Wednesday, May 1, 2013

Marital Obligations in Bankruptcy Clarified Spouse’s Duty to Pay Opponent’s Attorney Fees May Be Held Non-Dischargeable in Bankruptcy

From Rebecca L. Reinhardt

Attorney fees ordered to be paid by one spouse on behalf of the other are non-dischargeable in Chapter 7 bankruptcy proceedings, a bankruptcy judge in Central Illinois held recently.

In Johnson v. Johnson (In re Johnson), 2012 WL 2835462 (Bankr. C.D.Ill. 2012), the marital settlement agreement obligated the husband to pay the fees to the wife's divorce attorney, but the husband filed for bankruptcy before doing so.  Seeking to avoid the bankruptcy discharge, the wife's attorney argued to the bankruptcy court that the fees, though payable to him, were in the nature of a domestic support obligation and thus non-dischargeable under 11 U.S.C. § 523(a)(5), and the bankruptcy court agreed.

The Bankruptcy Code actually has two provisions relevant to the treatment of marital obligations in bankruptcy: § 523(a)(5), excepting from discharge debts "for a domestic support allegation," and 11 U.S.C. § 523(a)(15), covering debts "to a spouse, former spouse, or child of the debtor and not of the kind described in [§ 523(a)(5)] that is incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement, divorce decree or other order" of a court or governmental unit.

In Johnson, the court said that after the Bankruptcy Abuse Prevention & Consumer Protection Act of 2005 (119 Stat. 186) ("BAPCPA"), the distinction between domestic support obligations (§ 523(a)(5)) and other types of obligations arising out of the ending of a marital relationship (§ 523(a)(15)) is of no practical consequence in a Chapter 7 bankruptcy: neither is dischargeable in Chapter 7.  The court went on to state that it was of no consequence that the obligation was owed to the wife's attorney and not to the wife directly.  While 11 U.S.C. § 101(14A) defines "domestic support obligation" as used in § 523(a)(5) as a debt "owed to or recoverable by" the spouse or child, courts have not interpreted the statute literally, looking instead to the nature of the debt and not to whom the debt is owed. Johnson followed that trend.

Chapter 13 Different:  However, there is a significant distinction between the dischargeability of debts arising from a divorce or separation in a Chapter 7 and a Chapter 13 bankruptcy proceeding.

In Chapter 13, to obtain confirmation, plans must provide for payment in full of claims entitled to priority under 11 U.S.C. § 507.  11 U.S.C. § 1322(a)(2).  "Domestic support obligations" are entitled to such priority.  § 507(a)(1)(A).  Further, "domestic support obligations" are excepted from the general discharge granted to debtors upon completion of Chapter 13 plan payments.  11 U.S.C. §§ 523(a)(5), 1328(a)(2).  If the debtor's obligation is "domestic support," the debtor must propose to pay it in full through a repayment plan, and the obligation will not be discharged unless it is paid in full. 

However, in Chapter 13, debts arising under § 523(a)(15) are dischargeable if the debtor receives a full-compliance discharge.  In re McCreary, 2009 WL 5215587 (Bankr. C.D. Ill. 2009).  Thus, if the obligation is not a support obligation but arises from a divorce or separation agreement or order, the debtor is only required to pay a required pro rata share of the funds available in the Chapter 13 plan.  The creditor spouse is treated as a general unsecured creditor and, upon successful completion of the plan, any remaining balance is discharged.  In re Rabideau, 2011 WL 165179 (Bankr. C.D. Ill. 2011).

Thus, the distinction between support and other obligations is significant in Chapter 13 cases.  "Whether a debt is nondischargeable as being in the nature of alimony, maintenance or support . . . is a matter of federal, not state, law."  In re Marriage of Lytle, 105 Ill.App.3d 1095 (1982).  11 U.S.C. § 101(14A) defines a domestic support obligation as a debt (1) owed to or recoverable by a spouse, former spouse or child; (2) that is in the nature of alimony, maintenance, or support; (3) that is established by a court order; and (4) that has not been assigned to a governmental entity.  State law is used to ascertain the incidents or nature of the debt to determine whether it fits within the federal exception.

Marriage of Lytle.  The label attached and the language of the decree or underlying agreement are not controlling in determining dischargeability; rather, one must look to the substance of the decree or agreement to determine the essential nature of the obligation.  Marriage of Lytle. 

Thus, courts have held that attorney's fees owed to a former spouse, or the former spouse's attorney, in conjunction with or awarded in the context of a support obligation have met the definition of "domestic support obligation".  See Johnson, discussed above; In re Papi, 427 B.R. 457 (Bankr. N.D. Ill. 2010).

Whereas in Chapter 13 debts under § 523(a)(15) are potentially dischargeable, in Chapter 7 debts arising in the course of a divorce or separation are unqualifiedly non-dischargeable.  In re Harn, 2008 WL 130914 (Bankr. C.D. Ill. 2008).  (However, note that §  523(a)(15) was markedly changed by BAPCPA; previously, courts applied a balancing approach to determine whether the debtor could reasonably afford to pay such debts and the resulting harm posed to the creditor spouse in the event of a discharge, and this approach no longer applies.)

Serious Consideration Required:  An individual and his or her attorney involved in settlement of a dissolution action should clearly set forth the intent of the parties and insure that it meets the federal definition for the type of obligation the agreement is attempting to achieve.  Furthermore, the parties should be made aware that particular obligations set forth in the agreement may ultimately be non-dischargeable in a bankruptcy proceeding.  Hold-harmless agreements have been held nondischargeable in Chapter 7 proceedings per § 523(a)(15), as have agreements to pay mortgage obligations.  See In re Walden, 312 B.R. 187 (Bankr. C.D. Ill. 2004).

For debtors with significant marital debt, consideration must be given to the benefit afforded in a Chapter 13 case, when selecting under which chapter to file.  In McCreary, discussed above, the bankruptcy court held that a former husband's filing of a Chapter 13 bankruptcy instead of a Chapter 7 to avoid, among other things, paying the full amount due his former wife under a property settlement was legitimate and not in bad faith.

Call us to schedule a consultation if you have any questions about these issues!

--
Jon D. McLaughlin
(309) 319-6206