Estate Cannot Continue To Collect Trust Distributions after Debtor Dies

Posted by NCBRC - January 26, 2022

The bankruptcy court erred in finding that the portion of the debtor’s interest in ongoing Trust distributions that were part of the bankruptcy estate would continue to enter the bankruptcy estate after the debtor died and the Trust was distributed to his children. In re Rens, — B.R. —-, 2021 WL 5049829 (B.A.P. 9th Cir. Oct. 29, 2021) (case no. 20-1131).

At the time he filed for bankruptcy, the 80-year-old chapter 7 debtor was a beneficiary of an Irrevocable Spendthrift Trust created by his parents. The Trust property consisted of $14,000/month in rental income from real property (Miramar Park), and principal including a 50% interest in Miramar Park. The lease on Miramar Park property (Lease) was set to expire in 2035 at which time the Trust principal would be distributed to the beneficiaries or, if deceased, their beneficiaries “by right of representation.”

The chapter 7 trustee sought turnover of 25% of the rental income from the Miramar Park property, and 25% of Trust principal, claiming entitlement to the property for the life of the Lease without regard to whether the debtor survived until that time. The debtor agreed that the bankruptcy estate was entitled to 25% of the Trust income but only as the debtor received that income. The debtor further maintained that the estate’s right to Trust property terminated upon the debtor’s death assuming that it was prior to expiration of the Lease.

The bankruptcy court granted summary judgment to the bankruptcy trustee finding that the estate’s right to the property of the Trust continued to the termination date of the Lease in 2035 without regard to whether the debtor was still alive at that time. It found that because the debtor’s beneficiaries inherited “by right of representation” they would be subject to the same obligation to the bankruptcy estate that the debtor was subject to.

The debtor and the trustee for the Trust, Ms. Sparhawk, appealed to the Ninth Circuit Bankruptcy Appellate Panel. The debtor’s children entered the appeal as Intervenors.

As an initial matter, Ms. Sparhawk and the Intervenors argued that the bankruptcy court interpreted the provisions of the Trust in disregard of the “probate exception” to federal jurisdiction. That exception precludes a federal court from distributing property that is under the jurisdiction of state probate. They further argued that California Probate Code § 17000(a), rests “exclusive jurisdiction of proceedings concerning the internal affairs of trusts” in the state probate court.

The panel disagreed, finding that the bankruptcy court acted within its jurisdiction. The panel reasoned that the relevant statutes assigned exclusive jurisdiction to the state courts only when confronted with disputes between the parties to the trust. The panel further found that the probate exception was inapplicable because the bankruptcy court’s order did not go to the disposal of property which was under the jurisdiction of probate.

The panel also rejected the Intervenors’ argument that they were denied due process by the court’s order capturing Trust property after the debtor’s death. The panel found that, as trustee for the Trust, Ms. Sparhawk had a fiduciary duty to the Intervenors as well as to the debtor. Therefore, the interests of the Intervenors were adequately represented before the bankruptcy court. The panel further found that the Intervenors’ participation in the appeal was sufficient to protect their rights.

The appellants next argued that the bankruptcy court erred in finding that the estate had a right to Trust property after the debtor’s death. The panel looked to state law to determine the nature and extent of the debtor’s interest in the Trust at the time of his petition. While “[c]ontingent interests, including the right to distributions of property from a trust, are property of the estate[,]” those interests are “subject to whatever limitations existed on the petition date; the estate obtains no greater rights than those held by the debtor before bankruptcy.” Under section 544(a)(1), the bankruptcy estate’s entitlement to property is derived from, and limited by, the trustee’s status as a hypothetical lien creditor.

With these principles in mind, the panel turned to the nature and extent of the debtor’s right to the property of the Trust at the time of the petition. It found that the debtor’s rights were limited to his share of rental income as it was collected. As to the principal, he had no access to it before the expiration of the Lease in 2035. The panel rejected the trustee’s argument that when the debtor filed the bankruptcy petition, the bankruptcy estate became the owner of his interest in the Trust and that ownership right extended to the expiration of the Trust. The panel found that this argument improperly conflated “ownership” of a property interest with “the estate’s ability to realize upon it.” In fact, under California law, a creditor cannot collect a debtor’s Trust distributions or principal until it is actually paid to the debtor.

The bankruptcy court relied on Hernandez v. Hopper (In re Hernandez), BAP No. EC-12-1537-DJuMk, 2013 WL 1490995 (9th Cir. BAP Apr. 11, 2013), when it found that the estate could continue to collect income from the Trust after the debtor’s death. That case involved a trust which specified that the debtor would collect on the principal only after her mother’s death. The panel in that case upheld the bankruptcy court’s order sustaining the trustee’s objection to the debtor’s claimed exemption in the contingent interest and finding that the estate was entitled to 25% of any distributions the debtor received from the trust. That panel rejected the debtor’s argument that the spendthrift provision of the trust prevented the estate from realizing any portion of her recovery.

The panel here found the bankruptcy court’s reliance on Hernandez to be misplaced. It reasoned that Hernandez merely established that the bankruptcy court held the same contingent interest in property that the debtor held at the petition date, and that the estate could collect from distributions actually made from the trust. The Hernandez court specifically did not make a finding as to estate’s interest in trust property once the contingency of her mother’s death was removed. The panel cautioned that the filing of a bankruptcy estate does not create new ownership or distribution rights.

With respect to the Trust in this case, the panel further found a survival contingency was implicit in the Trust provision that, upon the death of the debtor, his beneficiaries were to receive the distributions from the Trust that he would have received had he lived. The panel disagreed with the bankruptcy court’s interpretation of the phrase “by right of representation” as tying the rights of the beneficiaries to the rights of the debtor. The panel explained that that language referred to a mode of distribution of the deceased debtor’s estate in a manner comparable to “per stirpes.” The bankruptcy court read too much into the term when it found that the debtor’s beneficiaries “would take as his representatives and not in their own individual right.”

In conclusion, the panel held that the bankruptcy court erred in ordering turnover of income and principal from the Trust after the debtor’s death before expiration of the Lease. The panel reversed.

The bankruptcy trustee has appealed to the Ninth Circuit. In re Rens, Case No. 21-60057 (9th Cir. filed Nov. 22, 2021).

Rens BAP 9th Cir Oct 2021


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