Common Collisions Between Bankruptcy Law and Family Law

• Publication year: 2017
• Citation: Vol. 21 No. 02

Common Collisions Between Bankruptcy Law and Family Law

by Hon. Robert J. Faris

Anyone who practices either family law or bankruptcy law knows that the two fields frequently collide. The reason is not legal, but practical: financial distress causes family distress, and vice versa. Many of us know couples whose relationship worked well until the money ran out. Also, when a couple breaks up, they have to support the cost of two households rather than one, using the same total income. People seeking a fresh start in their family lives often need a fresh start in their financial lives.

A. Basic Bankruptcy Concepts

To understand how bankruptcy law interacts with family law, one must first understand two basic bankruptcy concepts: property of the estate and the domestic support obligation.

1. Property of the Estate

Bankruptcy law has two fundamental goals. The first relates to the treatment of creditors: bankruptcy law attempts to sweep up all assets available to pay creditor claims and allocate the value of those assets among creditors on a pro rata basis, in accordance with statutory priorities. The second relates to the treatment of debtors: bankruptcy law gives "a fresh start to the honest but unfortunate debtor."¹

The concept of "property of the estate" relates to both of these goals. "Property of the estate" is the comprehensive pool of assets in which creditors share. Giving up "property of the estate" is part of the price debtors must pay in order to gain a fresh start.

"Property of the estate" generally includes "all legal or equitable interests of the debtor in property as of the commencement of the case[,]" "wherever located and by whomever held[.]"² The most salient characteristic of this definition is its breadth. If it is property, whatever interest the debtor had in it at the instant of the bankruptcy filing is included in the estate (subject to a few relatively narrow exceptions).

Other provisions make "property of the estate" even broader. Any property that would have been included in the estate if the debtor had owned it at the moment of bankruptcy, but which the debtor "acquires or becomes entitled to acquire within 180 days after such date" is also included in the estate, if the debtor acquires it:

(A) by bequest, devise, or inheritance;
(B) as a result of a property settlement agreement with the debtor's spouse, or of an interlocutory or final divorce decree; or
(C) as a beneficiary of a life insurance policy or of a death benefit plan.³

The Bankruptcy Code also gives the bankruptcy trustee "avoiding powers," which allow the trustee to recover property that the debtor transferred before the bankruptcy and to eliminate liens and other interests in the estate's property.⁴ A complete discussion of the avoiding powers is beyond the scope of this article, but family law practitioners should know that the bankruptcy trustee can often avoid transfers of property that were not perfected on the date of bankruptcy (for example, where a deed, mortgage, or similar document was not properly recorded) or where the debtor did not get reasonably equivalent value in exchange for the transfer.

Some property interests are excluded from the estate. Only a few of these exclusions are applicable to ordinary folks.

The most generally applicable exclusion applies to "earnings from services performed by an individual debtor after the commencement of the case" in a chapter 7 case.⁵ This is important because, for those of us who live paycheck to paycheck, our next paycheck is our most important asset. This exclusion does not apply, however, in chapter 13 cases,⁶ where property of the estate includes "earnings from services performed by the debtor after the commencement of the case but before the case is closed, dismissed, or converted to a case under chapter 7, 11, or 12 of this title, whichever occurs first."⁷

Another exception applies to so-called spendthrift trusts, meaning a trust where the beneficial interests are not transferable voluntarily or involuntarily. "A restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title."⁸ So if the creditors cannot reach the beneficiary's interest in a spendthrift trust under state law,⁹ the bankruptcy trustee cannot reach that interest either. This exception is relevant, not just to trust fund babies, but also to a great many ordinary people: because the tax law requires that qualified pension plans (including 401k plans) have anti-assignment provisions, most pension plans are also protected in bankruptcy.¹⁰

The debtor is also permitted to remove certain property from the estate and keep it. Bankruptcy law permits debtors to keep certain property that Congress thinks is necessary for an appropriate standard of living. Property that is protected from creditor claims under state or federal law is called "exempt." The topic of exemptions is broad and sometimes difficult. Fortunately for the author, it is also beyond the scope of this article.

2. "Domestic Support Obligation"

Recognizing the close connection between bankruptcy law and family law, the Bankruptcy Code recognizes and gives special treatment to a type of claim called the domestic support obligation ("DSO").

A DSO is a debt (including interest on that debt) 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.¹¹

Most of this definition is self-explanatory. The exception is the phrase "in the nature of alimony, maintenance, or support . . . without regard to whether such debt is expressly so designated. ... "

To determine whether a particular debt is "in the nature of alimony, maintenance, or support," the bankruptcy court "must look beyond the language of the decree to the intent of the parties and to the substance of the obli-gation."¹² The bankruptcy court must even look beyond the state law definitions of "alimony," "maintenance," and "support," because the "in the nature of" phrase comes from a federal statute that does not incorporate state law.¹³ The Ninth Circuit has provided a (probably non-exclusive) list of factors for the bankruptcy court to consider:

If an agreement fails to provide explicitly for spousal support, a court may presume that a so-called "property settlement" is intended for support when the circumstances of the case indicate that the recipient spouse needs support. Factors indicating that support is necessary include the presence of minor children and an imbalance in the relative income of the parties. Similarly, if an obligation terminates on the death or remarriage of the recipient spouse, a court may be inclined to classify the agreement as one for support. A property settlement would not be affected by the personal circumstances of the recipient spouse; thus, a change in those circumstances would not affect a true property settlement, although it would affect the need for support. The court will look also to nature and duration of the obligation to determine whether it is intended as support. Support payments tend to mirror the recipient spouse's need for support. Thus, such payments are generally made directly to the recipient spouse and are paid in installments over a substantial period of time.¹⁴

Many decisions construe the "in the nature of" phrase, but the fact-intensive nature of the question limits their precedential value.

For example, the Ninth Circuit has held that legal fees owed to the other spouse's attorney for divorce services are "in the nature of alimony, support, or maintenance."¹⁵ The court noted that, under California law, the decision whether to award such fees turns on the spouses' ability to afford to pay counsel, based on their respective needs and incomes. The court therefore held that attorneys' fees, at least under California law, are "in the nature of alimony, etc." The court rejected the argument that most of the fees were incurred in litigating property settlement issues, not support issues. The decision obviously does not say whether the result would be the same under Hawaii law, or whether fees incurred in enforcing a prior award of alimony, maintenance, or support should be treated as a DSO.¹⁶

The Ninth Circuit has also held that a debtor/parent's liability to a county for the costs of support of her son while her son was incarcerated is not a DSO.¹⁷ The court said that the debt is not "in the nature of . . . support" because the debt was...