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BRIEFING PAPER

Number 7321, 25 November 2019

Would a bankrupt be able to keep an inheritance?

By Lorraine Conway

Inside: 1. What is bankruptcy? 2. Functions of the trustee in

bankruptcy 3. Assets that pass to the

trustee in bankruptcy 4. After-acquired property 5. An undischarged bankrupt

inherits 6. A discharged bankrupt

inherits

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Contents Summary 3

1. What is bankruptcy? 4

2. Functions of the trustee in bankruptcy 5

3. Assets that pass to the trustee in bankruptcy 6

4. After-acquired property 8

5. An undischarged bankrupt inherits 10

6. A discharged bankrupt inherits 11

Cover page image copyright: Pound coins / image cropped. Licensed under CC0 Creative Commons – no copyright required

3 Would a bankrupt be able to keep an inheritance?

Summary

Summary

A beneficiary of an estate is an individual who receives, or may become eligible to receive, benefits under a will. Depending on the exact circumstances, a beneficiary who is still bankrupt may not be entitled to receive their inheritance, as it may need to go towards the payment of their debts under the bankruptcy.

Once a bankruptcy order has been made by the court, an official receiver will be appointed trustee in bankruptcy (unless a private sector insolvency practitioner is appointed). As at the date of the order, the bankrupt’s estate vests in the trustee. The bankrupt’s estate essentially consists of all the property which belongs to or is vested in the bankrupt at the commencement of his bankruptcy. The function of the trustee is to collect in and sell the bankrupt's assets and to make payments to creditors in accordance with the Insolvency Act 1986 (IA 1986).

“Discharge from bankruptcy” is a legal term used to describe the process that frees a person from the restrictions of bankruptcy and releases them from most of the debts they owed at the date of the bankruptcy order. A bankrupt will usually be automatically discharged 12 months after the date of the bankruptcy order, even if no payments have yet been made to creditors. After discharge, the bankrupt is released from all bankruptcy debts and any property he acquires after his discharge is his; the trustee cannot lay claim to it. However, property comprised in his/her estate at the time of the bankruptcy order remains under the control of the trustee to be sold for the benefit of the creditors.

Occasionally, a Member of Parliament may be contacted by a constituent who, whilst bankrupt, benefits from an inheritance (e.g. property or money). Any new asset obtained during the bankruptcy (i.e. after the date of the bankruptcy order and before the date of discharge) is referred to as “after-acquired property” and must be declared to the trustee. Under section 307 of the IA 1986, the trustee can make a claim to the property for the benefit of the creditors (subject to certain time limitations). In effect, any inheritance made to an undischarged bankrupt is potentially vulnerable to a claim by the trustee in bankruptcy.

This Commons briefing paper provides a brief outline of the position as it applies in England and Wales. Scotland has its own separate legal procedure for individual insolvency known as sequestration.

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1. What is bankruptcy? Bankruptcy is governed by the provisions of the Insolvency Act 1986 (IA 1986) (as amended), the Insolvency (England and Wales) Rules 2016, and the Enterprise Act 2002 (EA 2002).

Bankruptcy is an option for any individual who cannot pay their debts “as and when they fall due”. Under the IA 1986, the debtor can apply for their own bankruptcy online (known as a “debtors petition”) submitting detailed information about their financial position; it is for an adjudicator to decide whether to grant the order. The process is different if someone else wants to make the debtor bankrupt; this requires a bankruptcy petition to the court either by:

• one or more creditors who are currently owed £5,000 or more by the debtor and that amount is unsecured (known as a “creditor’s petition”); or

• the supervisor or anyone bound by an Individual Voluntary Arrangement (IVA)1

Once a bankruptcy order has been made by the court, an official receiver will be appointed trustee in bankruptcy (unless there are enough funds to appoint a private sector insolvency practitioner). Ultimately, the trustee will be responsible for collecting in and disposing of the bankrupt’s assets and making payments to creditors

For the purposes of this paper, it is assumed that the bankrupt is subject to a creditor’s petition (i.e. a compulsory bankruptcy order).

