Bankruptcy and Estate Planning Attorneys, Beware: Trustee Uses Strong Arm Powers to Avoid Disclaimed Inheritance as Fraudulent Transfer

Apr 20, 2023
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By: Michael L. Moskowitz, Esq., Melissa A. Guseynov, Esq., and Elizabeth Conklin

In a recent decision of interest to bankruptcy and estate planning attorneys alike, Chief Bankruptcy Judge Laura K. Grandy, sitting in the United States Bankruptcy Court for the Southern District of Illinois, held that a Chapter 7 Trustee (“Trustee”), utilizing the “strong arm” powers conferred by section 544(b) of the Bankruptcy Code, may ignore the disclaimer of an inheritance as a fraudulent transfer under the Fair Debt Collection Procedures Act (“FDCPA”).  See Case No. 22-03016 (LKG) (March 17, 2023).

Section 544(b) of the Bankruptcy Code provides, in relevant part, that a trustee may “avoid any transfer of an interest of the debtor in property … that is voidable under applicable law by a creditor holding an unsecured claim.” See 11 U.S.C. § 544(b)(1). In this case, the Trustee sought to claw back Debtor’s disclaimer of his $375,000 share of an inheritance by stepping into the shoes of the IRS, one of Debtor’s unsecured creditors, to recover the funds for the benefit of Debtor’s creditors. 

Not surprisingly, Debtor’s children (“Children” or “Defendants”), who received the inheritance prior to Debtor’s filing, fervently objected. Judge Grandy was not persuaded by the Defendants’ argument that the FDCPA does not constitute “applicable law” under section 544(b), although the Court acknowledged there is a split of authority on the issue, with the “overwhelming majority” of judicial interpretation siding with the Trustee.

The Defendants Argument

The Defendants also argued that since Debtor validly disclaimed his interest under Illinois State law, Debtor never held an interest in the inheritance. Judge Grandy was similarly unimpressed by this argument. Noting that Illinois law did not control the analysis at hand, Judge Grandy employed the FDCPA definition of “property,” which includes a “future interest” in “property held in trust,” bringing the disclaimed inheritance into the orbit of the Trustee’s broad avoidance powers. See 28 U.S.C. § 3002 (12). Thus, the Court denied Children’s motion to dismiss the case, stating the Trustee had pled sufficient facts to establish a cause of action to avoid the funds pursuant to the relevant provisions of the FDCPA.              

Although this case is highly fact-specific and holds no precedential authority in New York or New Jersey, bankruptcy and estate planning practitioners should be aware of the ruling. As a federal statute, the FDCPA can be applied in New York and New Jersey bankruptcy cases.

In particular, estate planning attorneys who regularly use disclaimer planning should pay close attention to the potential impact of this decision. Those who use disclaimers as a planning device often deal with clients who have the opposite problem as the Debtor in this case. These clients generally seek to avoid the payment of estate, gift, and generation-skipping transfer tax due to the size of their estates. Sometimes, disclaimers are employed in Elder Law scenarios, such as when a surviving spouse or another beneficiary seeks to maintain eligibility for government benefits through the Medicaid program. However, Medicaid applicants/recipients are required to claim all property to which they are legally entitled (which would then be budgeted for Medicaid purposes). Due to the outcome of this case, the government may, therefore, be inclined to simply ignore disclaimers and penalize applicants/recipients in cases where the government is aware that they have not exercised their legal right to claim such property.

A disclaimer could similarly be disregarded by the government in a scenario when the Medicaid program is seeking reimbursement for costs paid on behalf of a person who exercised a disclaimer while receiving benefits. Our estate planning department is a proponent of Clayton-style QTIP trusts to accomplish the same tax purpose as a disclaimer, partly because we think that a court would not reach the same result when considering the asset protection implications of that type of trust.

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DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship.  This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm.  Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.

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