Bankruptcy and Divorce: when to file and when to finalize

Please know that even though I represent folks in divorce actions, I truly hate to see divorces happen. If you are interested in knowing why, shoot me an email or give me a call. However, sometimes divorces do occur and often there is a tremendous amount of debt involved. In Kentucky, there is no presumption that debt incurred by one spouse is marital debt, but in these circumstances it is common for there to be marital debt being argued about. It is very smart to get an attorney who understands both family law for your state and bankruptcy law to review the situation and give a recommendation.

True, this involves bringing in yet another lawyer because the lawyer representing either spouse is ethically forbidden from doing a joint representation regarding bankruptcy. The small extra expense may well save a tremendous amount of grief or stress though. The assessment by the bankruptcy attorney will look at whether the couple can file Chapter 7 or if they would be forced into a Chapter 13 because of income levels. They would also help figure out what is marital debt and what is non-marital though this ultimately would be a determination made by the divorce action judge. They would also determine if bankruptcy must be filed prior to the divorce being finalized.

I recently did such an assessment for a couple and informed them, after months of trying to figure this out, that together they would HAVE to file Chapter 13 because their combined income, even with two households, was too high. This knowledge freed them up to look at other options, including finalizing the divorce first and one spouse possibly being able to avoid bankruptcy entirely. I was able to give both attorneys, due to a waiver of conflict, information they needed to consider regarding the settlement agreement and how it treated debts so as to allow the one spouse to achieve bankruptcy without the repercussion of non-dischargeable domestic support obligation of assigned debt.

However, ordinarily it is essential that any bankruptcy be filed prior to finalizing a divorce action so that both parties can realize a fresh start from debt. It is ordinarily much cheaper for a couple to file a joint bankruptcy, even with separate households, than to file separately. Some bankruptcy attorneys do charge more for a joint filing, but it is usually limited to only $200.00 more rather than doubling the fee. I do not routinely charge more for joint filings at this time.

Where Science Fiction and Bankruptcy Meet: The time traveling statute

When one files a bankruptcy, an estate is created. Essentially, everything the person filing (the debtor) owns goes into that estate so that at that moment, the moment of filing, they owe nothing and they own nothing. Now, certain debts cannot be discharged in a bankruptcy so it is not entirely accurate to say the debtor “owes nothing”. And, in fact, the discharge does not happen until the end of the process. Also, it is not entirely accurate to say one “owns nothing”.

It is true that an estate (basically a legal fiction – something that only exists as a matter of law) is created and nearly all the debtor’s possessions go into it. However, there are exemptions available (either state law exemptions or federal exemptions depending on your state of residences and some timing issues if you’ve moved – see this site for details by Attorney Max Garner). These exemptions allow you to retain property through the bankruptcy process.

This post is actually about an oddity in the law where there are certain assets that the debtor actually does not possess at the moment of filing that, nevertheless, become part of the estate. This provision is like legal time travel and causes an asset that was non-existent at filing to be sucked back into the bankruptcy as if it did exist. I am talking about 11 U.S.C. 541(a)(5). There are three assets that time travel from the future back to the filing date of the bankruptcy: 1) an inheritance, 2) assets from a property settlement subject to a divorce action, and 3) life insurance proceeds.

There is a limit to the time traveling capabilities of Section 541, and that limit is within 180 days. Some folks may be tempted to skirt around this tricky statute by avoiding actually receiving the asset until 181 days have passed, but the statute has thought of that in advance, as all time travelers should. The provision says “entitled to receive” rather than just receive. So, if your soon to be ex-spouse dies AFTER the settlement agreement is reached in the divorce that has not been finalized AND has not changed his or her life insurance beneficiary designation NOR changed his or her will AND it is only 179 days after you filed your bankruptcy, then you best contact your lawyer. Hopefully, you will have enough exemptions left to cover it all.

Now, you are astute and noticed that I said 181 days is safe and 179 days is not safe, but what if they die exactly on the 180th day? Well, that is where lawyers make their money – arguing over the definition of a single word: “within”. Does “within” include the day it references or refer to the day up until that day. Hmmm, I suppose I should research that.

It is also worth mentioning, because I am certain someone has wondered, “Well what if I just don’t mention the asset I became entitled too within 180 days?” (as if anyone thinks that way). There is a duty created by Federal Rule of Bankruptcy Procedure 1007(1) to update your schedules (where assets and other stuff is reported) if your circumstances change. Failure to do so could have worse results than just losing a few assets.

