Exemption Planning and the Conversion of Non-Exempt Assets to Exempt Assets

Hypothetical:
John Doe has $50,000 locked up in stocks.  John Doe needs to file for bankruptcy, but given his available exemptions, the stocks are wholly non-exempt.  John Doe’s attorney advises John Doe to sell his stocks and use the cash to pay down his mortgage, because even with the increase in equity, John Doe would still have enough exemptions to protect his home.
This sort of “exemption planning” and conversion of assets from one form to another happens all the time.  The question is whether such conversions are permissible under the bankruptcy code.
11 U.S.C. § 522(o) / Relevant Parts:

[…] The value of an interest in […] real or personal property that the debtor or a dependent of the debtor claims as a homestead shall be reduced to the extent that such value is attributable to any portion of any property that the debtor disposed of in the 10-year period ending on the date of the filing of the petition with the intent to hinder, delay, or defraud a creditor and that the debtor could not exempt, or that portion that the debtor could not exempt […] if on such date the debtor had held the property so disposed of.

Here again, whether such conversions will be permitted is going to depend on the facts of the case and the court where such an objection to exemptions is brought.
In re Lacounte, 342 B.R. 809 (Bankr. D. Mont. 2005) – involved a conversion of $42,500 and the exemption was partially denied.
In re Anderson, 386 B.R. 315 (Bankr. D. Kan. 2008) – involved a conversion of $240,000 and the exemption was permitted.  The court noted that this was a “close case”, but pointed out that it was unable to find that the debtor acted with intent to hinder, delay, or defraud his creditors, and that he apparently “did nothing more than take advantage of an exemption to which he is entitled.”

Alternatives to Bankruptcy: are 401(k) draws or loans a good idea?

Most people don’t want to file for bankruptcy, even if they have to.  There’s a lot of stigma attached to bankruptcy, and so people try to avoid it except as a last resort.  In the process of trying to avoid bankruptcy, people try certain alternatives.  Some of them are wise efforts.  Others – not so much.
Generally-speaking, efforts to modify your budget and living without incurring additional debt are the best way to try to avoid bankruptcy without causing yourself more harm.

For example, say you were doing fine with a mortgage and a car loan, but then you were involved in an accident and racked up $20,000 in medical bills, and now you can’t afford to pay everything.  One possible strategy might be to use payday loans to “punt” the problem down the field.  That’s a bad idea and will most likely cause you more harm.  On the other hand, if you can scale back on other expenses and slowly pay down the medical debt – that’s likely to be more successful.

One of the more common tactics people use is to withdraw money from their retirement accounts or to take a loan out from their 401(k).  Is this a good idea?
Answer: it depends.  As with most complicated situations like this, your best options will always depend on the specific facts of your case.  No two people are identical, and what may work for one person is not always the best option for another person.  An experienced attorney can help you parse the pros and cons of various approaches to determine which is likely to be the best option for you.
That being said, it has been my experience that drawing or borrowing from a retirement account is usually not a good idea.  Here are some of the common reasons why:
  1. Drawing from a 401(k) is going to trigger tax consequences.
  2. Borrowing from a 401(k) means you’re still paying on a debt, with interest.  It’s the proverbial “robbing Peter to pay Paul” except in this case, you’re robbing yourself.
  3. The obvious: you’re depleting savings that is meant to carry you through your retirement.
  4. You’re doing so to pay a debt that may be dischargeable in bankruptcy, and using an asset that is fully exempt in bankruptcy.  (In other words, someone who burns $10k of his retirement funds to pay a $10k credit card bill could have had the $10k debt paid off and fully retained his retirement money in Chapter 7.
  5. If you are using these funds to settle a debt (pay less than what is contractually owed), your credit will still be impacted negatively, and you are likely to have tax consequences as a result of the canceled debt.

Don’t Ignore the Garnishment Answer

You’ve been sued.
At some point during the lawsuit, you receive a form that looks something like this…
But instead of filling it out and returning it, you toss it into the garbage can.
Your wages are garnished.  Thousands of dollars are withheld and used to pay your debt.
Several months later, you finally meet with a bankruptcy attorney.  You tell your attorney that you’ve been receiving public assistance in the form of food stamps.  You’re dismayed to find out that your wages were exempt from garnishment and that you would not have lost all that money if only you had filled out the financial disclosure form.
DON’T THROW THESE THINGS AWAY.  Sticking your head in the sand and hoping your problems will go away on their own will only make problems worse.
Seek professional guidance.  Call today.

