What happens to the property of a spouse when the other spouse files bankruptcy in the midst of divorce proceedings? This is an incredibly complicated area for parties and practitioners alike since both bankruptcy and divorce concern sensitive property division issues.
A recent ruling from Judge Doyle of the bankruptcy court in Chicago in In re Zachmann illustrates some of these property division principles under Illinois law when divorce and bankruptcy intersect. Zachmann considered the effect of an Illinois state court’s divorce judgment equitably dividing marital property between former spouses while a bankruptcy is pending. In that case, over the objections of the debtor/ex-spouse, her case’s bankruptcy trustee and her former corporation, the court found that the state court order granting an 100% award of stock of the corporation to the other ex-spouse fully vested ownership of that property in him. In so ruling, the court found that the state court’s ruling divested the bankruptcy estate of any right to the stock. [FN1]
The treatment in bankruptcy of property distributed in marital dissolution proceedings depends on largely on the law of the state under which the marital property is being divided. [FN2] An award of marital property in many states does not vest until the state court enters an order equitably distributing the property. In Illinois, however, each spouse gets a property interest in all marital property, no matter which spouse holds legal title to the property, that vests when the divorce petition is filed. [FN3] This contingent interest then ripens into a full ownership interest for any property distributed to such spouse upon a final judgment for property distribution entered by the state court or bankruptcy court. [FN4]
Section 541(a) of the Bankruptcy Code provides that property of the bankruptcy estate includes all interests held by the debtor at the commencement of the case, but Section 541(d) also provides that a bare legal interest belonging to a non-debtor is not property of the estate. When a divorce petition is filed before either spouse files for bankruptcy in a state like Illinois giving spouses rights in property before the final divorce judgment, the non-debtor spouse has a pre-petition vested equitable interest in all marital property. [FN5] Conversely, the bankruptcy estate only holds the debtor-spouse’s contingent interest in marital property.
When the final judgment of equitable distribution of property is entered, therefore, the contingent interest ripens into a full ownership interest. As noted by a federal appeals court considering a similar situation, at that point, the estate’s interest “vanishes.” [FN6] In the case before the court in Zachmann, the bankruptcy court modified the automatic stay to allow the divorce proceedings to go forward in state court, including entering an order of equitable distribution of marital property. Once that order was entered, the contingent interests of the parties became fully determined, and the ex-spouse was entitled to full ownership of the property awarded to him.
[FN1] In re Zachmann, 2013 WL 1316647, No. 10 B 32410 (Bankr. N.D. Ill. April 2, 2013).
[FN2] Id. citing Ford v. Skorich, 482 F.3d 21, 24-25 (1st Cir. 2007).
[FN3] Id. citing Section 503(e) of the Illinois Marriage and Dissolution Act, 750 ILCS 5/503(e).
[FN4] Id. citing Skorich, 482 F.3d at 24-25, Voiland v. Kimmel (In re Kimmell), 480 B.R. 876, 886-87 (Bankr N.D. Ill. 2012), In re Dzielak, 435 B.R. 538, 547 (Bankr. N.D. Ill. 2010).
[FN5] Id. citing 11 U.S.C. §§ 541(a), (d).
[FN6] Id. citing Skorich, 482 F.3d at 24 and other cases.