Divorcing While Bankrupt Lays Traps for the Unwary

When divorce coincides with bankruptcy, the debtor’s matrimonial lawyer should take counsel from a bankruptcy expert to avoid the kind of mistakes described in a decision by Bankruptcy Judge Kevin R. Anderson of Salt Lake City. Having a tax lawyer close at hand would be another good idea.

As Judge Anderson said in his December 4 opinion, “timing is everything” at the “intersection of bankruptcy and divorce law.”

The wife filed for divorce years before bankruptcy. In terms of the division of marital property, the dispute centered on the husband’s $225,000 retirement account.

The day before the wife filed a chapter 7 petition, she and her husband signed a stipulation awarding her the entire $225,000, with about $115,000 earmarked to clear up child support and alimony arrears. The remaining $110,000 represented a division of marital property.

A month after bankruptcy, the divorce court granted the divorce and entered a so-called QDRO, meaning a qualified domestic relations order. The QDRO implemented the parties’ stipulation by awarding the wife the entire amount in the husband’s retirement account, allocated between support, alimony and property settlement.

The wife claimed that the entire $225,000 was exempt, for one reason or another. The trustee principally objected to the claimed $110,000 exemption regarding the division of marital property. The trustee won.

Initially, however, it appeared as though the wife had won, in view of Section 541(c)(2), which provides that a restriction on the transfer of an interest in a trust under nonbankruptcy law, like ERISA, is enforceable in bankruptcy.

On the petition date, Judge Anderson found that the wife was the survivor-beneficiary in her husband’s retirement account, which was held in an ERISA-qualified pension trust. In view of ERISA’s anti-alienation provisions, he held that the funds in the retirement account were excluded from the estate by Section 541(c)(2) as of the petition date.

But that’s not the end of the story. Recall that the matrimonial court did not sign the QDRO until a month after the wife’s bankruptcy. The QDRO gave her the retirement account to cover $115,000 in support and alimony arrears and her $110,000 interest in marital property.

Significantly, Judge Anderson said there was nothing in the QDRO indicating that the funds were to be rolled over into a rollover IRA in the debtor’s name. Likewise, he said there was no evidence that the debtor intended to roll over the funds into an IRA, which might be exempt in her bankruptcy.

In addition, Judge Anderson said there was nothing as of the filing date making the wife the “alternate payee” of the husband’s retirement account. Only later did the divorce decree or the QDRO make the wife the “alternate payee” whose interest would be exempt under a Utah exemption statute.

Claiming to be an “alternate payee” would avail nothing, Judge Anderson said, because Section 522(b)(3)(A) only allows exemptions “applicable on the date of the filing of the petition,” and the debtor’s interest as an alternate payee did not come into existence until after the filing date.

Absent a rollover into an account that might be exempt, Section 541(a)(5)(B) came into play. That section brings property into the estate that the debtor receives within 180 days of bankruptcy as a result of a property settlement or divorce decree.

Because the $110,000 became property of the estate within 180 days of filing and was not exempt, Judge Anderson directed that the funds be turned over to the trustee for distribution to creditors.

Judge Anderson upheld the debtor’s exemption in that portion of the $115,000 attributable to child support arrears. He withheld ruling on the debtor’s claimed exemption for alimony arrears until the trustee completes discovery on how much was reasonably necessary for the support of the debtor and her children.

One more question: Because the husband’s retirement funds were not rolled over into an IRA, there could be income taxes or penalties owing on account of early withdrawal. So, who is responsible for the taxes? The husband, the debtor, the bankruptcy estate, or no one?