As you likely know, all your debts are not treated equally in bankruptcy. Most debts can be discharged (legally written-off), but some can’t, or can only be under certain circumstances. Some debts are unsecured while others are secured by collateral. How the secured debts are treated depends on the collateral’s value, and whether you are surrendering or trying to keep that collateral. And then there are priority debts.
Priority debts are a list of debts which Congress has decided should get paid through your bankruptcy case ahead of other debts. This list is only relevant if some of your creditors are being paid through your case. So for consumers it only applies to “asset” Chapter 7 cases and Chapter 13. I’ll tell you about Chapter 7 today, then Chapter 13 in an upcoming blog.
There are 10 categories of priority debts. In fact, these ten are listed in the Bankruptcy Code in order of importance so that any category of debts higher on the list gets paid in full before the next one on the list gets anything.
Most of the 10 categories do not apply to a conventional consumer bankruptcy case. But two are very common: 1) back child and spousal support, and 2) many kinds of tax debts. The support debt is prioritized higher than taxes, and in fact is #1 on the list.
Priority debts are important in an “asset” Chapter 7 case—one in which the trustee collects some assets from you to liquidate (turn into cash) and distribute to your creditors. The vast majority of Chapter 7 cases are “no-asset” ones—everything you own is covered by “exemptions” so that the trustee cannot collect anything from you. But if you have a particular “non-exempt” asset, especially one that you do not mind surrendering to the trustee, AND you also owe a priority debt, a Chapter 7 case may be your best option. Most priority debts are not dischargeable in a Chapter 7 case, so it’s great when you can get them paid off during your bankruptcy.
Here’s an example to show how this works. Let’s say you own a boat free and clear worth about $5,000 that you can no longer afford to keep up and are willing to surrender. You owe $1,300 in last year’s income taxes, plus $2,200 in back child support. You could sell the boat before filing the bankruptcy and pay the taxes and support, but you may not have time to do so because of a garnishment or some other urgency. The Chapter 7 trustee would sell the boat, pocket a trustee fee (25% of the first $5000 collected), pay the support obligation in full, and then pay the remaining money towards the tax debt. Assuming the boat was sold for close to $5,000, you would finish your Chapter 7 case owing little or no priority debt, and probably owing no other debt either. Carefully planned and executed, Chapter 7 can be a good tool to accomplish this.