Tax Season Reminders

As your mailbox fills up with various W2s and 1099s, now is a good time for our annual reminder of certain tax-related issues in bankruptcy.
If you intend to file for bankruptcy (or think you might), do not use your tax refunds to pay unsecured debt until you have consulted with an attorney.  First – you would be wasting money on a debt that could be discharged.  Second – such a payment could be considered a preference and recovered by the Trustee for redistribution.  Third – using tax refunds to pay bankruptcy-related costs can help expedite your case to prevent things like creditor harassment, lawsuits, wage garnishments, bank levies, utility shut-offs, repossessions, and foreclosures.
Tax refunds are generally considered a contingent asset.  Most debtors can exempt their tax refunds and protect them from being seized by the Trustee.  Debtors who do not have sufficient exemptions to protect their refunds can plan their filing strategically to minimize the Trustee’s interest.  (For example, debtors using Wisconsin state exemptions to protect equity in real estate should file shortly after they have received their refund and deposited it, availing themselves to a depository account exemption.  Most other debtors can exempt their tax refunds with federal exemptions.)
All debtors who have filed Chapter 13 bankruptcy are required to submit copies of their tax returns to the Trustee.
Some debtors who have filed Chapter 13 bankruptcy may be required to submit 1/2 of their tax refunds to the Trustee.  Consult your bankruptcy attorney if your are uncertain about this obligation.
Debtors who plan to file under Chapter 13 (but haven’t yet) should plan to file their 2013 tax returns as soon as possible.   Cases filed after December 31, 2013 cannot be confirmed until after the 2013 tax returns are on file (even though they are not due to the IRS and state until 4/15/2014).
Debts discharged in bankruptcy are not income for federal tax purposes.  If you receive a cancellation of debt notice, show it to either your bankruptcy attorney or tax professional.
If you owe tax debt – certain debts more than 3 years old can be discharged in bankruptcy.  Tax debts entitled to priority status (generally, but not limited to taxes 3 years old or younger) can be folded into and paid through a Chapter 13 Plan with no interest.
If you owe tax debt and have already filed Chapter 13 Bankruptcy, notify your attorney immediately.  The IRS can file claims for post-petition taxes that will need to be funded.

Chapter 7 Exemption Planning & Strategizing

Before I begin this blog post, I just want to assure you that asset cases (what is described below) are relatively rare in the State of Wisconsin due to fairly generous exemption options.  Just based on informal observation, I’d estimate that fewer than 5% of cases have non-exempt assets that could be administered by a trustee, and fewer still are actually administered.  I say this now so as to not induce panic.  Filing for bankruptcy does NOT necessarily mean that you will lose property.  It is certainly possible, but an experienced attorney can estimate with a reasonable degree of certainty whether your case might have an exemption issue during a free initial consult, before you’ve invested a single dime into bankruptcy.  And worst case scenario, you can always file under Chapter 13 and avoid losing assets altogether.  This article below applies to only a very small number of cases.
So, you’re getting ready to file Chapter 7 Bankruptcy.  You’re at your attorney’s office, and he’s punching his keyboard furiously – polishing off the last of the exemption math.  Then he turns to you and says, “You have $10,000″ in non-exempt equity.”
Perhaps you knew this was coming.  Perhaps this news came out of the blue.  Either way, you have non-exempt assets.  So what does this mean?
Well, if we’re going to get technical and grim about it, it means that you either have to cough up $10,000 to give to the Chapter 7 Trustee, or you have to be prepared to lose whatever asset(s) are exposed.
In reality, you’re not in nearly as much trouble as it looks like on paper.  Over the years, I have filed dozens of what appeared – on paper – to be an “asset case” – sometimes with thousands or even tens of thousands of dollars in non-exempt equity.  And in many cases, the trustee still filed an asset report.  Here are just some of the factors weighing on the trustee’s mind when he decides to pursue or abandon a non-exempt asset…
  1. How much is the trustee going to get paid?  The trustee retains a percentage of the assets he recovers for the work he must perform in distributing the assets.  If the only thing he can go after is $100, the costs of administration will far outweigh the mere pittance he will recover.
  2. How much are the creditors going to get paid?  $10,000 is a lot of money if the unsecured claims are only expected to be $25,000.  Even after administrative costs, creditors would still likely get paid over 33% of what is owed them.  But if you owe $200,000, the percentage is a lot less (less than 5%).
  3. How easy will it be to liquidate?  Is the trustee seizing money in a bank account?  If so, that is easy to convert and use to pay creditors.  But what if the exposed money is in household furniture and appliances?  Even if the trustee realized the full market value that you estimated your stuff to be worth, he still has to go through the process of selling the stuff, and that costs money.  And the likelihood of him selling your stuff for even a fraction of what you think it’s worth is still pretty low.
  4. Is the asset contingent?  Sec. 541 of the bankruptcy code describes “property of the estate” and includes contingent assets – or assets that you are entitled to possess, but do not yet possess.  There are tons of contingent assets.  Rights to tax refunds are the most common.  Unresolved lawsuits, inheritances, and residual income are all examples of possible contingent assets (depending on the specific circumstances).  Okay, so you have a lawsuit pending against someone else for $5,000.  Does that mean the trustee wants to hold open your case for months or years, waiting for it to resolve?  Sometimes he will, but often times, he won’t bother.

