What happens if a beneficiary under a will is bankrupt?

Savvy business people often structure their affairs by holding very few assets in their own name, preferring to keep assets out of their own and their creditors’ legal reach. This is particularly so for individuals who are at risk of being sued, such as company directors and business owners. Any legal action taken against them personally does not normally extend to assets owned by others, such as a spouse or a trust. Whilst it is common for professionals to take care not to own assets in their own name throughout their career, what happens if they receive an inheritance?

The bankrupt beneficiary

Consider this example. John has retired after a successful career. He owns his home, several investment properties and various other assets. John is a widower and has two adult children, Vanessa and Peter. Upon his death, John would like to pass his assets to his two children equally.

Peter, the son, runs a business which is on the brink of failure due to reduced revenue, rent increases and unpaid tax. The ATO is threatening legal action and other creditors are now coming after Peter, who has provided personal guarantees. Peter is considering bankruptcy as a way to ease his financial and emotional stress.

Although Peter has always taken care not to own assets in his own name, if Peter is bankrupt when John dies, the share of John’s estate that would have gone to Peter is vested/paid to his bankruptcy trustee and will be made available for Peter’s creditors, the trustee’s costs and the administration of Peter’s bankrupt estate. Currently, a person remains in bankruptcy for a minimum period of three years, which is scheduled to be reduced to one year later this year.

Property that falls into a bankrupt’s hands after the commencement of the bankruptcy is called ‘after-acquired property’ and vests in the bankrupt’s trustee. There may be a temptation not to disclose this after-acquired property to the bankruptcy trustee but non-disclosure of after-acquired property is an offence, with penalties ranging from a fine, imprisonment and extension of the bankruptcy period up to eight years.

An executor of a Will who distributes property to a bankrupt beneficiary will be negligent and can be sued by the bankruptcy trustee in the trustee’s capacity as beneficiary (in place of Peter).

The use of a testamentary trust

With careful planning, a Will can be structured so that the potential for the Will-maker’s estate passing to a bankruptcy trustee can be avoided. A testamentary discretionary trust can be used to benefit a person who is financially vulnerable because of alcoholism, a gambling problem, threatened or actual bankruptcy.

A testamentary discretionary trust is a trust set up in a Will. It gives the trustee the power to decide how assets and income are to be managed and distributed to the beneficiaries. It allows the trustee to be flexible to address each beneficiary’s individual circumstances. Assets can be protected from external creditors and the bankruptcy trustee as the property is owned by the trustee and not the beneficiary.

If beneficiaries are financially vulnerable or are at risk of bankruptcy, these issues can be addressed at the time a Will is made and can provide the Will-maker with peace of mind that his or her estate will be protected for the benefit of children and other family members.