Bankruptcy Court Decision May Surprise Estate Planners

Last week we read a Bankruptcy Court appellate decision that surprised us. We think it might surprise other estate planning attorneys (and other advisors). It points out that the analysis applied in Bankruptcy Court might not reflect the same thinking that we apply. That court system views wills, trusts and estate planning differently.

We also need to start with two other observations:

1. The opinion from the Bankruptcy Appellate Panel is not a reported decision. That is, it does not create precedent for other, similar cases. Still, it reflects the likely view of estate planning generally.
2. The case comes from a California court. But Bankruptcy Court is a federal system, and a similar result would probably obtain on the same facts in Arizona.

The Klein Living Trust

The case arose from a living trust established by Leslie and Erika Klein in 1975. Though the trust is not included in the appellate court decision, it appears to be pretty straightforward. Mr. and Mrs. Klein were co-trustees and had the power to amend or revoke the trust. On the first death, the trust would split into two (or possibly three) separate trusts. One, the “Credit Trust” (probably actually called the Credit Shelter Trust) would hold most or all of the deceased spouse’s share of community property, and would become irrevocable.

Mr. and Mrs. Klein transferred their California residence into the trust’s name, along with most or all of their other assets. They amended their trust in 1990, but the broad outlines of the plan did not change.

To review: the Kleins’ estate plan was pretty ordinary for 1990, when they made the last significant change. They might have considered changes over the next two decades, as the importance of tax planning along the lines of what they had implemented began to diminish. But they didn’t.

Erika Klein died in 2012. Though Leslie was supposed to actually make a division of the trust, he didn’t. That is hardly uncommon; in our experience, failure to make the actual division is commonplace.

Leslie remarries

After Erika’s death, Leslie married Barbara. First, the couple signed a prenuptial agreement. That bound him to allow Barbara to live in the couple’s residence for the rest of her life if he died first. Of course, they would be living in the house owned by the trust.

Let’s pause a moment to see what we think about the status of the Klein family dynamics at this point. Most estate planning attorneys would tell Leslie that he had made an agreement with his new wife that exceeded his authority. Though he had not completed the trust division into shares, he had a fiduciary duty to do so, and his children could compel him to complete the steps. And they could presumably insist on their rights after his death, even though he had agreed to let Barbara stay in the home.

At this point in the trust’s history, the Survivor’s Trust technically owned half of the family residence, with the other half belonging to the (unfunded) Credit Shelter Trust (or, perhaps, one of the other trusts created by the Klein Family Trust). Failure to take steps to clarify titles didn’t change that reality.

If Leslie had consulted with an estate planning attorney, they might have told him that he had not given Barbara a “life estate” in the home. She wouldn’t have any title, and wouldn’t be able to sell her interest or collect rents if she moved out before her death. In fact, if she voluntarily moved out (into a care home, for instance), the successor trustee of the trust would have the ability to recover any interest and dispose of it under the trusts’ terms. And, as noted above, the successor trustee would already have that power as to the Credit Shelter Trust’s interest, despite Leslie’s prenuptial agreement.

What Leslie could have done, and what he actually did

A capable estate planning attorney might have counseled Leslie about possible revisions to the Klein Family Trust. Those changes would presumably be governed by California law, not Arizona law, and so the advice might be different from what he would hear from an Arizona attorney. But in similar circumstances, we frequently counsel clients about choices they face after failing to make the trust division. Those might include:

1. Making a belated division, retitling assets and notifying the remainder beneficiaries (the children) about their rights. This can sometimes create income tax consequences, as it might cause recognition of capital gains on some trust assets, depending on the division. But it might be the best choice, as it does not rely on cooperation from the children. But, of course, that might have violated his prenuptial agreement with Barbara.
2. “Decanting” the trust(s) into a new, single trust. This is very state specific, and might require consent or cooperation from the remainder beneficiaries. But it is an option that can be explored.
3. Entering into a “non-judicial settlement agreement” with the other beneficiaries. This is similar to the “decanting” option, and is also very dependent on state law. But if all the beneficiaries can agree, it might be possible to reconsider the trust division and specifically allow for Barbara’s right to reside in the property.

What did Leslie actually do? Nothing. But that might have been a good-enough plan — if the Bankruptcy Judge had been a former estate planning attorney.

How did the Bankruptcy Court get involved?

Leslie filed for Bankruptcy in 2023. By that time the California residence was valued at about $10 million, and Leslie had $32 million in liabilities.

The Bankruptcy Court ruled that the entire home was available to his creditors. Well, not quite; he did have an exemption for $189,050 under state law.

Leslie argued that:

1. He didn’t really own 1/2 of the property. That belonged to the Credit Shelter Trust and, though he was trustee, it wasn’t available to his creditors. It also included a “spendthrift” provision, meaning that they couldn’t reach it — and it should not be included in his bankruptcy estate.
2. Even the half interest that really belonged to him (the part that should have been retitled to the Survivor’s Trust) was subject to a life estate held by Barbara because of her enforceable claim under the prenuptial agreement.
3. Any action against the Credit Shelter Trust’s share of the home would require his children to be joined as defendants, since they had enforceable rights under the trust.

The Bankruptcy Judge disagreed, and ruled that the Bankruptcy Trustee was entitled to summary judgment on the issues. Leslie appealed the judge’s adverse ruling.

The Bankruptcy Appellate Panel ruling

The “unreported” decision we read last week was from the Ninth Circuit Court of Appeals Bankruptcy Appellate Panel. That’s the specialized court where Bankruptcy Court decisions are appealed. And it ruled completely against Leslie.

The Appellate Panel made several observations:

1. Even if a half-interest in the home should have been transferred to the Credit Shelter Trust, it wasn’t. Leslie continued to act as if he owned all of the trust’s assets and the Credit Shelter Trust didn’t really exist. Now that he wanted to recharacterize the ownership, it was just too late.
2. Even if he had made the division, he was still trustee of the trust and had complete discretion over it. He could legally reach the asset, and his children couldn’t complain. So they weren’t necessary parties.
3. Even though the trust had a spendthrift provision, that would be ineffective as to a self-settled trust. And since he and his first wife Erika had acted together to create the trust in the first place, the unfunded Credit Shelter Trust would have been self-settled.
4. The interest Barbara had wasn’t a life estate. They did not record anything, and besides the prenuptial agreement didn’t give her a life estate but just a right to reside in the property. Implicitly, she might have a claim against Leslie for breaching that agreement (and probably ought to get in line in Bankruptcy Court) but she had no enforceable interest as to the home.

In Re Klein, June 5, 2025.

What if…?

What if Leslie had, shortly after Erika’s death, actually divided the trust into separate shares and transferred an interest in the home into the Credit Shelter Trust (or any of the subtrusts other than the Survivor’s Trust)? Could he then have resigned as trustee, let one of his children take over, and protected at least a half interest in the property? And gotten good advice from an estate planning attorney before signing the prenuptial agreement? Would that have led to a different — and more favorable — outcome?

Maybe. But we think that the principal lesson here is that Bankruptcy Court tends to think of trusts and estate planning differently from estate planners’ view of the same landscape.