Law Office of Kristine A. Michael, P.C.

Article: The Interplay of Family Law and Bankruptcy

The following article was published in the 2010 Pennsylvania Bar Association Family Law Summer Meeting:

Interplay of Family Law and Bankruptcy

Representing a Client on a Budget in Divorce and Support Matters

Kristine A. Michael, Esquire

            A bankruptcy filing can have a major effect on a family law matter.  It is important to take into consideration the potential changes which it could bring to your client’s situation.

 

            Before you can understand the impact of a bankruptcy filing on family law issues, you need some basic understanding of how bankruptcy works.  This is a very generalized overview of consumer bankruptcy.  Essentially, there are two types of bankruptcies filed by ordinary people, Chapter 7 and Chapter 13.  The most significant difference between them is that a Chapter 13 involves a repayment Plan but a Chapter 7 does not.  Under either scheme, the theory behind the law is that the Trustee (the person appointed by the Court to oversee the case and watch out for the interests of the creditors) is to take control of the assets of the debtor’s estate, liquidate them and use them to pay the creditors a pro-rated amount of what they are owed.  Debts are divided into three primary classifications and are paid in order of the priority given to each classification.  The first to be paid, usually in full, before any other creditor, are called Priority debts.  This is a statutorily created classification of debts.  The next to be paid are secured debts and finally ordinary unsecured debts.  If all priority and secured debts are paid in full, the general unsecured creditors get whatever is left over.  However, before any liquidation of assets occurs, the debtor is allowed to retain certain property, this is called the debtors “Exempt” property.  The debtor sets forth in his petition an inventory of his property, including that which he claims is Exempt.  The debtor has various options for claiming exemptions, and exemption planning is a complex area of bankruptcy law.  However, for most people, especially people who are divorcing on a budget, the exemptions include everything they own.  Under the most commonly used exemption scheme, these exemptions include up to $20,200 equity in a house ($40,400 for a married couple), retirement assets, $3,225 equity in a vehicle and pretty much all ordinary household goods.  In addition, the debtor can keep $1,075 (double for married couple) in any property of any kind plus up to $10,125 (double for married couple) of the home equity exemption if it was not used entirely on a house.  As you can see, most of the clients who are the subject of this discussion will fit within these limits.  Additionally, it cannot be stressed enough that you should not conclude that a client will lose property if they file for bankruptcy based on a belief that they do not fit within these limits.  Always refer the client to a qualified bankruptcy practitioner as this was a very simplified summary of the law.  At the successful conclusion of a bankruptcy case, the debtor receives a “Discharge”.  A discharge means that the debtor is no longer liable for debts which are considered dischargeable.  This usually means all general unsecured creditors (credit cards, medical bills, unsecured personal loans).  Secured debt is dischargeable, however, the security interest created by the security agreement will probably survive the bankruptcy.  Therefore, the debtor must choose whether to “Reaffirm” a secured debt – agree to pay it and be allowed keep the collateral, or to “Surrender” the collateral and owe nothing further.  Priority debts are non-dischargeable, as are a few other exceptions.

            In general, a client will prefer to file a Chapter 7 as it does not include a repayment plan.  There generally are three situations where a client will file a Chapter 13 and enter into a payment plan.  The first is when a client is behind in payments on a secured debt (usually a mortgage but could also be a car loan).  If the client wishes to keep the collateral, they can file a Chapter 13 and enter into a payment plan which permits them to catch up of the arrears over a 3 to 5 year period of time.  Under ordinary circumstances, the client will also have to resume the normal monthly payment.  The classic scenario for this type of bankruptcy is when a debtor falls behind in their mortgage because they lost a job.  They have now resumed working and can afford to pay the mortgage again and could catch up on the arrears if given a fair payment plan.  The second reason to file a Chapter 13 would be to avoid losing non-Exempt property.  If your client has $30,000 too much equity in a house, under a Chapter 7 the Trustee would sell the house, give your client the $20,200 he was entitled to for his Exemption and use the additional $30,000 to pay off creditors.  Instead, the client can file a Chapter 13 and enter into a Plan which provides for $30,000 payment to creditors and keep the house.  Finally, a client would enter into a Chapter 13 because they have too much disposable income according to the “Means Test”.  The Means Test is a process of looking at income which is a strange hybrid of actual expenses and that which the law says should be your expenses. 

            Domestic Support Obligation

            At 11 USC 101(14A), the Bankruptcy Code defines a Domestic Support Obligation:

(14A) The term "domestic support obligation" means a debt that accrues before, on, or after the date of the order for relief in a case under this title, including interest that accrues on that debt as provided under applicable nonbankruptcy law notwithstanding any other provision of this title, that is -

          (A) owed to or recoverable by -

            (i) a spouse, former spouse, or child of the debtor or such child's parent, legal guardian, or responsible relative; or

            (ii) a governmental unit;

          (B) in the nature of alimony, maintenance, or support (including assistance provided by a governmental unit) of such spouse, former spouse, or child of the debtor or such child'sparent, without regard to whether such debt is expressly so designated;

          (C) established or subject to establishment before, on, or after the date of the order for relief in a case under this title, by reason of applicable provisions of -

            (i) a separation agreement, divorce decree, or property settlement agreement;

            (ii) an order of a court of record; or

            (iii) a determination made in accordance with applicable nonbankruptcy law by a governmental unit; and

          (D) not assigned to a nongovernmental entity, unless that obligation is assigned voluntarily by the spouse, former spouse, child of the debtor, or such child's parent, legal guardian, or responsible relative for the purpose of collecting the debt.

