03 Jun Demystify the Bankruptcy Process, Part II: To Discharge, or Not To Discharge
Through a series of quarterly articles, I aim is to demystify the bankruptcy process for our colleagues and demonstrate that it need not be intimidating. I will provide actionable insights designed to enhance your practice. Whether you are a litigator, family law attorney, real estate practitioner, or probate lawyer, these articles will help you understand the potential impact of bankruptcy filings on your area of expertise.
This next article will focus on the Holy Grail in most bankruptcy case: a discharge of debts. Each chapter of the Bankruptcy Code has its own specific section dealing with discharge as set forth below:
- In a Chapter 7 Case (Liquidation), Section 727 of the Bankruptcy Code applies;
- In a Chapter 11 Case (Reorganization), Section 1141(d) of the Bankruptcy Code applies;
- In a Subchapter V, Chapter 11 Case (Small Business Reorganizations), Section 1192 of the Bankruptcy Code applies;
- In a Chapter 12 Case (Family Farmers & Fishermen), Section 1228 of the Bankruptcy Code applies; and,
- In a Chapter 13 Case (Regular Wage Earner’s Plan), Section 1328 of the Bankruptcy Code applies.
My objective in this article is not to overwhelm the reader with an exhaustive dissertation on each statutory provision. Rather, a broader understanding of the types of debt that cannot be discharged (under Section 523 of the Bankruptcy Code) will be far more valuable. With that in mind, let’s explore some of the most significant categories of “non-dischargeable debt”—some of which are clearly defined, while others are subject to interpretation.
There is broad consensus that sound public policy justifies the classification of certain debts as “non-dischargeable”. Among these, two stand out: (i) child support obligations; and (ii) “debts arising from death or personal injury caused by the debtor’s operation of a motor vehicle, vessel, or aircraft while unlawfully intoxicated by alcohol, drugs, or other substances”. Furthermore, beyond child support, “domestic support obligations” in general remain non-dischargeable, reinforcing the legal priority placed on financial responsibilities to dependents. Importantly for my Family Law friends, the following debt is non-dischargeable in. Chapter 7 Cases, but is dischargeable in Chapter 13 Cases:
“[Debt owed] to a spouse, former spouse, or child of the debtor and not [a domestic support obligation] that is incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement, divorce decree or other order of a court of record, or a determination made in accordance with State or territorial law by a governmental unit…”
Other forms of debt discharge are far more contentious. One particularly debated issue during the previous presidential administration was student loan forgiveness, given the staggering $1.62 trillion in outstanding student debt, approximately 92% of which consists of federal loans. Generally, student loans are not dischargeable in bankruptcy. However, if a debtor—the individual responsible for the debt—can demonstrate undue hardship on both themselves and their dependents, a Bankruptcy Court has the discretion to grant a discharge. However, most bankruptcy attorneys will tell you that establishing undue hardship is tremendously difficult given the level of scrutiny that will be applied by the Court.
What about taxes? Well, it depends on the type of tax. For example, income taxes are dischargeable if (i) the tax debt is predicated on a tax return that was due at least three years before the bankruptcy filing (including extensions); (ii) the return was filed at least two years before the bankruptcy, and (iii) the tax debt must have been assessed at least 240 days before filing for bankruptcy (or not yet assessed). But other taxes are never dischargeable. The most common is payroll taxes and other trust fund taxes; they are never dischargeable. And, if the IRS already assessed a tax lien, a bankruptcy filing will be unhelpful (unless the bankruptcy case is filed within 90 days of the lien being established).
The final three categories of non-dischargeable debt frequently become the subject of litigation in Bankruptcy Court. Establishing non-dischargeability in such instances is inherently complex, typically requiring a trial before the Bankruptcy Court, unless a prior court has already made determinations of fact that resolve key issues. Such non-dischargeable debts are debts that are owed:
- for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny;
- for willful and malicious injury by the debtor to another entity or to the property of another entity; and,
- for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by—false pretenses, a false representation, or actual fraud.
Extensive legal scholarship exists on each of these three categories of non-dischargeable debt. However, the practical realities (which exist in any litigation) are as follows:
- Litigating non-dischargeability requires a trial, a process that is both costly and time-consuming.
- Creditors must weigh the financial burden of litigation against the potential benefit of securing a non-dischargeable judgment—particularly against a debtor who has already liquidated their assets through bankruptcy.
- Courts generally favor granting a fresh start to the “honest but unfortunate” debtor, making non-dischargeability under these categories relatively rare.
In my experience, when the evidence is ambiguous, the benefit of the doubt typically goes to the debtor. Thus, unless there is compelling, indisputable proof supporting a claim under one of these exceptions, successfully obtaining a non-dischargeable judgment against a Debtor is unlikely.