’Til Debt Do Us Part: The Interplay Between Bankruptcy and Divorce

Vol. 32 No. 4

By

Laura S. Mann, Esq., is the principal of the Law Offices of Laura S. Mann, LLC, Riverdale, New Jersey.

In almost 20 years of practicing law in a variety of settings and in a variety of substantive areas, I have seen, all too often, the bankruptcy issues that arise in the divorce context. Having practiced in both of these areas of the law for much of that time, I have seen many mistakes made when a client gets matrimonial advice from a lawyer who only does bankruptcy law or when a client gets bankruptcy advice from a lawyer who only does matrimonial law. Commonly, such lawyers advise clients about these cases without knowing the impact of this advice in both contexts.

Issues also arise when no advice is given outside the attorney’s usual area of practice. For example, a spouse might agree in a marital settlement to assume all marital debt, including that in both parties’ names, with the plan of filing bankruptcy afterward, believing the debt will be wiped out and there will be no adverse consequences for the post-discharge nonpayment of that debt. As will be discussed in more detail below, this is not necessarily the case and could have grave consequences for the divorced debtor.

Further complicating matters is the question of what laws govern. Whereas state laws govern matrimonial law almost exclusively, bankruptcy is governed by federal law, although it incorporates significant aspects of state laws. Knowledge of both is critical.

This article will provide an overview of how bankruptcy law and divorce law can interact. Given the limits of this article, however, this overview can only scratch the surface of the issues involved. If your client’s case will likely involve both areas of the law but you practice only in one or the other, I strongly advise you to collaborate with an attorney in the complementary field. (For more, see below under "Collaborating with Bankruptcy or Marital Lawyers.")

Bankruptcy Basics

The usual types of bankruptcy most people consider when they think about filing for relief are Chapter 7 and Chapter 13. The Chapter 7 commonly is referred to as the “liquidation bankruptcy,” while the Chapter 13 commonly is referred to as the “repayment bankruptcy.”

In most cases, a Chapter 7 discharges (wipes out, erases, eliminates any legal obligation to repay) all dischargeable debt. All debt is not dischargeable. The common types of debts that are not dischargeable are some taxes, criminal fines, debt incurred by fraud, and, of the most significance to this article, domestic support obligations.

A Chapter 13 usually requires a repayment of some or all of the filing party’s debt over a period of three to five years, then discharges the remainder. This article mostly focuses on issues that arise in a Chapter 7 bankruptcy, as this is the most common I see in my practice.

Collaborating with Bankruptcy or Marital Lawyers

If you are an attorney who practices primarily, if not exclusively, in either bankruptcy or marital law, I strongly encourage you to consult with one or more attorneys who focus on the other area of the law when issues like those mentioned in this article arise. Such collaboration can ensure, as much as possible, that the advice you provide does not create unforeseen disasters for your client—and then ultimately for you.

Thus, if you do matrimonial law only and you are handling a divorce where the parties have significant debt and may be contemplating bankruptcy, you should consult with a bankruptcy lawyer regarding the timing of the divorce versus bankruptcy, what terms are important to negotiate in any divorce settlement agreement, and how best to protect your client when negotiating those terms.

Conversely, if you primarily are a bankruptcy lawyer representing a couple or a married individual and there may be a divorce looming, you should consult with a matrimonial lawyer in your jurisdiction. This will enable you to assess the impact of the timing of your client’s bankruptcy filing on the financial aspects of the potential divorce.

Bankruptcy While Married

It is a common misconception that if one spouse files for bankruptcy, so must the other. This is not correct. One spouse is permitted to file without the other, although in most cases both spouses’ incomes are counted toward eligibility if the person seeking to file is pursuing a Chapter 7 that requires passing an income “test” to qualify.

Another common misconception is that if one spouse files for bankruptcy, the other spouse’s credit will be adversely impacted by that filing. It is not the filing of the bankruptcy or the discharge of debts that adversely affects a non-filing spouse’s credit. It is the nonpayment of joint debts and obligations that could do so.

If all debts in the non-filing spouse’s name are paid timely, that spouse’s credit should not be adversely impacted. Be aware, though, that clients often confuse, misunderstand, or frankly just do not know whose names are on what account, including mortgages, car loans, etc. Before you advise your client, verify the account status by pulling a credit report and contacting the creditor. This information may alter your advice to that client and the ultimate decision the client makes about whether or not to file bankruptcy. If the spouses are contemplating divorce, it definitely should impact the terms of any settlement agreement the parties reach.

Bankruptcy During Divorce

It is routinely understood that one of the most common causes of divorce is financial difficulties. With the economy being what it has been the past five or so years, these issues and the interplay between them have arisen far more often in my practice than I had seen before. Clients often ask me whether they should file for bankruptcy first or divorce first or whether they can pursue both simultaneously. Of course, almost always the answer is “it depends.” On what does it depend?

A detailed discussion of all the factors that play into this decision would make this article far too long and take away from its primary focus. Thus, I will touch on them briefly to enable essential issue spotting so you know when to research further or seek specialized assistance from a colleague.