            While it does not matter whether the support obligation arises from a support order, a property settlement agreement or an alimony trial, the distinction between “support” and other forms of payments (such as buy out from a house, etc.) is an important one because Domestic Support Obligations are a Priority debt and are ABSOLUTELY non-dischargeable in a Chapter 7 or 13 bankruptcy (there is one small exception for some support which is owed to a government agency – as distinguished from collectable by an agency -  but this will not affect the individual support recipient, only a government agency 11 USC 507(a)(4)).  11 USC 523(a)(5).  Further, even within the classification of Priority debts, most Domestic support obligations are paid before any other debt (except the Trustee’s expenses for administering the payments.  11 USC 507(a)(1)(A).  This is true in both Chapters.  In a Chapter 13, a debtors failure to make post-petition support payments can be a basis for dismissal or the case or conversion of the case to a Chapter 7.  11 USC 1307(c)(11).  This dismissal can be done on motion of the receiving spouse, so it is vital that counsel for the receiving spouse stay on top of the issue.  If the debtor spouse has assets which would not be exempt, you may want to ask to have the case converted to a Chapter 7 so that the Trustee can liquidate the assets and pay off the dependent spouse.  If there are no assets that make a Chapter 7 conversion desirable, but the debtor spouse is trying to use the Chapter 13 bankruptcy to discharge some other obligation to the dependent spouse (discussed more below), you want to get the case dismissed.  In addition the payment Plan which was proposed by the debtor will not be “Confirmed” (accepted) by the Court if post-petition payments are not being made.  11 USC 1325(a)(8).  You will want to object to confirmation if this is the case.  In most cases, the debtor must certify that all post-petition support payments are being made in order to receive the file Chapter 13 discharge.  11 USC 1328(a).  There are some exceptions to this and a bankruptcy practitioner should be consulted before discharge if post-petition payments have not been made in full.

          One of the most important features of a bankruptcy filing, under either Chapter is the “Automatic Stay.”  The filing of a bankruptcy petition immediately and automatically results in a stay being placed on all proceedings of any kind against the debtor.  In the past, this could have been used to avoid all family court proceedings.  The 2005 revisions to the Code set forth at 11 USC 362 (b)(2) have eliminated the automatic stay as to the following:

(b) The filing of a petition under section 301, 302, or 303 of this title, or of an application under section 5(a)(3) of the Securities Investor Protection Act of 1970, does not operate as a stay -

        (2) under subsection (a) –

          (A) of the commencement or continuation of a civil action or proceeding 

            (i) for the establishment of paternity;

            (ii) for the establishment or modification of an order for domestic support obligations;

            (iii) concerning child custody or visitation;

            (iv) for the dissolution of a marriage, except to the extent that such proceeding seeks to determine the division of property that is property of the estate; or

            (v) regarding domestic violence;

          (B) of the collection of a domestic support obligation from property that is not property of the estate;

          (C) with respect to the withholding of income that is property of the estate or property of the debtor for payment of a domestic support obligation under a judicial or administrative order or a statute;

          (D) of the withholding, suspension, or restriction of a driver's license, a professional or occupational license, or a recreational license, under State law, as specified in section 466(a)(16) of the Social Security Act;

          (E) of the reporting of overdue support owed by a parent to any consumer reporting agency as specified in section 466(a)(7) of the Social Security Act;

          (F) of the interception of a tax refund, as specified in sections 464 and 466(a)(3) of the Social Security Act or under an analogous State law; or

           G) of the enforcement of a medical obligation, as specified under title IV of the Social Security Act

          Another significant change of the 2005 revision provides that:

(c) Unless the case is dismissed, property exempted under this section is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 of this title as if such debt had arisen, before the commencement of the case, except -

        (1) a debt of a kind specified in paragraph (1) or (5) of section 523(a)[DOMESTIC SUPPORT OBLIGATION] (in which case, notwithstanding any provision of applicable nonbankruptcy law to the contrary, such property shall be liable for a debt of a kind specified in section 523(a)(5)[DOMESTIC SUPPORT OBLIGATION]

          This means that the support recipient may even proceed against property which the support creditor retains as their Exemptions under the bankruptcy laws.

          The practical effect is that virtually all support proceedings may continue and virtually any property or income can be attached, but, a the support creditor is still bound to the terms of a Confirmed Chapter 13 Plan to the extent that the plan deals with support arrearages.

          Division of Assets

          You must receive relief from the Automatic Stay in order to proceed with the division of property in a divorce.  This is done by motion to the bankruptcy court and the debtor-spouse will often consent to it.  The bankruptcy court does not want to do an equitable distribution (although they technically could), and will almost always return a divorce case to the state court for determination.

