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What’s So Special About “Priority” Debts?

Sept. 27, 2013

“Priority” debts are treated much better than other unsecured debts, but you can use that to your advantage in Chapter 7 bankruptcy.

Different Types of Debts

You may have heard that your debts are not all treated equally under the law in bankruptcy.

Most debts can be “discharged” (legally written-off). But some—such as child and spousal support–can’t be. Others—such as student loans and income taxes—can be discharged only under certain conditions.

Some debts have no collateral—they are said to be unsecured. Others are secured debts—they are legally attached collateral. A secured debt can be treated differently based on the worth of the collateral compared to the amount of the debt. You often have a choice to either retain or surrender the collateral.

Priority Debts

Today’s blog post is about a special type called priority debts. They are a list of debts which Congress has decided deserve special treatment. In most situations they get paid in your bankruptcy case ahead of other debts.

For consumers this priority list only comes into play in “asset” Chapter 7 cases and in Chapter 13 cases. In an “asset” Chapter 7 case the bankruptcy trustee collects and distributes assets, and the priority debt laws help direct how the proceeds of those assets get distributed. In a Chapter 13 case, the plan which directs how the plan payments to the trustee get distributed must comply with the priority debt laws.

This blog post will cover the “asset” Chapter 7 cases; the next one will cover Chapter 13 ones.

The 10 Priority Debts

The ten different priority debts are listed in Section 507 of the Bankruptcy Code in order of priority. Priority debts get paid in a bankruptcy case ahead of debts that are not priority debts. In addition the priority debts themselves get paid in the order that they are listed.

Most priority debts are not applicable to a conventional consumer bankruptcy—by way of example a certain amount of wages owed to an employee earned within a certain period of time would be a priority debt. But two kinds of the priority debts do pertain:

  1. child and spousal support arrearage, and

  2. tax debts of various kinds.

The support debt is listed as a higher priority than taxes, and indeed is the highest one on the entire list.

Priority Debts in an “Asset” Chapter 7 Case

Most Chapter 7 cases are “no asset” ones—all your assets are protected from creditors through “exemptions.” So you keep everything you own and nothing goes to the Chapter 7 trustee to distribute to your creditors. Therefore, the priority laws do not apply.

But in an “asset” Chapter 7 case, you own something that is not covered by any exemption, so the trustee can take, sell, and distribute its proceeds to your creditors. The priority laws are often crucial in that distribution process, particularly because the common result is that priority debts are the only ones paid.

Using the Priority Laws to Your Benefit in an “Asset” Chapter 7 Case

If you have a particular “non-exempt” asset, perhaps something that you do not mind surrendering to the trustee, and if you owe a priority debt, a Chapter 7 case can be way to turn these circumstances creatively to your benefit.

Most priority debts are also not dischargeable in a Chapter 7 case—examples being recent income taxes and child support arrearage. That means that after when you receive the discharge of your debts, you would continue to owe those two debts. So it would be handy if these taxes and/or support arrearage would be paid off or paid down by the Chapter 7 trustee’s sale, when he or she liquidates your unprotected asset and pays your creditors.

Here’s an illustration to make sense of it. Assume you own a boat free and clear with a marketable value of $5,000 that you really don’t want any more because you’d rather not pay its monthly moorage rent and constant maintenance costs. Also assume that it is not exempt, so you surrender it to your Chapter 7 trustee. You owe $1,350 in last year’s income taxes, plus $2,400 in back child support. You could have sold the boat before filing bankruptcy and used the proceeds to pay the taxes and support, but it wasn’t the right time of year, plus you could not wait because a creditor was garnishing your paycheck. So here the trustee would sell the boat, pay herself the trustee fee (25% of the first $5,000 collected, so $1,250), pay first the support obligation and then the tax debt. If the boat sold for $5,000, you would finish your Chapter 7 case owing neither of those priority debts. ($5,000 minus the trustee fee of $1,250 = $3,750 minus $2,400 support = $1,350 leaves just enough to pay off the income tax.) If all your other debts would be discharged, that would leave you current with your support and income tax, and otherwise debt-free.