YOU NEED TO KNOW! ( THE INHERITANCE EXCEPTION )
Updated: Jun 22, 2020
Some parts of the bankruptcy code are little known by the general public as well as among some practitioners. Those areas can lead to adverse results and possible malpractice traps for lawyers. One of those areas is the issue of what happens if a debtor files chapter 7 liquidation bankruptcy and then within 180 days after filing a relative who has named him/her in the will dies? Well, the general rule in Chapter 7 bankruptcy is that once a debtor files his/her bankruptcy petition all assets obtained thereafter ( that were not earned before filing for bankruptcy ) belong to the debtor and not the debtor's creditors.
For example, if a debtor files for Chapter 7 bankruptcy and subsequently buys a lottery ticket and wins millions of dollars those winnings are not property of the bankruptcy estate and cannot be used to pay the debtors creditors unless the debtor has a moral awakening and voluntarily decides to use the funds to pay his creditors. However, there are exceptions written into the bankruptcy code which do make property obtained post bankruptcy property of the bankruptcy estate and therefore can be utilized to pay the debtor's creditors. Under 11 U.S.C. 541(a)(5) of the bankruptcy code if a debtor receives or even becomes entitled to an inheritance within 180 days after filing for bankruptcy the inheritance automatically becomes property of the bankruptcy estate irrespective of when the inheritance is actually paid out to the debtor. The debtor has an obligation to notify the Chapter 7 Trustee or court and if the case is already closed must move to reopen the case so the inheritance can be paid into the estate. It is a bankruptcy fraud not to report it and could be a felony.
So , what to do? First, it is critical that the bankruptcy attorney advise the client about the provision and ask questions as to whether an inheritance is possible or likely within the 180 day period. In other words, I ask the client if he/she is in a will and expects a possible inheritance of any type or is a beneficiary under a life insurance policy or death benefit. ( the code section deals with all" bequeaths", " devises", " Life Insurance" ," death benefits" as well as a property settlement with a spouse). If an inheritance is a possibility, we discuss the likelihood of a death in the short term and balance the pro's and con's.
If there appears to be a real prospect of a death within a short period of time triggering the inheritance, then it is possible for the family member to change the will as long as the change is not a secret plan to funnel the funds back to the debtor from another relative in the event of a death during the 180 day period. The change must be real and the debtor risks losing any right to the inheritance , but it would prevent the inheritance from being utilized to pay creditors. The will could be changed back after the 180 day period expires if a death did not occur. Some may disagree with this strategy, but I do not believe it is improper as the person who directs the will has free will over how it is directed and whether he wants his/her funds to be used to pay the debts of the beneficiary.
Congress enacted this 180 day rule to discourage people form filing bankruptcy in anticipation of receiving a significant inheritance. Many bankruptcy attorneys do not flag this issue or advise their clients of it prior to filing. As you can imagine, the consequences can be dire if the issue is not anticipated, discussed and dealt with prior to filing for Chapter 7 bankruptcy.