          Other obligations created by a divorce (e.g. Property Settlement Agreements, etc.), are defined in 11 USC 523(a)(15), as follows;

(15) to a spouse, former spouse, or child of the debtor and not of the kind described in paragraph (5) that is incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement, divorce decree or other order of a court of record, or a determination made in accordance with State or territorial law by a governmental unit;

          Section 523(a) excepts these obligations from discharge.  Accordingly, under a Chapter 7 bankruptcy, these obligations are unavoidable.  Therefore, the conclusion that must be reached regarding a Chapter 7 bankruptcy is that a debtor spouse cannot avoid any obligations to the creditor spouse via a Chapter 7 Bankruptcy.  For example, if Husband assumes a joint credit card debt in the divorce and then files for a Chapter 7 bankruptcy, even though he is discharged from the debt as to his obligation directly to the credit card issuer, Wife may enforce his obligation to her.  If the Chapter 7 bankruptcy has already concluded, she may simply proceed in state court. 

          Although it would appear that the provisions of 523(a)(15), set forth above, would also prevent a debtor spouse from discharging a Property Settlement Agreement obligation in a Chapter 13, this is not the case.  The terms of a Chapter 13 discharge are governed by 11 USC 1328.  At section (a)(2) it provides:

(a) Subject to subsection (d), as soon as practicable after completion by the debtor of all payments under the plan, and in the case of a debtor who is required by a judicial or administrative order, or by statute, to pay a domestic support obligation, after such debtor certifies that all amounts payable under such order or such statute that are due on or before the date of the certification (including amounts due before the petition was filed, but only to the extent provided for by the plan) have been paid, unless the court approves a written waiver of discharge executed by the debtor after the order for relief under this chapter, the court shall grant the debtor a discharge of all debts provided for by the plan or disallowed under section 502 of this title, except any debt -

        (2) of the kind specified in section 507(a)(8)(C) or in paragraph (1)(B), (1)(C), (2), (3), (4), (5), (8), or (9) of section 523(a);

          In other words, all debts are discharged EXCEPT the ones listed in 1328(a)(2) and 1328(a)(2) fails to include paragraph 15 of 523(a).  Therefore, these debts are dischargeable and they are classified as ordinary, general unsecured debts, subject to the lowest priority of payment, often receiving absolutely no payment in a Chapter 13 Plan.

          As a practical matter, when representing the dependent spouse, you may want to choose to load alimony in exchange for property to assure priority and non-dischargeability in bankruptcy.

          If you represent a debtor spouse who will be filing a Chapter 7, it may still be to your benefit to load the alimony portion of the division in exchange for property division (assuming the property retained will fall with the exemptions).  Since both obligations are non-dischargeable in a Chapter 7 you might want to take advantage of the fact that alimony is a factor taken into consideration in the Means Test.  If a client has an income level that is borderline for permitting a Chapter 7, the alimony payment may offset income to bring down disposable income and prevent the forced filing of a Chapter 13.  It’s a balancing test and you may need to consult a bankruptcy practitioner to do the analysis of various alimony v. asset scenarios.

          It is important to know that alimony must clearly be alimony.  While it is legitimate to award some amount of alimony in exchange for less assets, if the “alimony” actually smells more like equitable distribution, the court may reject its characterization.  It must have all of the hallmarks of alimony – terminates at death, etc., and it must be reasonable.

          It is also important to remember that a debt cannot be incurred fraudulently.  Even a Chapter 13 bankruptcy does not discharge fraudulent debts.  11 USC 523(a)(2) and (4) and 11 USC 1328(a)(2).  If your client agrees to terms of a Property Settlement Agreement HAVING NO INTENTION OF PAYING THEM, a creditor spouse could prevail on a Motion to exclude the debt from discharge based on the fraud.

          Finally, it is worth mentioning that the determination of when to file a bankruptcy, pre or post divorce can be important.  For example, there are some cases where a debtor might elect a different Exemption scheme than the one that was summarized above.  A debtor might want to elect the Pennsylvania State Exemptions instead.  This exemption scheme includes the powerful tool of recognizing Tenants by the Entireties.  If all property is owned as Tenants by the Entireties (except retirement assets, which are generally also exempt) and all debts are only in one spouse’s name, you can usually have unlimited equity in a house and other jointly owned property.  Obviously, to take advantage of this, you must still be married.  Another example where timing could become important would be if the parties still maintain a joint household, and one spouse has little or no income, it can be advantageous to the Means Test to be able to claim the dependent spouse in the Means Test, which raises the income threshold for being permitted to file a Chapter 7.

          Remember that both spouses do not have to file for a bankruptcy.  If debts are primarily or solely in one spouse’s name, the other need not join in the filing.  However, the non-filing spouse may have to provide information if they are still in the same household.

         There are other issues not presented here that are not likely to arise, particularly in lower income, small estate cases.  This has been a generalized overview to help you recognize the issues.  Bankruptcy law is a highly complex area and specific advice regarding a specific case should be sought if you believe your client may be faced with these situations.