How Does the Bankruptcy of a Trustee Affect the Trust?

By Chaya Bail

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.


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.

Get a free, confidential bankruptcy evaluation. Learn More


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.

Get a free, confidential bankruptcy evaluation. Learn More
Can an Heir Be a Co-Trustee of the Trust?


Related articles

How to Set Up a Living Trust Fund

A trust can be a solid, safe way to send your assets where you want them to go. The grantor -- the individual who creates the trust -- places cash, investments and property under the control of a trustee, who manages the assets for the benefit of another individual or an organization. A "spendthrift" trust, for example, grants money or other assets to a minor, with the grantor setting the terms of disbursement. A "living trust" means simply that the grantor is still alive.

The Difference Between a New Hampshire and a Florida Living Trust

The difference between a New Hampshire and a Florida living trust lies in the area of asset protection from creditors. In New Hampshire, a legally compliant living trust, in which the trust maker is also a trust beneficiary, can shield the trust assets from the trust maker’s creditors. In Florida, however, the same living trust arrangement does not provide the same asset protection.

Enforcing a Trust

A trust is a legal relationship in which a trustee holds property for beneficiaries, who are the individuals benefiting from the trust. The trustee must abide by the terms of the trust to manage property and distribute it to the beneficiaries. The person who creates a trust is known as the settlor, or grantor. The settlor can also serve as the trustee, naming a successor trustee who will take over for him following his death. Alternatively, the settlor can name someone else to serve as the trustee at the time he creates the trust. A trustee owes certain duties to the beneficiaries -- and the beneficiaries have a right to enforce the terms of the trust and hold the trustee in breach of his duties if he is performs any wrongful acts or omissions that affect their interests.

Related articles

Does a Beneficiary of a Living Trust Have the Right to See the Trust?

All trusts, including living trusts, are established to benefit certain individuals or organizations identified in the ...

Can an Heir Sell Property When the Title Is in a Revocable Living Trust?

Revocable living trust property generally cannot be sold outright by a beneficiary; the property must be first ...

How to Settle a Trust in Indiana

Keeping assets well away from probate court is the main idea of trusts. These legal structures allow a settlor to place ...

Trustee Not Paying Beneficiary

A trustee is a party who administers the assets of a trust and distributes them to beneficiaries in compliance with ...

Browse by category
Ready to Begin? GET STARTED