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.