“Spending Down” Disposable Income and Effective Pre-Bankruptcy Planning

November 10, 2010

By: David M. Serafin

For many (if not most) of my chapter 7 bankruptcy clients here in the Denver metro area, there’s simply no need to spend down disposable income which does not exist. As such, these clients are not required to take and pass the Means Test in order to obtain a chapter 7 discharge.

However, many other chapter 7 filers in Colorado with incomes higher than the Median Income (as determined by the U.S. Dept. of Justice) are required to pass the Means Test to qualify for chapter 7. (Spending down disposable income may mean the difference between discharging all unsecured debt in a chapter 7 versus being required to pay back a certain percentage back in a chapter 13 plan, particularly if there’s no reason to voluntarily opt for chapter 13 relief.)

Other debtors in Colorado, who either chose to file for chapter 13 (due to a pending foreclosure or to protect non-exempt property or a profitable business) or whose income requires a chapter 13 filing, similarly have incentive to validly spend down disposable income in order to lower their monthly “applicable commitment period” 60 months to 36 months, and/or to reduce their Plan payment. (A lower chapter 13 Plan payment means less monies required to be paid to unsecured creditors and the bankruptcy trustee.)

In my experience as a Denver bankruptcy lawyer, I really need to press clients to account for all of their monthly expenses. Once I have an itemization of such expenses, I often recommend that clients further spend down disposable income to achieve the most favorable treatment under the Means Test by doing one or more of the following:

• Purchase or upgrade existing health, disability or (term) life insurance,
• Make or increase existing contributions to an ERISA qualified retirement account (401(k) or IRA) or Health Savings Account,
• Donate to charity (up to 15% of Adjusted Gross Income as per IRS standards),
• Determine a monthly average for payments made for out-of pocket medical/dental expenses (including deductibles, co-pays and prescriptions), court ordered payments (for child support, spousal maintenance, non-dischargeable judgments), child care, school expenses or minor children, and financial support for an elderly or disabled person, and
• Even consider incurring additional secured debt such as from a mortgage or car loan (as the Bankruptcy Code gives these types of debts favorable status under the Means Test).

You’ll also want to account for all household members even those not deemed by the IRS tax laws as dependents, such as elderly family members. Even though the Means Test in Colorado requires that income for a household member is also included in the calculation, such income may be nominal (e.g. a minimum wage job for a teenager or monthly PERA pension payments for the retired).