One of the first inquiries: Why a divorce (or bankruptcy), and why now? My bankruptcy consultations typically have three main components. The initial inquiry is whether the prospective client can file for bankruptcy (or for a particular type of bankruptcy). Other attorneys may end the inquiry there, believing that if the prospective client wishes to file and can file, it is his or her role or obligation to do so on the client’s behalf. This is not where the inquiry ends for me.

The next question I explore in a bankruptcy consultation is whether or not a prospective client should file. Just because someone can file for bankruptcy, does not necessarily mean he should. For example, I have had people come to me seeking to file over relatively minimal debt, say $5,000. In my opinion and in most cases, there typically are better options to address the relatively minimal debt than bankruptcy.

Another common example is people who come to me seeking to file bankruptcy who are uncollectible or “judgment-proof.” They do not own any assets that could be levied or have any income that could be garnished. Some insist on filing anyway (it’s their choice after all, which they are entitled to make after having all the pertinent information), but after hearing this advice, many decide it is not necessary and thus do not file.

If the answer to both of the above questions is “yes,” the next line of inquiry I make when assessing bankruptcies for my clients is when they should file. Timing can affect significantly the client’s rights regarding debt and the benefits and drawbacks realized from filing for bankruptcy at a given time. This is no less true when the clients are married and also contemplating divorce.

Bankruptcy first? There are many benefits to a married couple who are contemplating both divorce and bankruptcy to file a joint bankruptcy prior to filing for divorce. Of course, this option should only be considered when it is appropriate to wait for a divorce filing.

First, a couple who files jointly saves money. Filing for bankruptcy is a lot of work. Filing two bankruptcies can be almost double the work. Thus, if the bankruptcy is filed prior to the divorce, the spouses can file one bankruptcy petition instead of two. They pay one court filing fee. They pay one legal fee. If they were forced to file separately by waiting until after the divorce was over, this would double the cost and the amount of work required, as they each would have to provide the mass volume of information and documents to the court (or to their lawyers). Even if the legal fee when filing jointly is higher than for a single filer (this depends, of course, on each individual attorney’s fee structure), typically the total fee would be less than if each spouse filed separately. Getting a discharge of debts prior to filing for divorce also simplifies and cleans up the divorce issues, making the divorce less time consuming and, thus, less costly.

Second, a couple who files jointly prior to divorce saves stress and unnecessary time and worry addressing the issues of the parties’ marital debt in the divorce. If the debts are erased via a bankruptcy, these issues do not need to be addressed in the divorce. The parties both will be in a much better position to rebuild financially after the divorce if they walk away debt-free.

Finally, the exemptions to which a debtor is entitled under the Bankruptcy Code apply to each debtor. Thus, if a married couple files jointly, their exemptions are doubled. This could enable the protection of certain assets, usually the marital residence, that otherwise would not be protected if only one spouse filed.

One potential drawback of filing a joint bankruptcy prior to divorce is that the attorney may run into a situation where a conflict of interest arises, leading to complications and additional costs for the parties. Proceed with caution.

Another drawback is that filing jointly might render the couple unqualified financially to file under Chapter 7 given both incomes or only one set of household expenses, whereas one or even both of them would qualify financially if they waited until after the divorce and had separate households.

Divorce first? As mentioned above, there are many advantages to filing bankruptcy prior to divorce. But what if the divorce cannot wait? What if one spouse needs financial support from the other, and the only way to get it is by obtaining a court order in a divorce filing? What if one spouse needs a custody order that cannot wait until a bankruptcy is completed? What if one spouse’s income is too high, disqualifying the other from filing? If any of these fact patterns fits your client’s scenario, it may be necessary or prudent to file for divorce first and consider bankruptcy later.

Simultaneous filings of divorce and bankruptcy? In my experience, this would be highly unusual and typically not recommended, although I can envision a few scenarios where it may be the best course of action. For example, imagine that the divorce cannot wait as one spouse has physical custody of the children, the other spouse is failing to pay support, and the parent with physical custody needs a court order of support to provide for the family. At the same time, the parent with physical custody is facing a bank levy, wage garnishment, foreclosure, or eviction and needs the benefits of the bankruptcy to delay, or perhaps resolve, the potential loss of income or home for himself and his children.

In these scenarios, it may provide the most benefit to the client to seek both a divorce to put in place temporary orders of support or custody, as well as a bankruptcy to delay or stop a wage garnishment, bank account levy, foreclosure, eviction, etc., until these issues can be resolved one way or the other.

Bankruptcy after Divorce

What is dischargeable? 11 USC §727(a) provides that “(a) The court shall grant the debtor a discharge, unless . . .” then lists 11 exceptions to discharge. The pertinent exceptions are discussed in more detail below.

11 USC §727(b) of this section provides that “Except as provided in section 523 of this title, a discharge under subsection (a) of this section discharges the debtor from all debts that arose before the date of the order for relief under this chapter. . . .” The “order for relief” occurs immediately upon the filing of the bankruptcy petition in most cases.

