Understanding divorce and bankruptcy

Which comes first: divorce or bankruptcy? One of the leading causes of divorce in Canada is financial mismanagement. And one of the leading causes of bankruptcy is divorce.

As an advisor, it’s your job to prepare couples for their worst-case scenarios in the event they split.

You should also identify whether or not your clients might benefit from the protections offered by the Bankruptcy and Insolvency Act of Canada (BIA).

Read: Should clients file taxes if they’re bankrupt?

Divorce and bankruptcy rules

A separation or divorce agreement whereby one partner agrees to assume a debt or liability is not binding on the creditor that advanced the money in the first place. So unless the creditor actually signs the agreement, the family court can’t absolve either spouse from a debt they jointly signed.

Many times, I’ve spoken to clients who say, “But my spouse was supposed to pay off that debt. It says so in our divorce.” Typically, the spouse has already filed for bankruptcy, so the creditor turns to the co-borrower of record to recover the debt.

Also, neither bankruptcy nor family court will try to over-rule each other’s issued orders. This means if a person files for divorce, and in the family court divorce order he agrees to sign his share of the matrimonial home’s equity over to his estranged spouse, the equity transfer will not be attacked in bankruptcy court.

Similarly, if a person files for bankruptcy, he loses the right to assign any of his non-exempt assets (like equity in a house) as part of a divorce. His assets are vested with his trustee, so he no longer has assets to split with his estranged spouse.

Read: Personal bankruptcies fall…for now

If a client is considering filing for divorce or declaring bankruptcy, help him understand his financial position, and his spouse’s, before deciding to file. In amicable dissolutions, partners can use a separation or divorce agreement to legally move family assets around in order to minimize their loss in bankruptcy. For example, a husband could agree to sign over the family home to his estranged wife for a child’s benefit. He could then file bankruptcy and the transfer of the house would likely be safe under the law.

The separation and divorce agreement must be bona fide (real)—many people have tried to use separation as a trick to protect assets in a bankruptcy only to be discovered by the court. A real agreement is supported by independent legal advice for both sides and there is some plausible basis for the asset transfer. In the example of the matrimonial home transfer, the reason is usually for the benefit of children.

The penalties for attempting to trick the court are severe. If the court determines the agreement is not real, it may:

• order the asset to be seized and sold;
• impose severe financial penalties on either or both spouse;
• refuse the discharge of the spouse that filed bankruptcy; or
• charge the bankrupt person with an offence under the BIA. Offences are punishable by fines and imprisonment.

Read: 40% of marriages begin in debt

Alternatives

Consumer proposals are an alternative to bankruptcy that may work to both spouses’ advantage in a divorce.

A consumer proposal is a legal procedure whereby a debtor (or debtors) offers to repay a portion of his unsecured debts. If a couple has a significant amount of joint debt, it may make sense to agree to repay the debt together. This could be done as a requirement of the divorce agreement, or concurrently to the divorce. In most cases that utilize the option of a joint proposal, the divorce is reasonably amicable and the proposal is not specifically referred to in the divorce agreement.

The funds for the proposal could come from the sale of assets, or from each spouse proportionally based on income. I have seen this done quite effectively to relieve both spouses from onerous levels of debt, thereby allowing them a fresh financial start following their divorce.

Read: Canadians squeezed by rising debt, dependants

No one expects their advisor to know all the ins and outs of insolvency law. What clients appreciate is an advisor who recognizes when they should speak to someone with that specialized knowledge.

Ted Michalos

Tax & Estate

Ted Michalos , B.A., CPA, is a Licensed Insolvency Trustee and co-founder of Hoyes, Michalos & Associates Inc. in Ontario, Canada.