Trusts & Taxes 101: Bankruptcy Protection

Posted by Matt Rager and Kristin Spengler

Whether or not there is an immediate need to file for bankruptcy, it is important to understand the possibilities when it comes to protecting your assets and understanding your options. You can protect your assets prior to filing, or, if at a point in time bankruptcy becomes a potential reality, proper planning is key. Depending on the scenario, filing for Chapter 7 or Chapter 13 bankruptcy will offer different benefits to consider.

How Does Chapter 7 Bankruptcy Work?

First and foremost, Chapter 7 bankruptcy does not involve a repayment plan, like Chapter 13. Chapter 7 is often chosen over Chapter 13 when individuals are unable to make monthly payments toward the debts owed. However, an individual must apply the means test to determine eligibility to use Chapter 7.

Within Chapter 7, a bankruptcy trustee will gather the non-exempt assets of an individual and sell them to pay off debts to creditors. Some property may be exempt, allowing a debtor to retain the property. States have their own exemptions that should be used when filing under Chapter 7, but some states allow the option to use federal or state exemptions. Examples of items that may be considered exempt include vehicles (up to a certain value), clothing and household goods that are deemed necessary, qualified retirement accounts and life insurance policies, wages earned after filing for bankruptcy and Social Security benefits. For a full list of exclusions, individuals should check with the state in which they intend on filing. Other than exempt items, the remaining assets would then be liquidated.

Chapter 7 is ideal for those unable to actively make payments over the course of a few years, even though it may come at a loss of some assets.

How Does Chapter 13 Bankruptcy Work?

Chapter 13 allows an individual to pay back their debts with a court approved repayment plan. This chapter may only be used if there is a regular income flow that allows an individual to make these payments. The payments may be spread out anywhere between three to five years depending on the debts owed and income flow. Within this plan it may allow the individual to save their home from foreclosure as well as make payments on a delinquent mortgage.

Chapter 13 is beneficial to protecting assets if you have the means to make payments over time.

Steps to Take Before Filing Chapter 7 or Chapter 13 Bankruptcy

There are important steps to take before filing either Chapter 7 or Chapter 13 bankruptcy. The individual or couple, as these may be filed for jointly or individually, in debt will need to:

• File a petition at a court where they reside.
• Provide a variety of financial information, such as any assets and liabilities, current income and expenditures, and any contracts or leases held that have not expired.
• File, prior to bankruptcy, all tax returns required in the last four years (Chapter 13 only).

How to Protect Your Assets Before Filing for Chapter 7 or Chapter 13 Bankruptcy

In terms of protecting assets from bankruptcy, before filing there are additional steps to take. Irrevocable trusts are one of the best ways to protect assets. However, the trust must be created prior to filing for bankruptcy, and it can't be created with the intention of placing all the assets within a trust and then filing.

Once an irrevocable trust is in place, how the assets are distributed is not up to the individual, or grantor; this type of trust moves the assets from the grantor's control to the trustee's control. After an individual transfers assets into an irrevocable trust, the terms cannot be changed, which allows those assets to be protected from creditors in both Chapter 7 and Chapter 13 bankruptcy cases.

A specific type of irrevocable trust particularly helpful to protect assets from creditors during bankruptcy is the Domestic Asset Protection Trust (DAPT). DAPTs are formed as a grantor-type trust and can help protect trust, stocks, cash, LLCs and other properties. There are specific considerations and caveats, of course, when establishing a DAPT.

Life is unpredictable, so whether or not you are filing for bankruptcy, it's always good to be aware of your options. Being aware of the various bankruptcy statutes, or "chapters," available and the related tools, such as the irrevocable trust and DAPT, can help protect what is most important to you.

Contact Matt Rager, Kristin Spengler or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.

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