Protecting Yourself from Post-Divorce Bankruptcy
The threat of a potential bankruptcy is, in all too many divorces, a real one that should not be ignored. Recognize the warning signs and learn how to protect yourself.
Many divorce settlements have been undone by the filing of a petition in bankruptcy by the payor spouse – sometimes even before the ink has dried. As a direct consequence, what should have been a comfortable existence for the non-monied spouse will no longer be what had been anticipated.
It is reasonable to ask, “Were there warning signals I should have seen?” or “Could I have taken precautions to protect against this potentiality?”. Whether the bankruptcy be the handiwork of a vindictive former spouse or simply the unfortunate consequence of uncontrollable or unpredictable happenstance, sometimes it can be prevented.
In many middle-class divorces, there is little margin of safety – the ability of the monied spouse to make payments is inexorably tied to the financial vagaries of a closely-held family business, leveraged real estate or an executive position which is subject to the mercies of corporate downsizing. It is important when fine-tuning a settlement to take a step back and view the financial package (perhaps with the assistance of a CPA) to see if it can pass the “smell test” of comfortable cash flow.
If the marital estate has little or no liquidity, if the ability of the payor to make the structured payments is totally reliant upon the continued good fortune of a business or employment at current income levels, you may have a financial problem in the making. Particularly if the marital estate is leveraged, the danger of potential default is magnified by the slightest of financial reverses. Much like analyzing the financial statement of a business and coming to the conclusion that its working capital ratio is inadequate to meet a business downturn, so too is it possible to look at a divorcing party’s ability to make payments and conclude that any financial reversal, genuine or concocted, may cause bankruptcy.
Does the settlement agreement call for one or more large (or balloon) payments, particularly several months or a year after the agreement? This could be just enough time to let the dust settle and perhaps lend a slight aura of legitimacy to a filing of bankruptcy. Whether planned or not, the burden of a substantial property settlement payment, particularly if occurring at a time when finances are strained, may be sufficient to propel a spouse into bankruptcy court.
Another possible flag is where the monied spouse is too willing to consider a handsome property settlement (to be paid over a period of time) in lieu of a combination of ongoing support payments coupled with a smaller property settlement. A property settlement is relieved in bankruptcy, whereas a support obligation is not.
A payout that, in the context of what you know of the payor’s financial wherewithal, seems out of line, is another warning sign that what seems too good to be true may indeed be such. An important precaution is to consider redoing the balance sheet for the payor spouse, factoring in as an obligation the property settlement. If that exercise results in a negative balance sheet – liabilities exceeding assets – you may have a bankruptcy (perhaps even a planned bankruptcy) in the making.
Does the ability of the payor to make the payments rely heavily or solely on his/her continued income stream from a closely-held business, in which he/she has only a partial interest (particularly a minority interest), and the remainder of the interests are held by family or close friends? This may signal an increased likelihood for a bankruptcy. With a little cooperation from family and friends, it would not be too difficult to give at least a surface impression of things being worse than they are and direct one into a respectable impersonation of a bankruptcy.
Let us assume you are faced with a situation described above. What steps can you take to better protect yourself? One question to ask is whether any collateral is available. Unfortunately, in divorce, there is often no collateral that is truly adequate. You may have to accept (assuming you can get the payor to go along) a business as collateral. That works to a degree – though there is no protection against the business being driven into the ground. Nevertheless, this approach warrants consideration if the business has substantial assets that are not already otherwise pledged as collateral.
Another approach is to get as many assets up front as possible, leaving little on the table for a term payout. The more you receive initially, the fewer the risks arising from reliance on a former spouse. Unfortunately, in many middle-class divorces, there isn’t enough liquidity to get much up front.
Where there are assets, but not sufficient liquid assets, refinancing should be considered. For instance, assume you are to receive $500,000 as a property settlement – funds in this amount are not available, but there is a piece of real estate either unencumbered or slightly encumbered. A refinancing of that real estate might generate the dollars for an up-front payment. Certainly, many issues may weigh on whether a particular refinancing makes economic sense and you may have to accept a lesser gross amount in exchange for the benefit, security, and freedom of getting more up front.
Finally, if you have approached this from every possible angle and there simply isn’t any significant amount of liquidity available, consider structuring the agreement in the form of spousal support. Have the agreement explicitly call it spousal support (which means, unless stated otherwise, it will be taxable to the payee). Payments in the nature of support have a better chance of withstanding a bankruptcy discharge. Subject to negotiation skills and the relative positions of the parties, it is possible to have what would otherwise be a property settlement categorized as support payments, and have it agreed that these payments are not to be taxable to the recipient nor deductible by the payor. This is specifically permitted in the Tax Code.
The threat of a potential bankruptcy is, in all too many divorces, a real one that should not be ignored, and therefore one which demands your attention. Even if there is nothing you can do to prevent it, you need to be aware of this possibility. By doing so, you may avoid some of the shock and finger pointing should bankruptcy occur.
Kalman A. Barson, CPA/ABV, CFE is the founder of The BARSON GROUP, a CPA firm with offices in Somerville, New Jersey. Kal and The BARSON GROUP specialize in litigation support services — including financial investigations, income determination, business valuations, expert witness testimony, funds flow tracing, and related tax consulting and financial planning. Kal is a frequent lecturer, having spoken on behalf of the American Institute of CPAs, the New Jersey Society of CPAs, the Institute for Continuing Legal Education, various Bar Associations and legal groups and various other professional and business organizations. He is the author of four books on investigative accounting, and has had many articles published in professional publications. He is a member of the American Institute of CPAs, the New Jersey Society of CPAs, the Institute of Business Appraisers and the Association of Certified Fraud Examiners. Mr. Barson is also a past president of the National Associated CPA Firms. This article was first posted here in 2006.