It is important to note that all of the above are pragmatic considerations for the Trustee.  That doesn’t mean that you will always get off the hook.  The trustees are also under considerable pressure from the U.S. Trustee to pursue worthwhile assets, and of course, they have a fiduciary duty to unsecured creditors.
Trustees are also human beings.  Understand that sometimes, the trustee’s decision to pursue or abandon an asset could be influenced by what kind of a day he is having and what kind of mood he is in.  For example, if he just landed a million dollar asset case earlier in the day, he probably doesn’t care too much about your thousand dollar case.  On the other hand, if you (believing that the trustee is going to screw you over and take things from you) treat the trustee with hostility and contempt – he might just exercise his full rights just to be vindictive.  Fortunately, trustees in our district are pretty good people and easy to get along with.
Younger trustees tend to scrutinize cases more to look for assets.  With age and experience, apathy tends to follow.  They know an asset case when they see one, and they don’t bother with the tiny cases.
So, what are some strategies you can use to retain as many of your assets as you can?
  1. Don’t try to hide any assets.  Anything not disclosed, if discovered later, cannot be taken as exempt – even if you had plenty of exemption to use.  And trustees WILL go after non-exempt assets, if for no other reason than to make an example of you and deter other people from lying to the bankruptcy court.  Learn from the mistakes of others.
  2. Believe it or not, I have learned that it’s actually better to over-estimate the value of your assets.  Trustees can usually tell if you’ve perhaps been a little too generous about their personal belongings.  They can also tell if you’re short-changing your schedules.  If they believe that is the case, they will scrutinize your schedules moreso, and perhaps hire their own appraiser.  If you thought you had problems with $1k in non-exempt equity, wait until the trustee gets real values and finds out that you actually have $10k exposed.  (It’s worth dispelling a common myth at this point.  Trustees do not actually come out to your home to look at your stuff.  But they can, and they will, if they have good reason to believe you have not been truthful on your schedules.)
  3. Check your exemption options.  For example, Wisconsin residents who have resided in Wisconsin for at least two years may choose between federal exemptions and Wisconsin state exemptions.  Each set has its own benefits and drawbacks, so debtors may select whichever set is most beneficial to them (though they may not mix-and-match).  Which exemptions you are entitled to depends on which state you currently reside in, and which state you have resided in during the past 730 days.  (We’ll discuss residency requirements and exemptions a different day.)
  4. You will have access to a variety of exemptions, which can only be applied toward certain types of property, and most of which have dollar limits to them.  To the extent the exemptions allow you to do so, leave exposed things that are hard for the trustee to sell, like furniture and appliances.  Cover up cash and cash-like items (aka liquid assets, such as bank accounts, whole life insurance policies, retirement accounts, tax refunds, stocks, and bonds).  Then cover up real estate and motor vehicles – yes, the trustee has to sell them, but they’re easier to sell.  Whatever is left – that is what you want to leave exposed.
  5. If there are assets secured by liens that you intend to surrender back to the bank, leave those items exposed, too.  The trustee can try to intervene in a repossession or foreclosure action if he chooses to.  But since you’re already resigned to losing the property, it’s no skin off your nose.  If you have a piece-of-junk snowmobile sitting in your backyard collecting rust that you could care less about – don’t waste exemptions on it if they can be better utilized elsewhere.
  6. Expose contingent assets.  These are things you don’t have yet, and it’s harder to miss things that you never had possession of in the first place.
  7. If the trustee is not willing to abandon assets completely, he is still likely going to be open to a settlement – particularly if you have left exposed contingent or hard-to-sell assets.  He doesn’t want to go through the hassle of administration, or leave a case open for months or years to collect a contingent asset.  He would much rather get a cash payment from you, in exchange for which, he will settle for less than what is exposed.  So, for example, let’s say you have $5k exposed in a car.  The trustee may settle for $3k and you get to keep the car.  Now, this isn’t Chapter 13, so you would be able to stretch payments out for 3-5 years.  In Chapter 7, if the trustee settles, he is going to expect payment pretty promptly.  Sometimes he may give you a month.  Sometimes 3-4 months.  The longest I’ve ever seen a payment plan for was 12 months, and that was for an extremely large asset (as I recall, $60-70k).

