As discussed in our articles, Trusts and Duties of Trustees, both the executor of the estate or the successor Trustee of a revocable Trust have a duty to pay off the claims of legitimate creditors before the estate or trust can be closed and final distribution achieved. See our article on Probate of Estates. An issue can arise when a Trust has insufficient resources to pay all the creditors and also make specified specific bequests, as to how to allocate the scarce resources among the competing claims. This article shall address that issue and whether specific individual bequests are superseded by claims of creditors such that these assets may be liquidated to pay creditors.
The Basic Statutes:
Liabilities – California Probate Code Sections 11420 and 19001
Section 19001(a) of the California Probate Code states that, "upon the death of a Settlor, the property of the deceased Settlor that was subject to the power of revocation at the time of the Settlor's death (e.g. propery owned by the Settlor in a revocable trust or outright) is subject to the claims of creditors" of the Settlor's estate. Furthermore, the Settlor may designate in his or her will or trust the assets that are first to be consumed to pay off the debts of the estate, but under no circumstance can the Settlor, " ...alter the priority of payment... set forth in Section 11420" (19001(b)).
Section 11420 states that estate liabilities shall be paid in a specific order as follows:
- All expenses related to estate or trust administration.
- “Obligations secured by mortgage, deed of trust, or other lien” (11420(2)).
- Expenses related to funeral arraignments
- Medical expenses related to “last illness” (11420(4)).
- “Family allowance” (11420(5)).
- “Wage claims” (11420(6)).
- All other debts not covered by the preceding six categories. This also includes “judgments not secured by a lien” (11420(7)).
Each ‘class’ of liabilities has to be paid off in full before any debts in a subsequent class can be paid. In the event that the estate is unable to pay all the debts in a particular class, the remaining assets shall be used to “pay a proportionate share” (11420(b)).
Abatement – California Probate Code Sections 21401, 21402, 21403 and 21405
Section 21401 of the California Probate Code states that, "shares of beneficiaries abate...for all purposes, including payment of the debts, expenses, and charges specified in Section 11420".
The following section states the order in which bequests to, or "shares of", beneficiaries may be abated. The explicit order is as follows;
- Assets "not disposed of by the instrument" (21401(1)).
- "Residuary gifts" (21402(2)).
- General gifts to non-relatives.
- General gifts to relatives.
- Specific gifts to non-relatives.
- Specific gifts to relatives.
Note that a 'relative' is defined in California Probate Code sections 6401 and 6402 on intestate succession.
Section 21403(b) provides clarification as it states that, “gifts of annuities and demonstrative gifts are treated as specific gifts”. Additionally, section 21403(a) states that, "shares of beneficiaries abate pro rata within each class specified in Section 21402."
A beneficiary who wishes to retain an asset despite abatement does have the right to substitute other assets owned by the beneficiary. In the event that a specific gift is to be abated, "the beneficiary of the specific gift may satisfy the contribution for abatement out of the beneficiary's property other than the property that is the subject of the specific gift", such that the sale of the asset in question may be prevented (21405(b)).
Any abatement of beneficiaries’ shares must be approved by the court, as stated in section 21405(a); "In any case in which there is abatement when a distribution is made during estate administration, the court shall fix the amount each distributee must contribute for abatement. The personal representative shall reduce the distributee's share by that amount." As such, it is the court’s duty to determine what percentage of beneficiaries’ shares will be abated within each class mentioned in section 21402.
At times, the Trustee or Executor may face the need to sell assets to satisfy claims of creditors. Here, there is also procedure that must be adhered to.
Sale of Assets – California Probate Code Sections 10303, 10308, 10310, 10313 and 16226
California Probate Code section 16226 states that a trustee "has the power to dispose of property, for cash or on credit, at public or private sale". Furthermore, section 10303(b) states that real property held by an estate may be sold "with or without notice" when such authority is given in the will to sell real property". However, all sales of real property must be reported to the court before the transfer of title (10308(a)).
Furthermore, such sales will be subject to a hearing in which the court will examine "the necessity for sale or the advantage to the estate and benefit to the interested persons" (10310(a)). During this hearing the court will also, "examine into the efforts of the personal representative to obtain the highest and best price for the property" (10310(b)).
Written objections to the sale may be filed with the court by interested persons at or before the hearing (10310(c)).
As with other legal entities such as corporations, limited liability companies, and partnerships, trusts and estates can find themselves without sufficient resources to meet their obligations. In such event, the above criteria are what must be utilized to satisfy such competing claims. it should be noted that if the creditors cannot be paid without eliminating all the legacy, than that shall be required. Only such obligation as the Family Allowance and the costs of administration, including executor and/or trustee fees, shall take precedence over the claims of creditors.
This makes sense as stated to the writer by a creditor's attorney a decade or so ago. He made the salient comment, "If you're broke before you die, you can't suddenly be solvent just because you are in the ground." Of course, life insurance and life insurance trusts can alter that situation and should be considered by a person engaged in estate planning who is considering how to meet obligations that may impact heirs.