1 An IVA is a formal and legally binding agreement between a debtor and his/her

creditors to pay back their debts over a specified period (usually 3 or 5 years). An IVA is approved by the court and is supervised by an insolvency practitioner.

Official receiver is trustee of last resort

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2. Functions of the trustee in bankruptcy

Box 1: The role of the trustee in bankruptcy

• Once a bankruptcy order has been made by the court, the official receiver or a private sector insolvency practitioner will be appointed trustee in bankruptcy.

• As at the date of the order, the bankrupt’s estate vests in the trustee.

• The bankrupt’s estate essentially consists of all the assets which belongs to or is vested in the bankrupt at the commencement of the bankruptcy.

• The function of the trustee is to collect in and sell the bankrupt’s assets and to make payments to creditors in accordance with the IA1986.

• The bankrupt has a duty to provide information to the trustee, and attend at the trustee’s office as and when reasonably required.

The function of the trustee is to get in, realise and distribute the bankrupt's estate in accordance with the IA 1986. In the carrying out of that function and in the management of the bankrupt's estate the trustee is entitled, subject to the IA 1986, to use his/her own discretion (see Box 1 above).

The bankrupt has 21 days from the date of the bankruptcy order in which to provide the trustee with information relating to his/her financial affairs, including a full list of their assets (including property, pensions, insurance policies etc.) and a full list of their debts.

It is the trustee’s duty to investigate the bankrupt’s financial affairs for the time before and during the bankruptcy. The trustee must report to the court any matters which indicate that the debtor may have committed criminal offences in connection with his/her bankruptcy.

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3. Assets that pass to the trustee in bankruptcy

As at the date of the bankruptcy order, the bankrupt’s estate vests in his/her trustee (see Box 2 below). The bankrupt loses any rights to his/her property apart from any equipment needed for use in his/her business, basic domestic equipment (such as furniture), and certain pension rights. Creditors can no longer pursue the debtor for payment; payment becomes the responsibility of the trustee.

Box 2: Vesting of bankrupt’s estate in trustee – section 306 of the IA 1986

306. (1) The bankrupt's estate shall vest in the trustee immediately on his appointment taking effect or, in the case of the official receiver, on his becoming trustee. (2) Where any property which is, or is to be, comprised in the bankrupt's estate vests in the trustee (whether under this section or under any other provision of this Part), it shall so vest without any conveyance, assignment or transfer.

The “bankrupt estate” is the term used to describe that body of the bankrupt’s assets that pass to the trustee on his appointment for realisation and distribution to creditors. It consists of all the property which belongs to or is vested in the bankrupt at the commencement of his bankruptcy (i.e. the date on which the bankruptcy order is made).2 As outlined in Box 3 (below) property is defined widely in bankruptcy proceedings and there is no geographical restriction on the property which comprises the bankrupt’s estate.

Box 3: Definition of property – section 436 of the IA 1986

Under section 436 of the IA 1986, “property” is defined widely in bankruptcy proceedings. It includes:

...money, goods, things in action and every description of property wherever situated and also obligations and every description of interest, whether present or future or vested or contingent, arising out of, or incidental to, property.3

Importantly, property is also treated as being comprised in the estate where it becomes available after the commencement of the bankruptcy but before discharge. This includes “after-acquired property” (see section 4 of this paper below).

In other words, whereas “the bankrupt’s estate” is defined by reference to the date of the bankruptcy order, the statutory definition of property draws into the estate future and contingent interests, so long as they exist as proprietary interests at that date.

As already mentioned, certain property is specifically excluded from the estate in order to maintain the bankrupt’s ability to earn an income and maintain a reasonable standard of living (see Box 4 below).