Residency Requirements for Exemptions

In a Chapter 7 or Chapter 13 bankruptcy case, debtors must make a full disclosure of all of their assets.  Assets range from the tangible (furniture and appliances) to the intangible (stocks and intellectual property), from the valuable (real estate and vehicles) to the invaluable (clothing and timeshares), from the known to the contingent (tax refunds and personal injury claims), and include future, partial, and equitable interests.
Assets, particularly in Chapter 7, can be seized by a trustee and sold for the benefit of unsecured creditors unless the asset’s full value can be taken as exempt.  Each state has its own respective property exemption laws (and the federal bankruptcy code also provides for its own exemptions).  But you can only select one exemption set.  Which one should you choose?  Which ones can you choose?
It probably won’t come as much of a surprise that you can’t use California exemptions if you do not currently reside in California, nor have you resided there at any time in the past.
What might surprise you is that you can be a legal resident of California and not be eligible to claim its exemptions.
Let’s take a look at and parse the controlling rule, 11 U.S.C. § 522(b)(3)(A).

Property listed in this paragraph is […] any property that is exempt under Federal law, other than subsection (d) of this section, or State or local law that is applicable on the date of the filing of the petition to the place in which the debtor’s domicile has been located for the 730 days immediately preceding the date of the filing of the petition or if the debtor’s domicile has not been located in a single State for such 730-day period, the place in which the debtor’s domicile was located for 180 days immediately preceding the 730-day period or for a longer portion of such 180-day period than in any other place;

Quite a mouthful, eh?
Scenario #1.  For simplicity’s sake, 730 days is two [non-leap] years.  So, what this statute is saying is that – the state whose exemptions control is the state that the debtor has resided in for two years.  So, let’s start with a simple example.  John Doe is a resident of Wisconsin.  Today’s date is May 29, 2013.  John moved to Wisconsin from Rhode Island in 2006.  Therefore, John Doe has been a resident of Wisconsin for more than two years.  Therefore, John is entitled to use Wisconsin’s exemptions.
Before we continue any further, I should mention that Wisconsin is one of a few states that allows its qualifying residents to elect to choose Wisconsin’s state exemptions or the federal exemptions.  As a practical matter, most attorneys use federal exemptions because the federal wildcard exemption protects certain assets like tax refunds that Wisconsin’s state exemptions do not.  Wisconsin exemptions are favored when there is a lot of equity in a particular asset (such as a homestead) where the state exemptions are much more favorable than the federal exemptions.
Scenario #2.  So, let’s change the facts around a little bit.  Let’s say John Doe moved to Wisconsin from Rhode Island on June 12, 2012.  Let’s further assume that John Doe began living in Rhode Island since 2003.  John has had two residences in the past 730 days – Wisconsin and Rhode Island.  Now, we have to look past the 2 year mark and look at the timeframe of 2.5 years ago to 2 years ago.  During that time, John Doe was a resident of Rhode Island, which means Rhode Island exemption laws still control in John Doe’s case.  In order to be eligible to use Wisconsin exemptions, John must wait to file his case until June 13, 2014.
Scenario #3.  Now, let’s make it REALLY confusing.  John Doe moved from Rhode Island to Wisconsin on June 12, 2012, and today is May 29, 2013.  Prior to Rhode Island, John lived in Nebraska from 1999 to May 1, 2011.  In the last 2 years, John lived in Wisconsin and Rhode Island.  So, we shift our focus from the past 2 years, to the range of 2.5 years to 2 years ago.  During that time, he lived in Nebraska and Rhode Island.  Also during that time, he spent the majority of his time in Nebraska.  Therefore, Nebraska exemptions control in this case.
In scenario #2, we are stuck with Rhode Island exemptions.  Rhode Island allows nonresidents to claim its exemptions.  Like Wisconsin, Rhode Island residents may also use federal exemptions.  So, in this scenario, John Doe can choose between federal exemptions and Rhode Island state exemptions.
In scenario #3, we are stuck with Nebraska exemptions.  Nebraska also allows nonresidents to claim its exemptions, but does not allow federal exemptions.  Therefore, in this scenario, John would be limited to claiming Nebraska exemptions.
Other states, such as Arizona, do not allow nonresidents to claim its exemptions, but allow the use of federal exemptions.  If Arizona was the controlling state, John Doe would have to use federal exemptions.
What about a state like Idaho, which does not allow nonresidents to use its state exemptions, but also forbids federal exemptions?  In that case, the hanging paragraph in 11 U.S.C. § 522(b)(3) (just below subsection ‘C’) kicks in, and federal exemptions are available.  This is also true if there is no controlling state (the debtor resided outside of the 50 states and D.C. in the qualifying time period).

