Here’s an edited version of my colleague’s question:
A Chapter 7 debtor who is a real estate broker had some listings prepetition. He opened escrow postpetition, and eventually sold the properties. He received a $20,000 commission, none of which can be exempted. The Trustee has demanded all the commission received. What can be done?
Here’s my response:
Three cases that help to answer the question from different vantage points are: In re Fit zsimmons, 725 F. 2d 1208 (9th Cir. 1984), In re Ryerson, 739 F. 2d 1423 (9th Cir. 1984), and In re Wu, 173 B.R. 411 (B.A.P. 9th Cir. 1994).
I. The Key Statutory Provision
According to 11 U.S.C. § 541(a), when a debtor files for bankruptcy protection, the act of filing the papers “creates an estate.” The prepetition debts then become postpetition claims against that estate.
In a Chapter 7 bankruptcy, the Chapter 7 Trustee liquidates the estate to produce a dividend to the debtor’s creditors. The debtor can exclude assets from that estate by appealing to an appropriate exemption table (Cal. Civ. Proc. Code § 704 for homeowners with equity in their principal residence, and Cal. Civ. Proc. Code § 703.140 for everyone else). Anything the debtor cannot exempt is fair game for the Trustee to seize.
What goes into the estate? The gist of 11 U.S.C. § 541(a) is that everything the debtor owns or has an interest in on the day of filing the bankruptcy papers, anything the debtor becomes entitled to through bequest, inheritance, devise, or through life insurance proceeds during the 180 days after the petition day, and anything that is the fruit of estate assets (e.g., interest earned on an estate asset) is part of the estate.
But § 541(a)(6) has a carve-out for income earned by the debtor for services rendered postpetition. It is this provision that is at the heart of the answer to my colleague’s question.
II. Chapter 11 Bifurcation Of Income Prior To October 17, 2005
In In re Fitzsimmons, 725 F. 2d 1208 (9th Cir. 1984) the debtor, a sole practitioner attorney, filed a personal Chapter 11 bankruptcy. Prior to filing the debtor had a contingency-fee case pending on which he did postpetition work. For reasons not mentioned, the Court appointed a Chapter 11 Trustee. (This is rare, and happens only if there is malfeasance or incompetence on the part of the debtor. See 11 U.S.C. § 1104.)
The Bankruptcy Court entered an order requiring the debtor to remit all of the proceeds from the case to the Trustee. The Debtor appealed, claiming that the portion of the proceeds that were attributable to postpetition services performed fell under the language in 11 U.S.C. § 541(a)(6) that excludes from the estate “earnings from services performed by an individual debtor after the commencement of the case.” The Bankruptcy Appellate Panel for the Ninth Circuit reversed the Bankruptcy Court and the Trustee appealed. The Ninth Circuit held:
The Bankruptcy Appellate Panel reversed the decision of the Bankruptcy Court “insofar as it holds that post-bankruptcy earnings from services performed by an individual debtor are property of the estate in a Chapter 11 case.” . . . The decision of the Bankruptcy Appellate Panel is affirmed.
In re Fitzsimmons, 725 F. 2d at 1212 (internal cite omitted).
The key here is that because of § 541(a)(6), in 1984 earnings for services actually performed postpetition were not property of the estate ― except, of course, in a Chapter 13 because of 11 U.S.C. § 1306(a)(2) ― and had to be distinguished from “[p]roceeds, product, offspring, rents, or profits of or from property of the estate . . .” (11 U.S.C. § 541(a)(6)) Thus, a court had to determine which portion of the income was from services performed postpetition (to which the debtor was entitled), and which was merely offspring of assets already in the estate on the petition day.
On October 17, 2005, Congress added 11 U.S.C. § 1115 to the Bankruptcy Code, which put the postpetition earnings of an individual Chapter 11 debtor back into the estate. Therefore, in personal Chapter 11 cases Fitzsimmons probably no longer has any application. However, the reasoning in Fitzsimmons still applies in personal Chapter 7 cases because the § 541(a)(6) carve-out still applies in those cases.
III. Chapter 7 Bifurcation Of Income
A. In re Reyerson
In In re Ryerson, 739 F. 2d 1423 (9th Cir. 1984) the Ninth Circuit faced a fact pattern similar to that in Fitzsimmons, but in the Chapter 7 context.
In Reyerson the debtor’s employment was terminated almost nine months after he filed for bankruptcy protection. His employment contract contained a provision that entitled him to his service commissions upon termination. The Ninth was asked to determine whether the Chapter 7 Trustee was entitled to all of the commissions.
Echoing its Fitzsimmons opinion, the Court held:
The Bankruptcy Appellate Panel determined that only the debtor’s interest at the time of bankruptcy is property of the estate; any interest attributable to post-filing services was expressly excluded from the estate. We agree. Section 541(a)(6) excludes from the estate “earnings from services performed by an individual debtor after the commencement of the case.” Thus any portion of the $18,588 related to services performed after February 10, 1981 are [sic] not includable within the bankruptcy estate.
In re Ryerson, 739 F. 2d at 1426.
B. In re Wu
In In re Wu, 173 B.R. 411 (B.A.P. 9th Cir. 1994) the Chapter 7 debtor was an insurance agent who had sold policies prepetition. She was entitled to policy renewal commissions from those policy holders who renewed their coverage. The Chapter 7 Trustee demanded turnover of all the money. In its summary of the relevant facts, the Bankruptcy Appellate Panel for the Ninth Circuit stated:
[T]he bankruptcy court determined that the renewal commissions were not property of the estate because the payment of the commissions depended upon postpetition services by the debtor and the commission payment structure adopted by the Career Agent Agreement reflects that the renewal commissions are allocated to services performed postpetition.
In re Wu, 173 B.R. at 413.
In addressing the Trustee’s claim to all of the money, the Panel held:
This all or nothing approach is inconsistent with Fitzsimmons and Ryerson, which, in evaluating earnings having both a prepetition and a postpetition component, caution us to determine the extent to which the earnings are attributable to prepetition property or prepetition services. The proper analysis under Ryerson and Fitzsimmons is to first determine whether any postpetition services are necessary to obtaining the payments at issue. If not, the payments are entirely “rooted in the pre-bankruptcy past,” Ryerson, 739 F.2d at 1426, and the payments will be included in the estate. If some postpetition services are necessary, then courts must determine the extent to which the payments are attributable to the postpetition services and the extent to which the payments are attributable to prepetition services. That portion of the payments allocable to postpetition services will not be property of the estate. That portion of the payments allocable to prepetition services or property will be property of the estate.
In re Wu, 173 B.R. at 414-15.
IV. My Advice To My Colleague
In sum, your burden is to establish the portion of the commissions that are attributable to postpetition services performed by your client because that is the portion that belongs to your client. If the only thing that existed prepetition was the listing, then your client clearly had to perform postpetition services to get the commissions. Even if your client has poor records, he must have some dated documents showing that the escrow opened postpetition. Does he have records that can be used to establish that the house hadn’t been shown to anyone prepetition? You may have to use a different real estate broker as an expert witness to testify to the services a broker must perform to sell a house. If the house hadn’t been shown prepetition, then none of those services were performed prepetition.
Finally, try negotiating with the Trustee. Let the Trustee know about the holdings in Fitzsimmons, Ryerson, and Wu, and point out that any litigation will squander at least some of the money. Why not agree to an apportionment without litigation? While your client might not be too thrilled about giving up any of the money, he may need a reality check: Litigation is expensive.