2 Section 283 of the Insolvency Act 1986 3 Section 436 of the Insolvency Act 1986

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Box 3: Items specifically excluded from the bankrupt’s estate

The exemptions include:

• such tools, books, vehicles and other equipment as are necessary to the bankrupt for personal use by him in his employment, business or vocation (subject to the trustee’s right to replace any of these items at a lower cost if this is reasonable);4

• such clothing, bedding, furniture, household equipment and provisions as are necessary for satisfying the basic domestic needs of the bankrupt and his/her family;5

• property held by the bankrupt on trust for any other person does not form part of his/her estate – the bankrupt continues to hold the property on trust for the third party beneficiary who remains entitled to it, subject to the terms of the trust;6

• a student loan made to the bankrupt before or after the date of the bankruptcy order is not regarded as an asset that the trustee may claim, if a balance of the loan remains payable; and

• certain state benefits are also excluded from a bankrupt’s estate by virtue of the provisions of other Acts

It should also be noted that property in the bankrupt’s estate is held by the trustee subject to the prior legal right of any person (other than the bankrupt) in such property. For example, a freehold interest in land owned by the bankrupt falls within his/her estate and can be sold by the trustee in bankruptcy for the benefit of creditors. However, if all or part of the property has been mortgaged, the property passes to the trustee subject to the mortgagee’s interest, and subject to the mortgagee’s right to take possession even after the bankruptcy and to exercise all the other rights of a mortgagee (including the right of sale).

In circumstances where assets have been disposed of by the bankrupt before the commencement of the bankruptcy but have been reclaimed by the trustee (i.e. undervalued transactions7 or transactions at a preference8), the assets are also treated as being part of the bankrupt’s estate.

4 Sections 283(2)(a) and 308(1) of the Insolvency Act 1986 5 Section 283(2)(b) of the Insolvency Act 1986 6 Section 283(3)(a) of the Insolvency Act 1986 7 A transaction at undervalue occurs when a business asset is transferred or sold to

a third party, either for no payment at all, or for a price that is considerably lower than its true value. The relevant provisions are contained in sections 339, 341 and 342 of the Insolvency Act 1986

8 A preferential transaction is where a company pays a creditor in preference of other creditors, just before going into insolvency. The relevant provisions are contained in sections 340,341 and 342 of the Insolvency Act 1986

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4. After-acquired property Any new assets or sources of income obtained during the bankruptcy (i.e. after the date of the bankruptcy order and before the date of discharge) are referred to as “after-acquired property”. An unexpected inheritance that passes to the bankrupt during the life of the bankruptcy is an obvious example of after-acquired property.

All after-acquired property must be declared to the trustee. The trustee can make a claim to it, under section 307 of the IA 1986, for the benefit of the creditors (see Box 5 below). The bankrupt has a responsibility to be honest about their situation with the trustee in bankruptcy.

Box 4: After-acquired property – section 307 of the IA 1986

307. (1) Subject to this section and section 309, the trustee may by notice in writing claim for the bankrupt's estate any property which has been acquired by, or has developed upon, the bankrupt since the commencement of the bankruptcy. (2) A notice under this section shall not be served in respect of -

(a) any property falling within subsection (2) or (3) of section 283 in Chapter II (b) any property which by virtue of any other enactment is excluded from the bankrupt's estate, or (c) without prejudice to section 280(2)(c) (order of court on application for discharge), any property which is acquired by, or develops upon, the bankrupt after his discharge

(3) Subject to the subsection, upon the service on the bankrupt of a notice under this section the property to which the notice relates shall vest in the trustee as part of the bankrupt's estate; and the trustee's title to that property has relation back to the time at which the property was acquired by, or developed upon, the bankrupt. (4) Where, whether before or after service of a notice under this section -

(a) a person acquires property in good faith, for value and without notice of the bankruptcy, or (b) a banker enters into a transaction in good faith and without such notice,

the trustee is not in respect of that property or transaction entitled by virtue of this section to any remedy against that person or banker, or any person whose title to any property derives from that person or banker (5) References in the section to property do not include any property which, as part of the bankrupt's income, may be the subject of an income payments order under section 310.

It is important to note that the trustee has a limited time frame in which to decide whether to claim all or any of the after-acquired property for the benefit of the creditors (see Box 6 below). In effect, the trustee must notify the bankrupt in writing of his claim within 42 days of his becoming aware of the after-acquired property. In practice, time would run either from the date the bankrupt informs the trustee of his/her acquisition of new property or the date the trustee becomes aware of the after-acquired property by some other means.

