You may or may not know that all of your debts are not all treated equally in bankruptcy.
Most debts can be “discharged” (legally written-off), but some can’t be, or only in certain situations. Some debts have no collateral—they are unsecured—while other debts are secured by collateral.
A secured debt can be treated differently depending on how much the collateral is worth compared to the amount of the debt it secures, and depending on whether you intend to surrender or retain the collateral.
A handy starting point in understanding debts in bankruptcy is to divide all debts into three categories: secured debts, unsecured debts, and “priority” debts. Today’s blog is on this last category.
Priority debts are a list of special debts which Congress has decided deserve special treatment, and in certain circumstances should get paid through your bankruptcy case ahead of other debts.
For consumers this priority list only comes into play with “asset” Chapter 7 cases and with Chapter 13 cases. This blog will cover the “asset” Chapter 7 cases; the next one will cover Chapter 13.
10 Different Priority Debts
There are 10 different priority debts. They are listed in the Bankruptcy Code in order of priority. So not only do priority debts usually get paid in a bankruptcy case before debts that are not priority debts, the priority debts themselves get paid in the order that they show up on the list.
Most of the 10 different kinds of priority debts are not applicable to a conventional consumer bankruptcy. But two of them are quite common: 1) child and spousal support arrearage, and 2) tax debts of various kinds. The support debt is listed as a higher priority than taxes, and indeed is the highest one on the entire list.
Most Chapter 7 cases are “no asset” ones—all your assets are protected from creditors through “exemptions,” so you keep everything you own and nothing goes to the Chapter 7 trustee to distribute to your creditors.
But in an “asset” Chapter 7 case you own something that is not covered by any exemption, so the trustee can take, sell, and distribute its proceeds to your creditors.
If you have a particular “non-exempt” asset, perhaps something that you do not mind surrendering to the trustee, and if you owe a priority debt, a Chapter 7 case can be way to turn these to your benefit.
Most priority debts are not dischargeable in a Chapter 7 case—such as support arrearage and most debts—so it’s beneficial to have the trustee use your unprotected asset as the means to paying off or paying down a support arrearage or tax.
Here’s an illustration. Assume you own a boat free and clear with a marketable value of $4,000 that you admit that you can’t afford to keep any longer, it is not exempt, and so you would surrender it to your Chapter 7 trustee.
You owe $1,000 in last year’s income taxes, plus $2,000 in back child support. Theoretically you could have sold the boat before filing bankruptcy and paid the taxes and support, but you may not have time if you were trying to stop a garnishment or some other creditor action.
In this case, the Chapter 7 trustee would sell the boat, pay herself a trustee fee (25% of the first $5000 collected, so $1,000 here), pay first the support obligation and then the tax debt. If the boat indeed sold for $4,000, you would finish your Chapter 7 case owing neither of those priority debts, and hopefully with all your other debts discharged.
You can see by this illustration that a carefully planned Chapter 7 can be a good tool in these kinds of situations.