A word about workouts

Whether you are a small business owner or an individual who is insolvent (cannot pay their debts as they come due), then you may look at doing a workout outside of bankruptcy. The starting point for this, oddly enough, is to get an analysis by a lawyer who practices bankruptcy to see what a Chapter 7, Chapter 13, or a Chapter 11 would look like. This requires looking at debt, assets and income. The attorney would see if you qualify for a Chapter 7 or if you can bypass the means test. It would also involve looking at what a plan would look like in a Chapter 13 and whether a Chapter 11 would actually be cost-effective. For example, if you have a certain level of debt, you are precluded from a Chapter 13, but if most your debt is personal rather than business, you could be precluded from filing a Chapter 7.

Once you know what is at stake and what is exempt in a bankruptcy, you have a cut-off point where it no longer makes financial sense to pursue a work-out with creditors. This helps one avoid the tendency to start down one path and just keep going no matter what to the bitter end. Instead, you draw the stopping point before hand. You will also know what you have to offer to bring creditors to the table; you’ll know what the creditors will lose and what you can afford to put forward as incentive. If you have nothing new to offer to creditors or if they would not lose significantly more in a bankruptcy, then the work-out will likely fail.

If a workout is going to be preferable, the next thing to do is avoid doing it one creditor at a time. Over and over again I have seen people tackle one creditor at a time to great success in negotiating a settlement only to arrive at the end to have one creditor refuse to play ball. In this scenario, the person has usually paid out thousands in lump sum payments settling with creditors but STILL be forced to file bankruptcy because of one recalcitrant creditor. Often, the thousands paid out would have been exempt assets they could have kept through the bankruptcy. So, to do a workout you must be negotiating simultaneously with all one’s major creditors and condition any deal with a single creditor on the remainder of the creditors coming to the table. Sound impossible? Unfortunately, it often is impossible, but with skillful negotiating and armed with knowledge, it can happen.

What options do small businesses have to deal with debt?

This economy has been tough on the small business owner. Many of the people I talk with are sole owners of a Limited Liability Company, S Corporation, or sole proprietorship. Invariably, the owner has invested a great deal of his or her own resources into the business to fuel their dream. Because small business ventures, especially start-ups, lack assets and reliable revenue streams, banks always insist that the company and the owner individually AND the owner’s spouse all co-sign any loans. They typically also insist on a lien against personal property, such as the family residence.

So, when a small business start-up becomes insolvent (which statistically accounts for the majority of new businesses) there is far more at stake than just the business assets. The home and other personal property are at stake as well. Because of what is at stake, many folks understandably push on past the point of wise investing and empty out retirement accounts and cash in other exempt assets to keep the business going just a little longer.

When the economy first began faltering, this strategy had some wisdom to it because everyone expected a rebound in a few months. Now, though, the new reality of our economy is setting in and fewer people are expecting a big turn around. Because of this, the small business owner is compelled to a new level of shrewd thinking.

However, what happens when one’s best laid plans simply are no match for sluggish sales? It basically boils down to two possibilities: 1) an out of court work-out, or 2) bankruptcy. The way to determine which route to go involves an analysis of debt, income and assets. One business owner I consulted with was being pressed very hard by creditors and wanted to do a bankruptcy, but when I reviewed the assets he had that were not encumbered (were not collateral on a debt) he realized how much he stood to lose in a bankruptcy. The analysis allowed him to explore an out of court restructuring of debt because he had a dollar number where it made sense to incur additional debt and a cut off point. In other words, the analysis gave him a make it or break it line. I’m happy to say he avoided bankruptcy and his business is still going.

Out of court work-outs are generally a good thing to attempt, but you have to be careful. I’ll visit that more in-depth soon. The other option is bankruptcy. If most of your total debt is from business debt (your home loan debt is non-business in nearly every instance, so that is often a stumbling point for this) then you can file a personal Chapter 7 bankruptcy without having to pass the means test (the test that sets a threshold of income for taking Chapter 7 bankruptcy). I say a personal bankruptcy because a business cannot receive a discharge from debt; only an individual, and as I said earlier, small business owners are on the hook individually 99 and 44/100s percent of the time. Whether or not the business also takes bankruptcy is a case by case analysis. Often, the company can be dissolved prior to filing bankruptcy and then a new business can be created afterwards. Sometimes the value of the business is so low that one can exempt their ownership interest.

Many small business owners have heard about Chapter 11 bankruptcy. This is an option to consider if you have too much at stake in terms of non-exempt assets (assets you stand to lose in a bankruptcy) to file a Chapter 7 but your creditors are unwilling to cooperate in a work-out. However, Chapter 11s are not a viable option for the overwhelming majority of small businesses because they are incredibly expensive. And, if any secured creditor has a perfected security interest against your cash collateral (including revenue coming in), then you are going to have to have a new source of funding on-line whether that is a new creditor who gets a super-priority position for the new value they bring or if it is an investor who will inject unencumbered cash.

