"Priority" Debts in Chapter 7 Bankruptcy

 Posted on September 07, 2016 in Bankruptcy Procedure

Here’s what happens to “priority” debts in an “asset case.”

Our last blog post introduced “priority” debts. They are debts that are favored in bankruptcy because Congress has decided they are of a type that should be favored. Today we focus on how they’re favored in Chapter 7 “straight bankruptcy.”

Chapter 7 Trustee Usually Doesn’t Pay Any Debts, Including Priority Ones

Last time we said:

In most Chapter 7 cases the bankruptcy trustee does not take possession of any of your assets to distribute to your creditors. Because there are no funds for the trustee to pay any debts, priority debts do not come into play. But there are (relatively few) cases where there are unprotected assets for the trustee to liquidate. In those cases the trustee must pay the priority debts in full before paying the general unsecured ones anything.

So, in most Chapter 7 cases you get to keep everything you own; the bankruptcy trustee gets nothing. Those are called “no asset cases”—the trustee has no assets to collect and distribute among your creditors. And because the trustee is paying none of your debts out of your unprotected assets, the order in which the trustee would pay the debts makes no practical difference. It doesn’t matter whether you owe any priority debts because the trustee is paying nothing to anybody.

So let’s look at the more unusual situations where you owing priority debts would make a difference. These are “asset” cases, in which the bankruptcy trustee does pay some of your debts, likely your priority ones.

Consumer Priority Debts

Let’s first remember that there are only two types of priority debts in most consumer bankruptcy cases: 1) all child and spousal support owed at the time of the bankruptcy filing; and 2) income taxes that meet certain conditions.

Of these two, support debts have a higher priority. That is, the Chapter 7 trustee pays a support debt in full before paying anything on a priority income tax debt. And the trustee would pay both priority taxes in full before paying any other debts.

In an “Asset Case” the Priority Debts Are Paid in Full Ahead of Other Debts

So let’s now show how this works in an example of an “asset case.”

Imagine that you owe $4,000 in back child support and $5,000 in income taxes for last year. These are both priority debts. The support is because that’s always a priority debt. The income tax is a priority debt because it’s new enough to meet the conditions making it a priority debt.

You also owe $90,000 in other debts—credit card balances, medical bills, personal loans. None of these are priority debts.

Also imagine that you own a $10,000 boat free and clear. It is not protected from a bankruptcy trustee; it’s not “exempt.” You can no longer afford to insure, maintain, and operate the boat, so you don’t mind giving it up. You file a Chapter 7 case knowing that the bankruptcy trustee will get the boat from you, sell it, and pay the proceeds to your creditors.

You especially don’t mind this when you learn two things. First, you learn that the support and income tax debts are priority debts, to be paid ahead of your other debts. Second, you learn that those two debts would not be discharged in your Chapter 7 case. That is, you’d continue to owe them after your Chapter 7 case would be completed. You’re happy to hear that debts that you’d still have to pay would instead likely be paid in part or in full out of the boat’s sale proceeds.

So What Happens?

The Chaper 7 trustee sells your boat for $10,000. The bankruptcy court gives permission to pay him or her $2,500 in compensation for services. (See Section 326(a) of the U.S. Bankruptcy Code.) That leaves $7,500. Out of that the trustee pays the $4,000 child support debt in full. He or she then pays the $3,500 that’s left towards the $5,000 income tax debt. That leaves $1,500 of the tax debt not paid. The trustee does not pay anything on the $90,000 in other debts because there’s no money left to do so.

The end result is that $7,500 of debts that you would have had to pay after bankruptcy are instead paid by the trustee through the boat sale proceeds. Yes, the $2,500 the trustee received is arguably wasted to you. And yes, you’d still need to pay off the remaining $1,500 in taxes (likely through a reasonable monthly payment plan).

But in the right circumstances it’s quite a good deal. If you didn’t owe any support or taxes the trustee would distribute the $7,500 among your $90,000 in general debts. Those are debts that most likely would have simply been discharged in the Chapter 7 case. You would owe nothing on them regardless what the trustee paid or didn’t pay. The boat proceeds would have done you no personal good.

In our scenario, in contrast, the majority of the boat proceeds ARE doing you personal good. Those sale proceeds are going to eliminate or reduce debts that otherwise you would have had to pay in full out of your own pocket after the bankruptcy case was over.