If the effect of the domiciliary requirement under subparagraph (A) is to render the debtor ineligible for any exemption, the debtor may elect to exempt property that is specified under subsection (d).

Tri-Annual Statutory Inflation Adjustments

On April 1, 2013, certain dollar amounts contained in the U.S. Code will undergo their three year adjustment.  The full adjustments can be found here, but I want to highlight the numbers that will impact clients of Holbus Law Office, LLC the most.
11 U.S.C. § 109(e).  Although almost any individual is eligible to file Chapter 13 (even if you’re not eligible for a discharge), there are debt limitations to Chapter 13.  That maximum amount of secured debt allowable in Chapter 13 is being raised from $1,081.400 to $1,149,525.  The maximum amount of unsecured debt allowable in Chapter 13 is being raised from $,360,475 to $383,175.
11 U.S.C. § 507(a).  Some debts that are owed to creditors are entitled to priority treatment.  Certain dollar amount restrictions placed on creditors have been increased.  Specifically, wages earned within 180 days of the petition or cessation of business have been increased from $11,725 to $12,475.  Allowable security deposits are being increased from $2,600 to $2,775.
11 U.S.C. § 522(d).  Federal exemption limits are increasing – always good news for the debtors.  The homestead exemption is increasing from $21,625 to $22,975.  The vehicle exemption from $3,450 to $3,675.  The household good exemptions are increasing from $11,525 to $12,250.  Jewelry from $1,450 to $1,550.  Wildcard from $1,150 (+ $10,825 in unused homestead exemption) to $1,225 (+ $11,500 in unused homestead exemption).  Tools of the trade from $2,175 to $2,300.  Life insurance policies with cash value, from $11,525 to $12,250.  Personal injury from $21,625 to $22,975.
11 U.S.C. § 523(a)(2)(C)(i).  Presumption of non-dischargeability on debts incurred just prior to filing for bankruptcy.  The dollar threshold being increased from $600 to $650 for consumer debts incurred within 90 days of filing, and from $875 to $925 for cash advances incurred within 70 days of filing.
11 U.S.C. § 707. Deductions and allowances on the Means Test.  I’m not going to go through each number here, but there are 8 provisions that have been increased anywhere from 5.6% to 8%.
It’s also worth noting that there have also been suggested changes to the bankruptcy forms, which you can read more about here.

What you need to know about wage garnishments.