Just in time for Christmas

If you are rushing out in the next couple of days to buy that ‘just right’ present for someone special on your list, but you have been struggling financially, beware. If your debt struggles have mounted to the point where you are faced with filing bankruptcy, then as I’ve cautioned before, large purchases are to be avoided.

The term “large purchases” is relative and so the bankruptcy code spells it out in 11 USC 523(a)(2)(c). Purchases TOTALING $500.00 or more to a single creditor in the 90 days prior to a bankruptcy are presumed to be non-dischargeable. This does not apply to routine purchases necessary to the household, such as groceries.

That same code section keeps cash extensions of credit totaling more that $750.00 dollars within 70 days of filing bankruptcy are also presumed to be non-dischargeable. If you file bankruptcy, you will have to produce bank records and the trustee or a creditor can object to such purchases or case advances.

So, resist the urge to impress that certain someone with a large gift; instead, focus on the true meaning of Christmas.

The case of mismatched law: alimony and bankruptcy

Alimony, or maintenance as it is called here in Kentucky, is an interesting topic because how state law defines and treats alimony does not necessary mesh with the bankruptcy code. In this post, I am talking about when a non-debtor ex-spouse owes the person filing bankruptcy (the debtor) alimony or maintenance (the two terms are interchangeable and I’ll stick with alimony since it is the most recognized). The scenario is a divorced debtor filing a bankruptcy (it can be either a chapter 7 or a chapter 13) because their ex has failed to pay the alimony as ordered as is now in a world of hurt. So, the debtor has to list the alimony owed to him or her because it comes into the bankruptcy estate through 11 USC Sect. 541. There is even a “clawback” provision in 11 USC 541(a)(5)(C) that reaches 180 days beyond the filing date of the petition in cases where a divorce has not yet been finalized.

To be sure, 11 USC Sect. 522(d)(10)(D) appears to exempt alimony (“the right to receive”) so that the debtor gets to hold on to it. However, appearances can be deceiving because the bankruptcy courts do not have to accept the determination of the parties or the state court in deciding if a certain asset is alimony. The debtor may have a court order that calls what the ex owes them alimony and he or she may believe it is alimony, but the bankruptcy court can decide differently. If the bankruptcy court deems the awarded monies to actually be a property settlement, then it is not exempt beyond any available “wild card” exemption from 11 USC 522(d)(5).

The bankruptcy court makes its determination as to whether or not an award of alimony is truly alimony or if it is actually a property settlement mechanism by looking at what actually transpired. There are different aspects that the court may focus on and so it is more likely to be alimony if: 1) it ends at death or remarriage, 2) it can be modified based on need, 3) the debtor did not have property or resources to meet their basic needs, 4) it is subject to the tax treatment for alimony in the tax code (taxable to recipient; deductible by payor), and 5) the payments go directly to the debtor. If, on the other hand, the award of monies was in lieu of other property or debt, then it is unlikely to be deemed alimony. These are not necessarily exclusive factors, but will give an idea of how the courts analyze an alimony claim of exemption. The bottom line is that the court wants to be sure that the monies are actually for the support and sustenance of the recipient. This is consistent with the other items in Sect. 522(d)(10)(D) because each is a replacement for wages.

Be careful entering into a bankruptcy if you are the recipient of alimony or maintenance. When you interview your prospective attorney, but sure they understand the nuance behind the stated words of the law. They need to be able to analyze how likely the court is to see the award as alimony. If the award is sizable, then you can expect to have an objection to the exemption be filed by the trustee. If you win by convincing the court that it is indeed alimony, you will still have to show that all of it is “reasonably necessary” to live on – and that does not mean living in style or luxury.

Yet another reason to consider Chapter 13 over Chapter 7

In either chapter 13 or chapter 7 bankruptcy there is an automatic stay with broad protection that stops creditors from attempting to collect debts. This stay is found in 11 USC Sect. 362 of the bankruptcy code. There is an additional “stay” afforded debtors who file chapter 13 and it is found in 11 USC Sect. 1301.

Upon first glance at Section 1301 it appears to be a protection given to non-filing co-debtors such as mom or dad who co-signed on the car loan. However, the intent is actually to expand the protection given to debtors. In other words, if the provisions are violated, it is the debtor who would file the action against the creditor. The co-debtor can join in that action, but it does not give standing to the co-debtor to pursue the action unilaterally (or at least that is what some courts have decided). See In Re: Marlon Durone Stacker (Bankr. S.D. Ill., 2011). This explains why there is no provision for the awarding of attorney fees for a violation of Section 1301 whereas there is such an award under Section 362.

The idea is that during the protracted chapter 13, a creditor would take action against the co-debtor and in so doing, would coerce the debtor into paying more to that creditor than the plan allowed. Congress wanted to prevent such an end run around the automatic stay by crafting this more limited provision.