Thus, all debts except those specifically listed in the statute are discharged. In the matrimonial and post-matrimonial context, some of the debts and obligations are eligible for discharge, while others are not. Generally speaking, debts and obligations that are not “in the nature of support” including those that are for the settlement or distribution of marital property are dischargeable. This includes the division or buyout of equity in a marital residence, the division of marital bank accounts, etc.

What is not dischargeable? 11 USC §523(a)(5) provides that “A discharge under Section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt . . . for a domestic support obligation. . . .” 11 USC §101(14A) defines “domestic support obligation” as:

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’s parent, 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.

In other words, domestic support obligations in the nature of support are not dischargeable. This applies regardless of how the agreement or court order designates the obligation. The courts will look at what the obligation actually is for to determine whether or not it is dischargeable. They are not bound by how the agreement or underlying order characterized it.

For example, if a state court orders one spouse to pay the other’s attorney fees or mortgage payments, if the bankruptcy court determines that award is “in the nature of support,” the obligation will not be discharged. Conversely, even if the state court order or divorce agreement characterizes an obligation as “support,” if the bankruptcy court determines it really is not “in the nature of support,” the obligation will be discharged. Whether an obligation is “in the nature of support” is interpreted broadly by some courts to prevent the discharge of those obligations when inappropriate.

Thus, in most instances, child support or spousal support will not be discharged. This includes both arrears and future obligations. Obligations relating to the distribution of marital assets typically will be discharged. Attorney fees ordered to be paid by one spouse to another may or may not be discharged, depending on whether or not the bankruptcy court determines the obligation is “in the nature of support.” This is a very fact-specific and case-specific inquiry.

If the right to collect an alimony obligation has been assigned to another, the alimony obligation can be discharged in bankruptcy.

Establishment, modification, and enforcement proceedings? Are establishment, modification, or enforcement proceedings subject to bankruptcy’s automatic stay (11 USC §362)? The answer to this question again is the clichéd attorney response: “It depends.” On what does it depend? If the establishment, modification, or enforcement proceedings do not relate to or affect any part of the “bankruptcy estate,” then the proceeding is permitted. 11 USC § 541 defines “property of the estate” as all legal or equitable interests of the debtor in property as of the commencement of the bankruptcy case. This includes all property in which the debtor has an interest, even if it is owned or held by another person.

The automatic stay does not affect most proceedings relating to the divorce or parenting. This includes the establishment, modification, or enforcement of actions relating to current child support and spousal support, the collection of child support or spousal support arrears from property that is not in the bankruptcy estate (typically future income), the establishment of custody and parenting time, the establishment of paternity, the modification of child support or spousal support, the seeking of protection from domestic violation for a spouse or child, the withholding of income to collect child support, the reporting of overdue support to credit bureaus, the interception of tax refunds to collect child support arrears, or the suspension or restriction of drivers’ or professional licenses to collect child support arrears.

Post-filing income of the debtor is not part of the bankruptcy estate. Thus, an enforcement action for the nonpayment of support seeking to garnish from the debtor’s post-filing wages is not prohibited by the automatic stay. Thus, it may proceed.

Criminal contempt actions are not governed by the automatic stay and may proceed. Courts are split as to whether or not civil contempt actions are allowed. Some courts have held that the automatic stay prohibits all civil contempt actions. The majority of courts, however, have held that civil contempt actions that seek to uphold the dignity of the court order and punish the contemnor for violating said order are not governed by the automatic stay and may proceed.

When the modification or enforcement action impacts any part of the “bankruptcy estate” or the enforcement of an obligation that would be discharged, then the automatic stay does prohibit enforcement actions. A violation of the stay subjects the movant to possible monetary sanctions and attorney fees.

To determine whether the order is intended to coerce obedience or to effectuate collection of a judgment, courts examine the totality of the circumstances. If it is unclear, the safest course of action is to file a motion in the bankruptcy court seeking relief from the automatic stay. This is a request to the bankruptcy court seeking the court’s permission to be allowed to proceed against the debtor in state court for the relevant enforcement action.

Violations of the automatic stay? A debtor who alleges any action in state court is a violation of the automatic stay can challenge that action in state court or can bring an action in bankruptcy court under 11 USC §362(k). This section permits the debtor to seek relief for violations of the stay, including actual damages, attorney fees, costs, and, when appropriate, punitive damages for willful and knowing violations of the automatic stay that damaged the debtor. Further, the debtor can pursue such relief in bankruptcy court not only against the ex-spouse but also against the attorney who allegedly violated to stay.

Conclusion

The interplay between matrimonial law and bankruptcy law is a complex quagmire that must be navigated carefully. Not only is it important to determine whether or not a client should proceed with relief, but an even more important question can be when to proceed. Although bankruptcy can prevent the matrimonial lawyer from seeking certain relief on behalf of a client, it does not prevent all or even most relief from being sought. When questions arise, do not hesitate to consult with a knowledgeable lawyer in your jurisdiction experienced in the issues that relate to your particular case.

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