Filing for bankruptcy is an excellent way to stop wage garnishments.  The automatic stay immediately stops all collection actions, and the discharge wipes out the judgment debt.
However, as any quality bankruptcy attorney will tell you, filing for bankruptcy requires some time and work.  If you want you case done properly and without errors, you should expect that the process will take a couple of weeks, minimum.  In other cases, people need to deliberately wait to file their case for any number of reasons.
But you’re facing a wage garnishment NOW.  What can you do to avoid wage garnishment until your bankruptcy case is ready to be filed?
Let’s start out with some basic facts that you should know about wage garnishment.  Note: everything in this post is specific to Wisconsin law.  If you have been sued in another state, consult with an attorney who practices in that state.
  • The maximum amount that can be garnished is 20% if your “disposable earnings” (your gross wages, minus amounts taken out for federal tax, state tax, and social security taxes, but does not include other deductions such as insurance or union dues).  If you have child support deducted from your paycheck, then the combined amount of child support deductions and the wage garnishment can be no greater than 25% of your disposable earnings.
  • Garnishments typically last for 13 weeks.  They can end sooner if the underlying debt is fully paid.  They can be extended for a longer period either by stipulation, or by a new application that takes effect after the first 13 week period is up.  Also, public employees can be garnished until the debt is paid off.
  • You can only be garnished by one general creditor at a time (does not include tax levies, federal student loan levies, and child support).
  • You cannot be fired solely because of a wage garnishment (though most employment in the United States is “at-will” employment, which means an employer can fire you for any reason or no reason at all, so long as it is not solely for a discriminatory reason).  There is also an exception to this rule if you have a collective bargaining agreement that permits termination under such circumstances.
  • You may dispute a wage garnishment.  To do so, click here for the form.  Send a copy to the Clerk of Courts, the creditor and/or the creditor’s attorney, and your employer.  Your employer must not garnish you if you file one of these responses, unless and until the court overrules your application and directs the employer to proceed with the garnishment.  Your employer must wait at least 5 days after your pay date before sending garnished funds to the creditor, to allow time for you to file a dispute.
  • Most creditors cannot touch certain types of income (such as social security).  However, if you owe debt to the government, social security and other types of income can become fair game.

You may be exempt from wage garnishment.  If you are, make sure that you file a response with the court and copy your employer.  Your employer is not required to investigate on his own to determine whether or not you are garnishment-proof.  All exceptions (except proof of bankruptcy filing or discharge) require a judicial determination.
You may be garnishment-proof if:
  • You have filed bankruptcy and the automatic stay is still pending.  (In pending Chapter 13s, only until property of the estate revests back to you.)
  • You have received a bankruptcy discharge, and the debt was incurred before your bankruptcy case was filed.
  • Your household income is below the federal poverty guidelines.
  • If your household income is above the federal poverty guidelines, but the garnishment would bring you below the guidelines, you can only be garnished to the extent that it brings you down to the poverty guidelines.
  • Currently, or in the past six months, you have received – or determined to be eligible for – public assistance (food stamps, W2, SSI, etc.).

