Beware the Revocable Trust Creditor Trap

4:01 pm Medicaid

In Maryland, creditors may not make a claim against a deceased person’s estate once six months have passed since the person’s death. What that means is that a creditor seeking to assert a claim six months or more following someone’s death will not be allowed to collect the debt.

One exception to this rule is that a creditor who has a secured interest, for example, a bank that holds a mortgage on the deceased person’s real property, will still be able to collect against the proceeds of the sale of such real property, and retains the right to foreclose on the real property if the mortgage payments are not being made. However, such bank would be precluded from collecting more than the sales proceeds if the house sells for less than the mortgage loan balance if the bank did not make a claim in the estate of the deceased person within six months following that person’s death.

Another significant exception to this rule involves Revocable Trusts. When a person creates a revocable trust and transfers his or her assets to the trust, those assets are not considered to belong to the person for probate purposes, and when that person dies, those assets are not included in the deceased person’s probate estate.

Under the law then, if, when that person dies, no probate estate is opened because all of that person’s assets are titled in the revocable trust, then the six month limit on creditor’s claims does not apply. In that instance, if the trustee of the revocable trust distributes assets to the trust’s beneficiaries six months after the creator of the trust dies, but then, later, a creditor of the deceased person makes a claim or demand on the trustee to pay the deceased person’s debt, that trustee may find himself subject to personal liability for the debt if he cannot recover the funds he distributed to the trust beneficiaries.

This is one of the little known problems with revocable trusts, which are popular probate avoidance tools. Indeed, people who meet with attorneys who advocate using revocable trusts to avoid probate, more often than not, are not advised of this issue.

This was a problem without an easy solution until late last year. In October, 2015, however, Maryland’s new Trust Code became law, and that new law provides a solution to the Revocable Trust creditor claims problem.

What the law now provides is that, if a probate estate is opened for the person who created the trust, then the same six month creditor claim limitation period that applies to the probate estate also applies to the trust. This is true only if the probate estate is a regular estate or an estate under modified administration. This claims limitation rule does not apply for revocable trusts if the deceased person’s estate is not opened for estate administration, or if the estate is opened as a “small estate.”

In addition, the new law adds protections for trustees even if there is no regular estate or modified administration for the deceased person. Under the new law, a trustee can publish a notice following certain strict procedures, and if that notice is published, then creditors will not be able to assert a claim against the trust six months following the publication of the notice. It is important to note that, with respect to revocable trusts, creditor’s are precluded from asserting a claim six months following the publication of the notice by the trustee, whereas, for assets in a probate estate, creditors are precluded from asserting a claim six months following the individual’s death.

Even with a probate estate, there are some creditors, such as the State of Maryland, who have six months following the publication of a notice, even with respect to assets in a probate estate, for claims relating to Medicaid benefits provided by the state.

Many people use revocable trusts, thinking them to be a panacea for various ills, and they are touted by some lawyers seeking to sell such trusts as probate avoidance mechanisms. However, using revocable trusts have a number of serious pitfalls, pitfalls that often are not addressed by the people who advise clients to use them. The creditor claim problem discussed in this article is just one of the potential problems that might arise for people who employ revocable trusts without proper legal guidance.

William M. Gatesman works with clients to utilize revocable trusts in appropriate circumstances, and counsels clients when not to use such trusts if doing so would cause them problems in the future.