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Can a Trust File a Bankruptcy Case?

7th Wednesday, 2011  |   Legal  |  no comments

In a word, maybe. Let’s take a step back and think about the general nature of a trust. Very often, trusts are a vehicle for transferring wealth in a way that is tax favorable and avoids court oversight and litigation. Often, in such cases, a trust acts as a safety deposit box into which a grantor places assets that a trustee will dole out to beneficiaries of that trust pursuant to the trust’s terms.

In other cases, a trust is less like a safety deposit box and much more like a business. A trustee, trust employees or professionals paid through a trust make decisions that put property in the trust (commonly called the “corpus” or the “res”) at risk with the goal of increasing the value of the corpus.

As much as it may seem counter-intuitive to some, bankruptcy protection should be available to individuals and businesses. That concept is so essential to our economy that its basis lies in Article 1, Section 8 of the United States Constitution. Individuals and businesses have creditors who are interested in getting paid as much as possible from the estate of a debtor in bankruptcy and bankruptcy law provides an orderly process for the fair treatment of creditors.

Now, back to the question of whether a trust can file a bankruptcy case. A trust that acts as a business has all of the hallmarks of a debtor. It may have an income stream from its operations that is not sufficient to meet the demands of its creditors but it generates income and has assets and liabilities. It may even have some value as a going concern. It should be permitted to file a bankruptcy case. Contrast this with our “safety deposit box” trust. A safety deposit box trust should not have the right to file bankruptcy for the same reason that your house is not able to file bankruptcy to avoid foreclosure.

The reality of a safety deposit box trust is that its beneficiaries only have an interest in the property contained within the trust. For simplicity, let’s imagine a safety deposit box trust thats res consists only of cash and that pays its sole beneficiary the interest from the res on a monthly basis. There is no reasonable justification to allow that trust to shield itself from the claims of its creditors via the bankruptcy process. To do so would allow the trust beneficiary to reap the benefit of funds to which the trust creditors are entitled.

And now to complicate matters. The safety deposit box/business trust distinction is not one that grantors and the drafters of trusts make. Trusts come in more than 31 flavors. Additionally, the Bankruptcy Code provides no clear delineation and the case law varies by jurisdiction and typically involves an analysis of the trust formation documents and the trust’s business activities. To determine whether a particular trust is eligible to be a debtor under the United States Bankruptcy Code, you should contact commercial insolvency professional.

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