Would you expect to find an exemption applicable in bankruptcy in the probate code?
But that’s where I found one yesterday. And if it exists under California law, it may exist where you practice as well.
A testamentary trust paying some current income to a prospective client sent me to the cases. I needed to know
- did the trust have a spendthrift clause
- if so, was the income stream exempt
- does the corpus come into the estate if the trust terminates within 180 days of the filing of the bankruptcy
What I found is case law holding that under state law, the exemption created by the sprendthrift provision protects 75% of each income distribution. The remaining 25% is subject to levy in the hands of the beneficiary. That mirrors the exemption provisions for levies on wages.
But the probate code went further: the 25% that creditors, and therefore the trustee, can reach is a cap, and under state law, any part of that 25% that is necessary for the support of the beneficiary or his dependents is also exempt.
Behold the marvelous operation of the intersection of state law and bankruptcy law. This probate exemption is nowhere found in the two sections of the California Code of Civil Procedure that identify the alternative exemption systems. Yet it holds out the prospect of reserving unto the debtor all of the stream of income flowing from the spendthrift trust.
By the way, I found that even if the death that will terminate this trust occurs within 180 days of the commencement of the bankruptcy case, the corpus does not become property of the estate by reason of §541(c).
Another time, let’s talk about some of the other issues that trusts, intervivos, testamentary and spendthrift, raise when a bankruptcy is in prospect.
In the mean time, see what the law of your state provides on spendthrift trusts and the vulnerability of income distributions to claims of creditors.
Image courtesy of Wikimedia and the US Forest Service.
Great find, Cathy. What’s your take on whether we could expect a fight from the trustee on these matters? Similarly, if a bankruptcy judge hasn’t encountered these issues before and we have to fight the trustee about it in front of the judge, would you agree that it may not be a slam dunk for our side in spite of the case law.
Cathy Moran, Esq. says
It’s 9th Circuit Court of Appeals, so the only fight I see likely is the claim that your facts are somehow different.
Malcolm Ruthven says
Great find, Cathy. What’s your take on whether we could expect a fight
from the trustee on these matters? Similarly, if a bankruptcy judge
hasn’t encountered these issues before and we have to fight the trustee
about it in front of the judge, would you agree that it may not be a
slam dunk for our side in spite of the case law.
I think you’re right Cathy, that this exemption would apply in a bankruptcy proceeding. At the very least, I think it would be a complex, somewhat intensive and risky piece of litigation for a trustee. This might lead to resolution by means of a small, lump sum payment from the trust. I’m not an expert, but it’s my recollection that most trust documents of this sort leave ultimate discretion in the distribution to a third party trustee. If so, could the trustee stop distributions if the trustee knew that the funds would not go to beneficiary for support?
I think the answer to Malcolm’s question is partially answered by the fact that the exemptions are statutorily proscribed and, as I remember, fairly explicit. I don’t think there’s much wiggle room for a bankruptcy judge, but of course, facts matter, and often matter most.