What happens to inheritances in a bankruptcy

The last thing an aging parent or relative wants is for his estate not to be passed on as intended. But if an heir is bankrupt, what happens to his inheritance?

Assignment of assets in bankruptcy

When someone files for bankruptcy, he signs over the assets he owns at the time, and any right to additional assets while he remains in bankruptcy. That means if he’s entitled to an inheritance before he files, or becomes entitled to an inheritance during his bankruptcy, his unsecured creditors may seize that inheritance.

Let’s say your client left $50,000 to her son, John, in her will. If John’s bankrupt, the $50,000 payment will go to his bankruptcy. Similarly, if her will states that John is entitled to a 1963 Corvette, it will be seized and sold to recover cash for John’s creditors.

The date of your client’s death, not the date the estate is distributed, matters in a bankruptcy. If your client dies before or during John’s bankruptcy, then the bankrupt estate takes John’s place in the will. It may take five years or more to liquidate the assets of the deceased’s estate. That makes no difference. The eligible creditors are entitled to whatever the beneficiary is entitled to.

Read: Why your broke client shouldn’t choose bankruptcy

Estate planning

As part of any estate planning review, ask your client if the financial statuses of any of her beneficiaries have changed. If you know your client’s son or daughter has financial problems, you could recommend restructuring your client’s will. There’s a way to minimize or eliminate the potential for creditors to seize an inheritance.

Instead of leaving John $50,000 (or a Corvette), if the will places the asset in a trust or annuity, then the bankruptcy only has access to the asset on the same terms as John. If he can’t access the capital, then neither can his creditors.

There is no law prohibiting your client from altering the terms of her will if a beneficiary has filed (or may have to file) bankruptcy.

Inheritance during a consumer proposal

In a consumer proposal, the debtor’s assets do not vest in the proposal. Unless the proposal specifically states that inheritances received during the proposal’s period are payable to creditors, then the beneficiary would receive whatever inheritance he’s entitled to.

It may make sense to use the proceeds from the inheritance to pay off the proposal, but that’s a decision the beneficiary gets to make for himself.

Read: What happens to RRSPs in bankruptcy?

Beneficiary planning in bankruptcy

If your client is bankrupt and could soon receive an inheritance, he has options for protecting it.

Your client could file a consumer proposal with payment terms based on the inheritance, and thereby annul the bankruptcy. If the inheritance exceeds the value of your client’s debts, your client could apply to the Court to have the bankruptcy annulled. Even if the inheritance isn’t enough to fully repay the debt, offering to repay a portion of the debt from the inheritance could also annul the bankruptcy.

The creditors may accept a proposal to repay part of the debt, even though they’re entitled to the inheritance in the bankruptcy anyway. Most creditors understand an inheritance isn’t something you can plan for. As it’s money neither the bankrupt person nor the creditors were expecting to receive, the creditors will often agree to take less than 100% of the inheritance. We have done this dozens of times in our own practice. Unfortunately, not all bankruptcy trustees will make this suggestion, so it falls to you to make this suggestion if the situation arises.

Read: Rebuilding clients’ finances after bankruptcy

Ted Michalos , B.A., CPA, is a Licensed Insolvency Trustee and co-founder of Hoyes, Michalos & Associates Inc. in Ontario, Canada.