Divorce and Bankruptcy

Divorce and bankruptcy tend to go hand in hand.  Either the financial stresses that led to bankruptcy also break down the marriage, or ex-spouses use bankruptcy as a way to clean-up and get a fresh start after divorce.
However, the issue of divorce can weak havoc on bankruptcy, and vice-versa.  So it’s good to revisit some of these themes.  Particularly when you’re trying to decide which to do first: file for divorce or file for bankruptcy, and whether to file joint or individual.  Many of these themes have circular reasoning, so there really was no linear way to present these, other than randomly…
  • Filing a joint bankruptcy before a divorce is finalized is almost always the preferred route.  It’s cheaper to file one joint petition rather than two separate individual petitions.  Both debtors benefit equally from the discharge, neither one has to rely on the “phantom discharge”, and it renders most “hold harmless” clauses in divorce papers moot.
  • On the other hand, some debtors don’t want to file joint because of impact on credit scores, because bankruptcy causes the revelation of certain financial information that could give one of the spouses leverage in divorce proceedings, or because the income potential of one debtor disqualifies both debtors – as a married couple – from Chapter 7.
  • For reasons beyond my comprehension, creditors are not required to abide by the terms of divorce orders.  Which means that a bankruptcy filed after divorce may not be as effective as a bankruptcy filed before divorce.  Divorce orders usually contain “hold harmless” clauses.  Which means if one spouse gets a debt discharged in bankruptcy that was assigned to him or her in the divorce, and the creditor then pursues the other spouse for payment, the second spouse can go into family court and get a non-dischargeable support order from the first spouse for damages resulting from their failure to pay the debt assigned to them in divorce.  So, if you do file divorce before bankruptcy, make sure that your attorney knows of your intent to file for bankruptcy and that your divorce papers do not include “hold harmless” clauses.  (DO NOT FILE FOR DIVORCE WITHOUT AN ATTORNEY!  Most divorcees who have done so will tell you that it was a mistake.)
  • Get rid of the mentality that you and your spouse split everything 50-50, or that credit cards in one spouse’s name are not the responsibility of the other spouse.  Wisconsin is a community property state, which means that married spouses are deemed a single legal entity, and each spouse is presumed to own a whole and undivided interest in all assets (and share a whole and undivided liability in all debts).
  • Consequently, a bankruptcy petition must disclose the assets of both spouses (if the divorce is not yet finalized), even if one spouse is filing without the other spouse.  Assets of the non-filing spouse that are not disclosed (even if it is due to the non-filing spouse’s lack of cooperation) cannot be taken as exempt, which means the trustee can seize and liquidate unreported and non-exempt assets of the non-filing spouse.  While the filing spouse might not care, this adverse impact on the non-filing spouse could hurt the filing spouse when it comes time to settle the divorce.
  • Additionally, in a non-filing spouse scenario, only the filing spouse can claim exemptions (which are generally half of the exemptions available to joint filers), often creating non-exempt assets where there would be none of both spouses filed.
  • Bankruptcy filed after divorce also must contend with a potential fraudulent conveyance issue.  Were the assets in divorce split roughly 50-50?  If not, why?  If the non-filing spouse got the house, both cars, and all the jewelry, and the filing spouse got stuck with nothing, there could be a fraud issue.  It is not unheard of for a married couple to get divorced just to protect assets from unsecured creditors (in fact, I had a client once myself who tried to pull this stunt, and I fired her as a client).
  • In the event that a single filer has enough exemptions on his own to cover the assets of both spouses, then the question becomes whether the filing spouse can exempt the non-filing spouse’s interest.  If that seems strange to you in light of what I said earlier about community property, you’re not alone.  It seems that this is where the “whole and undivided interest” standard breaks down into a 50-50 theory, again for reasons beyond my comprehension.  At any rate, the court then looks at the non-exempt asset.  Is it readily divisible – like a bank account?  If yes, the debtor can only exempt their half share.  If it is not readily divisible (like a house or single vehicle), then the debtor can exempt both spouse’s share in the asset, provided enough exemptions exist to cover the asset.
  • Once a divorce is final, former spouses can no longer file a joint petition.  A joint bankruptcy petition must be filed before the divorce is finalized.
  • As you may have gathered, it is quite simple for one spouse to adversely impact the spouse by filing for bankruptcy.  Some people would say this is unfair.  I agree.  But it is also part of the cost of marriage that too few people understand and appreciate before they get married.
  • I get a number of clients who cannot provide me with the information of their non-filing spouse because they have been estranged for so long.  They may not be on speaking terms, or they may not even know how to contact the spouse anymore.  Does that mean the filing spouse is off the hook for disclosing the information of the non-filing spouse?  Unfortunately, no.  As stated earlier, unreported assets could potentially be liquidated by the trustee, and even if the filing spouse doesn’t care, it would impact the divorce proceedings when they come.  The solution – if you are unable or unwilling to work with your spouse in a joint filing is to file for divorce first.  Newspaper publication resolves any problems with being unable to locate/contact the other spouse.  Just remember that in filing divorce before filing bankruptcy, to be on the lookout for “hold harmless” clauses that can affect your discharge.

Cases of Note: Halling and Bronk

Two recent cases out of the Western District of Wisconsin (by Judge Utschig, who is retiring at the end of the year) I’d like to share with you.  Neither of these creates mandatory precedent in the Eastern District.  However, it’s good to be aware that these cases are out there, because both decisions end with terrible results.
The first case is Osberg v. Halling (In re Halling), 449 B.R. 911, 913 (Bankr. W.D. Wis. 2011).
In this case, the debtor attempted to obtain a $45k loan from a bank, but was denied.  In order to secure the loan, the debtor’s son agreed to guarantee the loan and put his real estate up as collateral.  The debtor made payments to the bank – and in the 12 months prior to filing the bankruptcy case – paid in a total amount of $4,100.
Ordinarily, a trustee can recover “preferential payments” to a creditor if the amount exceeds $600 in the 90 days prior to filing the bankruptcy case.  The public policy rationale is as follows:

A preferential transfer occurs when a debtor favors one creditor over another by paying that creditor to the detriment of other creditors. Preferences are treated with disfavor in bankruptcy because they contradict the fundamental bankruptcy policy of ensuring the equitable distribution of a debtor’s nonexempt assets among similarly situated creditors.  In re Eckman, 447 B.R. 546, (Bankr. N.D. Ohio 2010)

However, when the beneficiary of payments is an insider (someone close to the debtor, such as corporate partners or relatives), the trustee can recover preferential payments going back 12 months prior to filing bankruptcy.

