Summary
Learn about a hidden risk in estate planning: trusts generally cannot file for bankruptcy. It centers around a 2024 court case where a trust created by Vera Welte left farmland to her son. When the son couldn’t repay debts secured by a mortgage on the trust’s land, the trust tried to file bankruptcy to stop foreclosure. The judge ruled it couldn’t, because it wasn’t a "business trust" under bankruptcy law. This article explains that most estate planning trusts, like Vera’s, aren’t designed for business purposes, which means they don’t qualify for bankruptcy protection. As a result, the creditor foreclosed and sold the land. While trusts are useful tools in estate planning, they have limits—especially when it comes to debt and bankruptcy. It's critical to understand these limitations and plan carefully, possibly by limiting a trustee’s power to pledge trust assets or choosing alternative structures.
It’s important to consider all factors when making out an estate plan. Trusts are a common estate planning tool, and can provide significant value when used properly; however, trusts also lack certain important legal rights that people and corporate entities have, including the right to file bankruptcy.
In 2024, Judge Thad Collins, the chief bankruptcy judge for the Northern District of Iowa, decided a case called In re: Vera Welte Testamentary Trust. When Vera Welte died, she left farmland to a trust with her will, naming her son as the beneficiary. The son needed to borrow money and had the trust pledge a mortgage on its land to secure those debts. When the son couldn’t pay those debts, the creditor sued to foreclose the mortgage.
In response, the trust filed bankruptcy. Judge Collins was asked to decide whether the trust was eligible to file bankruptcy.
The Bankruptcy Code says that, in general, a “person” can file bankruptcy, but then broadly defines “person” to include individuals, partnerships, and corporations. “Corporation,” in turn, is broadly defined to include entities people would generally think of as corporations, but also a “business trust.” Unfortunately, the Bankruptcy Code does not define “business trust.”
To fill this void, courts have developed a six-factor test, with the most weight being given to whether the trust was created and maintained for a business purpose. It’s not sufficient for a trust to merely conduct business operations—business operations must be its primary purpose, not a side effect.
The problem becomes apparent: A testamentary trust isn’t created or maintained for business purposes. It is created to facilitate the grantor’s estate planning wishes by protecting and preserving the property in the trust for the beneficiary’s benefit. That’s why Judge Collins dismissed the case—since the trust was not created for a business purpose, it was not a business trust and therefore was not eligible to become a bankruptcy debtor.
Make Your Wishes Clear
After the dismissal, the creditor foreclosed its mortgage and sold the trust’s land at a sheriff’s sale. Vera Welte could have prevented this outcome by prohibiting the trustee from mortgaging the trust’s land to secure other debts, even though most trusts give the trustee broad powers to pledge the trust property to secure debts.
The trustee, too, could have prevented this by refusing to sign the mortgage—but perhaps she thought that the son, as the trust’s beneficiary, was only pledging land that was ultimately his, so it was his business if he wanted to do that. If the son had owned the land himself instead of being the trust’s beneficiary, then he could have filed bankruptcy himself and stopped the foreclosure.
While there were several opportunities to prevent this outcome, they share a common thread: The testamentary trust. Moreover, while the business purpose test was determinative in Vera Welte, other typical features of estate planning trusts made it difficult for this trust to satisfy some of the other factors in the six-factor business trust test.
Trusts are powerful tools. They can reduce taxes, avoid probate, facilitate distribution of complex assets, allow for assets to be distributed to heirs over time or based on conditions, maintain privacy, protect assets from creditors, and avoid will contests. They can serve many functions in an estate plan.
But it is essential to also recognize their limits. Nobody plans to experience financial distress, become unable to pay their creditors, and file bankruptcy—but it can happen. In addition to concerns about cost and losing a step-up in basis, property owners and their estate planning attorneys who consider establishing trusts should carefully contemplate the likelihood that the trust will not be eligible to file for bankruptcy if the trust, or its property, becomes subject to debts that cannot be repaid.
It may be appropriate to restrict the trustee’s powers to pledge trust assets to secure non-trust debts, set a date certain when the trust’s property will vest in the beneficiary, or use a different tool to accomplish the grantor’s goals.
If your estate-planning attorney has recommended setting up a trust for your farm or business property, reach out to knowledgeable staff at Ag & Business Legal Strategies to discuss the bankruptcy implications of doing so. We can help you and your attorney account for this threat to carrying out your last wishes.
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