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Box 5: Section 309 of the IA 1986 - Time limit for notice under section 307

309.(1) Except with the leave of the court, a notice shall not be served –

(a) under section 307, after the end of the period of 42 days beginning with the day on which it first came to the knowledge of the trustee that the property in question had been acquired by, or had devolved upon, the bankrupt; (b) under section 308, after the end of the period of 42 days beginning with the day on which the property in question first came to the knowledge of the trustee.

For the purposes of this section –

(a) anything which comes to the knowledge of the trustee is deemed in relation to any successor of his as trustee to have come to the knowledge of the successor at the same time; and (b) anything which comes (otherwise than under paragraph (1) to the knowledge of a person before he is the trustee is deemed to come to his knowledge on his appointment taking effect or, in the case of the official receiver, on his becoming trustee.

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5. An undischarged bankrupt inherits

In practice, the named executors of a will should undertake a bankruptcy search to check whether there are any bankruptcy orders in place before distributions are made to the beneficiaries. If a beneficiary is indeed bankrupt, their inheritance (or part of it) may fall due to their trustee in bankruptcy.

In any event, under the IA 1986, the bankrupt has a responsibility at all times to be honest with their trustee about their situation. An undischarged bankrupt is obliged to tell the trustee about any inheritance or windfall they receive within 28 days. If the bankrupt fails to do so, the trustee has powers to reverse any transaction if it is seen to be a measure undertaken by the bankrupt to put assets outside of the reach of his/her creditors.

If the bankrupt inherits before his discharge, the inheritance would be treated as “after-acquired property”; property acquired after the date of the bankruptcy order but before the date of discharge from bankruptcy. As such, the trustee can make a positive claim to it under section 307 of the IA 1986.

A positive claim means the trustee is required to notify the bankrupt in writing of his claim within 42 days of his becoming aware of the inheritance. In practice, the time would run either from the date the bankrupt informs the trustee of his inheritance or the date the trustee becomes aware of the inheritance by some other means.

In exceptional circumstances, the bankrupt could make a representation to the trustee as to why they should be allowed to keep some (if not all) of the after-acquired property. The bankrupt would need to obtain proper legal advice as to whether or not they have grounds for making such a representation.

An inheritance made to an undischarged bankrupt is potentially vulnerable to a claim by his/her trustee in bankruptcy.

11 Would a bankrupt be able to keep an inheritance?

6. A discharged bankrupt inherits

Box 6: Automatic discharge from bankruptcy

As a general rule, the bankrupt will be automatically discharged from bankruptcy one year after the date of the bankruptcy order. Automatic discharge will occur even if:

• no payments have been made to the creditors

• the bankrupt is still making contributions under an income payments order/agreement; or

• some of the bankrupt’s assets have not yet been sold On discharge, the bankrupt is released from bankruptcy restrictions and from most of the debts they owed at the date of the bankruptcy order. However, there are certain debts a discharged bankrupt is not freed from, including:

• any court fines or debts arising from fraud or certain other crimes;

• debts incurred after the date of the bankruptcy order; and

• all outstanding student loans

On discharge from bankruptcy, the bankrupt is released from bankruptcy restrictions and from most of the debts they owed at the date of their bankruptcy order.9 However, discharge from bankruptcy does not return ownership or control of bankruptcy assets to the bankrupt or prevent the trustee from carrying out any of his remaining functions in relation to the bankrupt’s estate. Any inheritance (or other property) that is left to the bankrupt after discharge may usually be kept by them in full; the trustee cannot lay claim to it.

9 A discharged bankrupt is not freed from the following debts: court fines or debts

arising from fraud or certain other crimes; debts incurred after the date of the bankruptcy order; and all outstanding student loans

After discharge, the bankrupt has a continuing obligation to attend on and provide information to his/her trustee in bankruptcy.

BRIEFING PAPER Number 05270, 25 November 2019

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