The reason that Congress created an extended period for insider transactions is simple. In a corporate setting, insiders are typically the first to recognize that a company is failing, and they may have an incentive to pay themselves, or to pay obligations which might otherwise result in their personal liability. The longer preference period was established to address the concern that a corporate insider (such as an officer or director who is a creditor of his or her own corporation) has an unfair advantage  over outside creditors.  […]  Likewise, in a personal bankruptcy a debtor is likely to want to avoid harming family members and will pay (or “prefer”) debts which would impact them. The bankruptcy code strives to eliminate the incentive for doing so by providing that these payments (or transfers) can be brought back into the bankruptcy estate for the benefit of all unsecured creditors, not simply those closest to the debtor.

In this case, the court rules that because the debtor was making payments to the bank, that it caused a decrease in liability from the debtor’s son to the bank.  That benefit created a preference to an insider, which was recoverable against the insider.  Since the look-back period was longer for insiders than it was for ordinary creditors, the trustee could recover more by voiding the benefit bestowed upon the debtor’s son, rather than voiding the benefit bestowed upon the bank.

Payments to the “lender” in such a scenario are “for the benefit of” the guarantor because every reduction of the debt reduces the guarantor’s potential liability to the lender.  Osberg v. Halling (In re Halling), 449 B.R. 911, 915 (Bankr. W.D. Wis. 2011)

The result: the debtor’s son was a creditor of the bankruptcy estate, received a benefit of decreased liability to the bank in the amount of $4,100 which was recoverable from the son as an insider preference.
The lesson: If you have a loan cosigned by a relative, consider having the relative make payments on the loan in the 12 months prior to filing bankruptcy, or consider filing Chapter 13.
Again, this is a Western District of Wisconsin case with no mandatory authority over any other federal district.  To date, it has not been appealed, nor has it been cited as authority in any other case.  But that could change, which is why I share the story.
The second case is Cirilli v. Bronk (In re Bronk), 444 B.R. 902 (Bankr. W.D. Wis. 2011).
In this case, the debtor had a considerable amount of non-exempt assets, owing partly to his residence which was owned free and clear of any mortgages.  Prior to filing his case, he took a mortgage out on the home to reduce equity, and converted the cash he received from the mortgage into college savings plans (EdVest accounts) for his grandchildren, which he could exempt.
What is described above is one of the more extreme examples I’ve read of “exemption planning” which converts non-exempt assets into exempt assets.  Does that seem wrong to you?  It is.  You can be denied discharge for these transfers if it can be shown that you intended to hinder, delay, or defraud creditors.  Curiously enough, the court held in this particular case that there was insufficient evidence to prove fraud – presumably because either not all elements were proven or the trustee did not meet his burden of proof.
Nevertheless, this is a practice I hear about repeatedly from my clients who have non-exempt assets, and this is why I discourage the practice of intentionally converting non-exempt assets into exempt assets.
Though the debtor in this case retained his discharge, he wasn’t completely off the hook, and in that sense, there is some justice in this case.  (Although the way in which the debtor was nailed doesn’t seem to make much sense, either.)
The court held that the debtor could not exempt the EdVest accounts because the exemption statute Wis. Stat. § 815.18 only covers the beneficiary’s interest in the account.  In other words, if the grandchildren had filed for bankruptcy, they would be able to exempt the EdVest accounts, but the creator of the account (the debtor in this case) could not.
The reason this is odd is because the money in an EdVest account is completely in the control of the creator.  The beneficiaries cannot touch the funds.
Lesson: Don’t convert assets from one form to another – you could be denied discharge for fraud.  And if you are the creator of an EdVest account, you may encounter exemption issues.
This case has been followed by the Northern District of Illinois.