Bankruptcy: Just the beginning

Well, I am not being terribly original today because I just wrote a post on my family law blog entitled “Divorce: Just the beginning”, but it occurred to me that there are similarities that are worth comment. People sometimes look to divorce to end their interpersonal pain and conflict and, similarly, people sometimes turn to bankruptcy to end their financial stress and conflict. However, in both situations, it is really important to recognize that the legal process involved is merely a beginning. Rather than an end, both processes really just begin the process of working out whatever issues led to the problem. And, just as important, it may be that those issues can and should be worked out without going through the bankruptcy or the divorce.

I spoke about how this plays out in a divorce situation in that other post, so I want to focus on bankruptcy. When people come to me, I take a comprehensive look at their finances and give them one of three opinions: 1) you can work this out without bankruptcy, 2) you might be able to work this out without bankruptcy, but here are the dangers and where to draw the line, or 3) bankruptcy is inevitable short of a miracle. My hope when I take someone through the bankruptcy process is that they will have a fresh start and never, ever have need of my services again.

However, if the debtor sees bankruptcy only as an end to their financial struggles, chances of repeat business for me remains high. Instead, if the debtor recognizes that they must make major changes to how they deal with money in their life, then I may never see them again. Now, there are some folks facing bankruptcy purely due to circumstances beyond their control such as being laid off or the economic downturn. The majority, though, have a mix of misadventure coupled with poor financial management skills.

One red flag for me is when a potential client asks about how fast their credit score will go up. There is a legitimate reason to ask this and that is if there is a plan to buy a house in the near future. Sometimes, though, the question really turns more on when they can reestablish credit worthiness for credit cards. So, a second red flag is when a client asks if they can hold one credit card out of the bankruptcy (the answer, by the way, is “no”).

Here is what I hope my clients will realize: that credit scores should have no meaning in your life and credit cards should be the incredibly rare exception rather than a rule. If one wishes to really seize upon a financial fresh start from bankruptcy, then I highly recommend a cash system for their ongoing purchases. A cash system means if you do not have the cash, then you do not make the purchase.

There are two exceptions to the cash system: purchasing a house and purchasing an education. Even when purchasing either of these items, it is still important to use discretion. For a home purchase, one should not purchase a house where you do not have in hand 20% of the purchase price to put as a down-payment. This is a good rule of thumb and it will also lessen the monthly payments because you typically will not have to pay for PMI insurance (private mortgage insurance). A second rule is to never buy as much of a house as you can afford. I know this flies in the face of conventional wisdom and your realtor’s recommendation, but figure the most expensive house you can afford on your budget and then subtract AT LEAST 10% from that figure. Actually, subtracting 20% would be even better.

The rules for purchasing an education involves some research. Before going to school be sure to find out the trends in employment for the degree you are seeking. Find out the most common pay range in the geographic area where you hope to live. Find out the price tag (tuition, books, fees, etcetera) for the degree. After you find out all these things, take a look at how long it will take you to repay the debt you will owe from that degree. If you are still feeling called to this particular vocation, then by all means proceed.

There are many other financial habits that one can develop post-bankruptcy to insure a true fresh start. Some are really basic such as balancing one’s checkbook instead of using the ATM’s balance. Perhaps learning what exactly compound interest is and how it works (both for debt and savings). Another is developing a monthly budget and sticking to it. Two excellent resources for learning to be financially free are Dave Ramsey and the ever reliable Crown Ministry. These resources may even allow you to avoid bankruptcy in the first place. However, if you cannot avoid bankruptcy, be sure to realize that filing the petition is really just the beginning of a process of reforming your relationship to money.

Small businesses and the bankruptcy estate

I wrote a while back about strategies for dealing with debt for the small business owner. I will get more focused here about a key issue involved in a business related individual bankruptcy. As I explained in that previous post, most small business owners who become insolvent are forced into a personal bankruptcy even though most of the debt belongs to their business because of the owner’s personal guarantee. I refer to these as business related bankruptcies even though it is actually the individual person who files.

For an oversimplification, when someone files a bankruptcy, everything they own (with some exceptions) goes into an estate under the control of the trustee. The individual then uses exemptions to reach into the estate and keep certain property. Now, the issue in focus is what happens to the business when the owner files. Although the business itself is not in bankruptcy, the owner’s interest in that business goes into the bankruptcy estate the moment the bankruptcy is filed. And, there is only a small exemption for business equipment and tools of the trade so most exemption must come from the “wild card” exemption of 11 USC Sect. 522(d)(5). So, if the company has many assets, accounts receivables, ongoing contracts for work, inventory, or transferable goodwill, the owner may not be able to exempt it all. That creates a real problem and a potential battle over the real value of the owner’s interest or the forced sale of the interest.

Ordinarily, the owner’s interest is actually very small or zero due to debt load or because most of the company’s value is tied to the owner’s personal efforts. However, there is little reason to tempt such complications when there is another option. The best practice in such situations is to wind down the business and dissolve it administratively just prior to filing the bankruptcy. Then, immediately after filing the bankruptcy, create a new Limited Liability Company or S-Corp and begin doing business as a new entity. While the trustee could attack the new company as an alter-ego of the first, there is a strong disincentive because now the trustee has to first win through on an alter-ego theory and then still argue over the value.

There are many details involved in the winding down of the old and the starting up of the new business including how bank accounts, accounts receivables, contracts and employees are all handled. So, it is best to get in with a bankruptcy attorney that is versed in these types of business related bankruptcies early on to give adequate time to plan and prepare.

Settlement strategies in divorce with an eye to bankruptcy

As a follow-up to my prior post on domestic support obligations, I wrote a post on my family law blog that goes into a little more detail on strategies to keep in mind in reaching a financial settlement.  This is worth reading if you are in a pre-divorce situation where bankruptcy seems likely.

Domestic Support Obligations: child support, alimony, and equitable distributions

There are two different sorts of domestic support obligations defined in the bankruptcy code.  The first kind of domestic support obligation encompasses things such as child support payments and alimony (called maintenance in Kentucky).  The second sort comes from an equitable distribution of property subsequent to a divorce. The term “domestic support obligation” first appears in 11 USC Sect. 101(14A), but these two different kinds of domestic support obligations only become apparent when one looks at how they are treated in terms of discharge of debt.

At first glance at 11 USC 523(a)(5) & (15) it looks like these two types of domestic support obligations are treated the same. That is to say, neither child support and alimony type obligations nor equitable distribution of property appear to be discharged in bankruptcy. This is true when it comes to Chapter 7 liquidation type bankruptcy. However, it is a different story in Chapter 13, but one has to look at the bankruptcy code carefully to discern this difference.

So, now we have to turn to 11 USC Sect 1328(a)(2) to see the rest of the story. This oddly written statute basically says that all debts except for certain ones get discharged once all the plan payments are made. The specific provision mentioned includes 11 USC Sect 523(a)(5) as an exception that does NOT get discharged. However, that provision conspicuously leaves our 11 USC Sect. 523(a)(15). This latter provision, 523(a)(15) pertains to equitable distribution of assets subsequent to a divorce.  

Bottom line: if you agree to let you soon to be ex-spouse pay you later for your share of equity in the marital residence, then you may end up loosing out if he or she ends up in a Chapter 13. That chunk of equity may well end up being treated as a general unsecured debt receiving only pennies on the dollar. However, child support and alimony (maintenance) will not be discharged in a Chapter 7 or a Chapter 13.