estate." Because the debtor had the power to invade potentially all of the trust income and assets for his benefit, the court held that the trust assets were part of the debtor's bankruptcy estate. Consequently, the debtor's creditors also had access to all of the trust assets, leaving the debtor’s surviving beneficiaries with the possibility of receiving nothing from the trust upon the debtor's passing.

It's important to note that the result in the case of In re Cutter would have been the same if the trustee-debtor had not also been the trustor, or creator, of the trust. The trust assets would have still been vulnerable to collection by the debtor's creditors, even if someone else had created the trust, because the trust document gave the debtor-trustee the same broad, discretionary and self-serving powers.

To avoid trustee bankruptcy issues altogether, the trustor should choose a trustee who is unlikely to file for bankruptcy. Moreover, the trust document should permit the trustee to withdraw from the trust only what is necessary to cover trust administration expenses.

If the trustor is also the trustee, the trustor should consider creating an irrevocable living trust and transfer assets to the trust when he no longer needs them to pay existing debts. If the trustor is not the trustee, but the trustee is a beneficiary, the trustor should consider creating a spendthrift trust. Irrevocable and spendthrift trusts can be valuable asset-protection mechanisms when they are created properly. It is very important that trustors, beneficiaries and trustees obtain competent legal advice regarding trusts, selection of trustees and trustee bankruptcy issues.