Priority Debts in Chapter 13 Bankruptcy

Chapter 13 can be a stronger and more flexible tool for dealing with priority debts than Chapter 7.

The last blog explained how sometimes Chapter 7 can be a good tool to pay or reduce your priority debts. Priority debts are ones specially designated in bankruptcy law to be treated better than you ordinary debts.

For consumers, the most common priority debts are back child/spousal support payments and taxes. But as the last blog showed, you need to have a relatively unusual “asset” Chapter 7 case, meaning that you need to have an asset or assets that is not protected—not exempt—that you would surrender to the trustee.

It helps if when that asset is sold by the trustee the sale proceeds would be enough to pay off your priority debts, after paying any costs of sale (such as a broker’s commission) and the trustee’s fee.

Chapter 13 is much more likely to apply to your circumstances if you owe a bunch of priority debts.

Here are some ways that it is better than Chapter 7, and better than trying to pay your priority taxes or back support without any bankruptcy.

1. Be protected from the priority creditors: Tax authorities and state support agencies have been provided by law with extraordinarily aggressive collection powers against you. These often include the ability to seize your assets; garnish your wages, bank accounts, and business receivables without additional court proceedings; suspend your driving and occupational/professional licenses, and even hunting and fishing licenses.

Some of these collection efforts can even continue when you file a Chapter 7 case, and all can continue as soon as your Chapter 7 is completed, giving you just a three month or so break. In contrast, Chapter 13 stops virtually all of these collection efforts, so long as you comply with the terms of your payment plan, as well as keep current going forward.

2. Stop further accumulating interest and penalties: Usually in a Chapter 13 case, the interest and penalties on priority debt stops being added, and then is discharged at your successful completion of your case. If you have large income tax debt, this can significantly reduce the amount you would pay.

3. Get a more sensible budget: Your monthly obligation under Chapter 13 tends to be based on more realistic expenses than what the IRS or your support enforcement agency will allow..

4. Allows you to favor the priority debt over other debt: Usually you are able to and indeed must pay your priority debt ahead of and often instead of your “general unsecured creditors.” So you are able to concentrate your financial efforts on paying off the debts that are usually in your self-interest to pay anyway.

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What Are Priority Debts and Why Are They Important?

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.

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Do Bankruptcy Filing Go Up or Down As Credit Becomes More Available?

One of the best sources of intelligent information on bankruptcy and related topics is a blog by a bunch of law professors called Credit Slips, “A Discussion on Credit, Finance and Bankruptcy.” (Well, OK, it can get a little heady, but they’re professors, after all.)

In a blog called “Debt Causes Bankruptcy (But Sometimes in Counter-Intuitive Ways)” Prof. Robert Lawless, had this to say:

The long-term growth in U.S. consumer bankruptcies closely tracks the long-term growth in U.S. consumer debt. When the financial crisis hit, consumer credit dried up, and outstanding consumer debt experienced unprecedented declines.

There are fewer reasons to file bankruptcy today because there was less borrowing two to three years ago.

Consumer debt also has a profound but perhaps counter-intuitive short-term effect on consumer bankruptcy rates. In the short-run, a decline in consumer credit will lead to a bump in consumer bankruptcy filings.

As people run out of options–as they become less able to put this month’s grocery or utility bills on a credit card–bankruptcy becomes a more attractive option. People can and will continue to borrow to stave off the day of reckoning.

If a lender is willing to extend credit, further borrowing is a rational decision.

The take-away from this: 

1) Most debt is incurred because credit is available. So, more bankruptcies happen when more credit is granted. (The exceptions are debts not based on credit, such as lawsuits for personal injuries or other disputes.)

2) People with debt problems try to avoid filing bankruptcy if possible, so when credit is available to them they will tend to use it instead of filing bankruptcy, or at least will put off filing bankruptcy until they run out of credit. This indicates that people still generally hate filing bankruptcy, avoiding it when they can, even if it often only kicks the can further down the road.

This may sound commonsensical, but shows that the answer to the question in the title is a bit more complicated than it might seem.

The answer is that historically credit availability to consumers has resulted in higher bankruptcy filings, but a short-term increase in credit availability will lower bankruptcy filings on an immediate basis.


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