There’s a simple way to avoid this and to protect the heir from him or herself.
In the trusts that I prepare, most clients choose to leave the inheritance in a “flexible protective trust.” This is fancy name for a “spendthrift trust.” Usually, a flexible protective trust leaves it up to the child/heir to decide whether to withdraw the funds ( if the coast is clear) or leave the funds in the trust where the inheritance is protected.
Inherited money that the child leaves in a flexible protective trust cannot be taken in the child’s divorce, cannot be attached by child’s creditor and it is exempt is bankruptcy, meaning the child will not lose the inherited money if he files bankruptcy.
A recent bankruptcy court case, In re Lunkes, illustrates that there is really no reason to leave an inheritance directly to a child or heir. It is always better to play it safe and at least set up a flexible protective trust and let the heir decide if it should be protected within the trust or not.
In the Lunkes case, a parent died and left money to the children, but the funds were left outright, not in a flexible protective trust. One of the kids filed a chapter 7 bankruptcy and claimed that the inheritance was exempt, and that he should be able to keep the inheritance. The kid’s argument was that, hey… the funds are still being administered in the trust (there was a lot of real estate that now takes an eternity to liquidate) so since I don’t have the inheritance yet, it can’t be taken away in the bankruptcy. The court said, sorry, the funds were left outright to the child, not in a flexible protective trust, so the inheritance goes to the bankruptcy trustee. This could have easily been avoided by using a flexible protective trust. Inherited money left in a flexible protective trust is exempt in bankruptcy (meaning the child/heir gets to keep the inheritance).
There are only three rules to for setting up a flexible protective trust:
1. The funds have to be held in trust, not left outright.
2. The child/heir cannot be the trustee.
3. The trust has to contain a spendthrift clause. Most trusts contain these. An Illinois spendthrift clause reads like this: “No interest under this instrument shall be assignable by any beneficiary, or be subject to the claims of his or her creditors, including claims for alimony or separate maintenance. The preceding sentence shall not be construed as restricting in any way the exercise of any right of withdrawal or power of appointment or the ability of any beneficiary to release his or her interest.”
So, do your heirs a favor and at least give them the option of protecting their inheritance in a flexible protective trust.