Friday, September 16, 2016

Receipt of an Inheritance While in Reorganization Bankruptcy – Implications for Debtors and Creditors

A bankruptcy reorganization plan may be modified, at the request of the debtor, the trustee or the holder of an unsecured claim, at any time after confirmation of the plan and before completion of payments.  11 U.S.C. §1229(a).  A modification enables the debtor to make adjustments to financial obligations when the family farm debtor's financial situation has changed. But, a modified plan must meet all of the requirements for plan confirmation.

A change in finances can occur, for example, when the debtor wins the lottery or receives an inheritance.  Under 11 U.S.C. §541, a debtor’s bankruptcy estate includes all assets that the debtor inherits within 180 days of the bankruptcy petition.  That is true in a Chapter 7, but it can also be the result in a Chapter 11, 12 or 13 bankruptcy.  Whenever an accession to the debtor’s wealth occurs, a significant question is whether that accession is particular to the debtor or, in the case of a joint bankruptcy petition, whether that accession to wealth also belongs to the debtor’s spouse.  That can be a big deal when there are creditors of one spouse that aren’t creditors of the other spouse.  In that event, can a modified bankruptcy plan specify that only the creditors of one spouse be paid from the increase in the debtor’s wealth, or are the creditors of both spouses entitled to be paid?  A recent case sheds some light on the issue.

In the recent case, the debtors, a married couple, filed Chapter 13 bankruptcy. The husband received a $221,510.53 inheritance 34 months into the Chapter 13 reorganization plan. They proposed to use a portion of the funds to pay off all of the husband’s debts (including the mortgage on the couple’s home) and keep the rest of the funds without paying on any of the debts of the wife. The result would be to leave about $12,000 of the wife’s debts unpaid. The bankruptcy trustee objected on the basis that all claims should be paid from the inheritance.

The court noted that there was no controlling authority in the jurisdiction (MO) on the issue of whether a post-petition inheritance was property of the bankruptcy estate, but also determined that state law governs the nature of a property interest. On that point the court noted that MO. Rev. Stat. §451.250.1 specifies that an inheritance is the separate property of a spouse that receives it and cannot be taken by process of law to pay the debts of the other spouse. Thus, the question was whether a joint bankruptcy filing of the spouses alters the outcome of the state law provision. The court noted that in In re True, 285 B.R. 405 (Bankr. W.D. Mo. 2002), a farm was not available to pay the debtor-spouse’s separate debts under §451.250.1 where the farm was titled exclusively in the non-debtor spouse’s name. The court in the present case believed that In re True was directly on point, and that, as a result, the husband’s inheritance was his separate property and was included in the bankruptcy estate for payment of debts for which he alone was responsible.

The court also held that the inheritance constituted a substantial change in circumstances that required an amended plan be filed. Under 11 U.S.C. §1322(a)(1), the plan must provide for the submission of all or such portion of future earnings or other future income of the debtor to the trustee’s supervision and control. The court held that the proposal to commit the inheritance to pay the husband’s creditors in full complied with that requirement, given that the inheritance is the husband’s separate property. The proposal was also not in bad faith, because the wife’s creditors would not be entitled to be paid from the husband’s inheritance if the couple were not in bankruptcy.  Given the similarity of Chapters 12 and 13, the same situation could occur in a Chapter 12 bankruptcy.


It's an interesting case, with important implications for debtors and creditors in a reorganizational bankruptcy.  But, from a planning standpoint, is there anything that can be done to address this potential situation?  One suggestion is to have the will or trust of any person that is likely to leave a potential debtor property contain clause language that conditions the bequest.  Under the clause, if the property would become property of a bankruptcy estate, the bequest lapses and passes to a spend-thrift trust for the benefit of the intended beneficiary.  At least, that is the approach of one rather prominent bankruptcy attorney that I know. 

The case is In re Portell, No. 12-44058-13, 2016 Bankr. LEXIS 3301 (Bankr. W.D. Mo. Sept. 9, 2016).

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