Section 1301 is also limited in that if the co-debtor received consideration (something of value) from co-signing on the loan, then then stay does not protect them to that extent. So, if a non-debtor business partner co-signed a loan and the consideration (value) came into the business to both his and the debtor’s benefit, then action against that co-debtor is not prevented. Or, perhaps a friend co-signed a loan for $1,000.00 and received $200.00 of it, then the creditor can pursue him or her for that $200.00, but no more than that. Another limitation is that if the chapter 13 plan only provides for a certain amount of the loan to be repaid, then the amount in excess of the plan is not protected. So, if the plan provides for $9,000.00 of a $10,000.00 debt to be repaid, then the creditor can still pursue the co-signor for the extra $1,000.00.

There are some other, non-enumerated limitations to Section 1301. For example, the creditor may still be able to report a delinquency on the co-debtor’s credit report. One could say that this constitutes a false report because the terms of the agreement have been altered by the chapter 13 plan. But, the plan only altered the relationship between the creditor and the debtor, not the creditor and co-debtor. However, such an action could constitute a violation of both Section 362 and Section 1301 if one can show that there was intentional action by the creditor likely to coerce the debtor into paying beyond the plan. See In re Singley, 233 B.R. 170 (Bankr. S.D. Ga., 1999). If you look at the Singley case, be aware that the court there said the intent of the creditor had to be shown to be one of coercing the collection of the debt, but other courts say the intent only has to be that the act of violation was intended to occur regardless of the result.

Despite the limitations of Section 1301, non-filing co-debtors being protected from lawsuits, garnishments and the like may make the extra work of a chapter 13 worthwhile.

Drive through law

I just read an email advertising a “virtual bankruptcy assistant” service. As part of the ad, they offer an “estimator” that promises to cut initial consultation times down to fifteen (15) minutes (as opposed to the traditional 30 that many offer). I must confess that I am crazy. I use no such service. The only estimator I use in consultations are my brain, a pen, paper and a hand-held calculator. My initial consultations average a little over an hour long.

You want to know the really crazy part? If folks do not need or want to use my services I usually waive any consultation fee. I just believe that people are in the second most stressful legal bind that most will ever encounter when facing bankruptcy (the most stressful is divorce which I handle with just as much care) and so I take time to explain what is involved and how bankruptcy will impact their lives. Then if they do need my help and retain me, I personally go through their documents and petition and makes sure everything is in top-notch shape before filing.

I know, simply crazy. I still believe in excellence.

Judge Joe Lee Bankruptcy Institute

I just finished attending the Judge Joe Lee Bankruptcy Institute here in Lexington, Kentucky. It was great to celebrate Judge Lee’s 50th year as a bankruptcy judge and learn about the major impact one of our local judges has had in shaping bankruptcy law and practice. It was also reaffirming to hear a call to raise the bar in bankruptcy practice by our Chapter 13 trustee, Hon. Beverly Burden. She pointed out how specialized and potentially complicated Chapter 13 bankruptcy practice is and that one must be knowledgeable in the area before taking on these matters. I heartily agree and that is why I take such training opportunities and why I do extensive research in order to become more knowledgeable. The practice of law is much akin to the practice of medicine in that unforeseen events can arise in any case and having a solid knowledge base is essential to react appropriately.

Debt and Divorce

In Kentucky marital law there is no presumption that debt incurred by one spouse is marital debt and the recent Supreme Court of Kentucky opinion in Rice v Rice, 2009-SC-000730-DG, March 24, 2011 (to be published) reaffirms that doctrine. Sometimes you can tell when a court gets hacked off, and some of that comes through in this opinion written by Justice Noble. One clue as to the court being upset is when they use the word “egregious” and it appears in this opinion.

The husband and wife had been married for 42 years. The wife, Carolyn, worked at an $8.00 an hour job. The husband, Jackie, allowed their adult son to accumulate around $65,000.00 debt by letting him use credit cards and co-signing for loans. This went on for about four (4) years before Carolyn got wind of her husband allowing this mountain of debt to arise and when she confronted Jackie about it, he just changed the mailing address for the bills so she would not find them. Are you starting to see what lead to the divorce?

Anyway, the trial court that granted the divorce assigned each of the parties one half (1/2) of this debt even though Carolyn had not authorized it. The Court of Appeals let that decision stand, but the Supreme Court would not tolerate it. They held that a debt incurred or authorized by one spouse and which the other spouse neither authorized nor received a benefit from is not marital debt.

The reason it was important that Carolyn take her fight to the Supreme Court of Kentucky instead of filing bankruptcy is that the assignment of debt may have been deemed a “domestic support obligation” by the bankruptcy court. So, even though her legal obligation to the creditors may have been extinguished in bankruptcy, she might have remained on the hook to Jackie for around $32,500.00 because domestic support obligations are not discharged.