Bankruptcy and Divorce

Originally published by Jason B. Freeman.

Divorce is often coupled with financial difficulties for one or both spouses. Thus, it is not uncommon for spouses seeking divorce to also pursue bankruptcy. The combination of divorce and bankruptcy proceedings can give rise to complicated and competing legal issues. The two bodies of law, after all, often have fundamentally conflicting goals. The primary goal of divorce is to achieve an equitable result, while the primary goal of bankruptcy is to provide the debtor with a fresh start.

Common Issues. 

The first issue that arises is the optimal timing for filing a bankruptcy petition. There are many circumstances and considerations at play. The first consideration is the type of bankruptcy. For example, a Chapter 7 bankruptcy is typically faster than a Chapter 13 bankruptcy proceeding. However, a couple’s income may be too high to qualify for Chapter 7 relief. Thus, a couple might opt to file for divorce first to limit the single debtor’s income. Also, if a couple has extensive debts, filing for bankruptcy first can facilitate or streamline divorce proceedings. Lastly, the local and state rules in each jurisdiction will likely affect the timing of each petition.

A second significant issue is whether the couple should file a joint petition for bankruptcy or file separately. If the couple has a significant amount of joint debt, filing for bankruptcy can reduce or eliminate this debt before divorce proceedings. This may be helpful, because if only one spouse files for bankruptcy, the other spouse remains liable for all joint debt. Additionally, the couple’s state of residence can affect decision making. For example, in a community property state (e.g. Texas), the bankruptcy estate will include both spouse’s interests regardless of whether the petition is filed jointly or separately.

Where possible, spouses may benefit from a joint, cooperative approach to bankruptcy issues.  While cooperation is not always possible in the context of divorcing spouses, mutual financial benefit can, at times, help align their interests in the bankruptcy context.    

The Automatic Stay.

If spouses file separately and if a divorce proceeding is pending when one spouse files for bankruptcy, the “Automatic Stay” precludes the continuation or initiation of many actions and proceedings against the bankruptcy debtor. While the stay provides the bankruptcy debtor with some relief, it does not preclude the continuation of all actions and proceedings. The stay does not preclude certain proceedings, including those related to the dissolution of marriage (unless the bankruptcy estate is involved), the establishment of paternity, child custody or visitation, and domestic violence.

Domestic Support Obligations.

Domestic Support Obligations (“DSOs”) have a special status in bankruptcy proceedings. DSOs can accrue before, on, or after the petition date and can accrue interest. A DSO cannot be discharged under any Chapter of the Bankruptcy Code. DSO’s are given priority status and are paid before general unsecured obligations. There are also exceptions to the Automatic Stay to collect DSOs. Prepetition payments of DSOs cannot be avoided as preferential payments. Maintaining payments on DSOs is usually an obligation to obtain discharge, and failing to make payment can result in dismissal of the case.

A Fresh Start?

Another crucial issue at the intersection of bankruptcy and divorce is whether or not certain obligations or entitlements can be entirely eliminated by a bankruptcy filing. Because the primary purpose of bankruptcy is to give the debtor a fresh start, a bankruptcy allows a debtor to discharge certain debts and obligations in bankruptcy that the debtor is otherwise required to satisfy. While the long-established principle that obligations that are in the nature of alimony, maintenance, and DSOs are not dischargeable in bankruptcy remains, other divorce obligations and entitlements can be eliminated.

Fraudulent Transfers. 

Notably, transfers made as a part of the divorce decree can potentially be considered a fraudulent conveyance. A transfer is a fraudulent conveyance if the transfer is actually fraudulent—meaning that the intent of the transfer was to hinder, delay, or defraud creditors. However, a transfer may also be constructively fraudulent.  Constructive fraud is usually based on the value exchanged as part of the transfer.

If the bankruptcy court makes a “surface determination” that the division of marital property is within the range of likely distribution that a court is likely to order in divorce litigation (had the division of assets been litigated), a transfer will not likely come under attack as a fraudulent transfer.

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In conclusion, bankruptcy and divorce can be complicated legal arenas in which competing legal theories collide. Before instituting bankruptcy and divorce proceedings, the decision whether to file an individual or joint petition should first be analyzed. A debtor spouse must consider the limitations and differences of each type of bankruptcy filings. A debtor must also note the limited breadth of the automatic stay with respect to support obligations. A creditor spouse should structure a settlement agreement in a manner that best protects their claims in bankruptcy court and should consider seeking relief from the automatic stay.

Anticipating potential issues in the intersection of bankruptcy and divorce proceedings is vital for both the debtor and creditor spouse, as both parties may have opportunities to protect their interests and achieve their desired objectives. To prepare for the possibility that a spouse files for bankruptcy while a divorce is pending, a divorce attorney should prepare a divorce settlement agreement with the possibility of a future bankruptcy filing in mind.  Divorce counsel should also contemplate related federal tax issues and ensure that a divorce decree adequately protects the spouse from tax exposure, as the intersection of bankruptcy and tax law creates numerous traps for the unwary. If a spouse or former spouse does file for bankruptcy, the creditor spouse should retain bankruptcy-specific counsel to address such issues.

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