In my last post I began to set the stage for a discussion of § 706(b) motions to convert a Chapter 7 bankruptcy case to one under Chapter 11 by considering § 707 motions to dismiss. I noted that § 707(b)(2) only applies to individual cases in which the debtor’s debts are primarily consumer debts.
In today’s post I’ll focus on the question of what kinds of debts are nonconsumer debts because in determining whether a Chapter 7 case should be dismissed, there can be a battle over which debts are nonconsumer and which are consumer.
II. Nonconsumer Debts
The obvious starting point for this discussion is 11 U.S.C. § 101(8): “The term ‘consumer debt’ means debt incurred by an individual primarily for a personal, family, or household purpose.”
The statute does not distinguish between secured and unsecured debt, so the home mortgage must be included in the calculation. This fact alone means that most individual homeowners will probably not be nonconsumer debtors. (Please pardon the somewhat awkward double negative construction. It is necessary because our focus is on nonconsumer cases.)
At first blush this definition seems straightforward, and clearly must include a home mortgage on the principal residence, a car loan for the family car, and credit card charges used to pay for groceries for the household and to pay home utility bills.
Consumer debt must exclude business debt. “Debt incurred for business ventures or other profit-seeking activities is plainly not consumer debt for purposes of section 707(b).” In re Kelly, 841 F. 2d 908, 913 (9th Cir. 1988).
So we add up the business debt, and divide by the total of all the debts. If the result is more than 0.5, it’s a nonconsumer case. Otherwise it’s a consumer case. And that’s the end of it, right?
Not quite; things are a bit more complicated. Just because a debt is not a business debt does not mean it is a consumer debt.
[W]hile debts incurred with a profit motive clearly are not consumer debts, the reverse is not true: a debt that is not incurred with a profit motive may, or may not be, a consumer debt. In re Grillot, 2017 WL 4286882, at *4 (Bankr. D. Kan.); In re Brashers, 216 B.R. 59, 61 n. 2 (Bankr. N.D. Okla. 1998).
In re Garcia, 606 B.R. 98, 106 (Bankr. D. N.M. 2019).
Moreover, since the definition of “consumer debt” concludes with the word, “purpose,” an important part of the analysis must include determining the purpose for which the debt was incurred.
It is the purpose for which the debt was incurred that determines whether it is a consumer debt. In re Kelly, 841 F.2d 908, 913 (9th Cir. 1988). In determining a debtor’s purpose for incurring a debt, the Court must examine the totality of the circumstances as they existed at the time that the obligation was incurred. Millard, 585 B.R. at 187.
In re Stine, 254 B.R. 244, 249 (B.A.P. 9th Cir. 2000) (emphasis added).
What about tax debts? Are they consumer or nonconsumer debts? What about student loans? What if the principal residence is a duplex and the debtor rents out one of the units? Should the mortgage be bifurcated into consumer and nonconsumer parts? Same question if the debtor conducts a business out of the principal residence. Suppose the debtor is an actor who has cosmetic surgery to get roles more easily. Are those medical debts consumer or nonconsumer?
Can the debtor pay down enough consumer debt prior to filing to turn it into a nonconsumer case? Maybe. But that can create a preferential transfer problem, so timing is very important. See 11 U.S.C. § 547 for details.
Because I recently faced a § 706(b) motion filed by the IRS against my client whose debts were primarily tax debts, let’s begin with tax debts.
B. Tax Debts
Pace an unfortunate statement by Harry Reid, a tax debt is an involuntary debt. An involuntary debt is not a consumer debt. The Court in In re Westberry, 215 F. 3d 589, 591 (6th Cir. 2000) identified four reasons why tax debts are not consumer debts. I realize that it’s usually considered bad form to provide an extended quote, but seeing all four reasons helps to put tax debts in their proper perspective. Here are the four reasons:
First, a tax debt is “incurred” differently from a consumer debt. Although it is true that tax debts may be incurred under the Bankruptcy Code, this incurrence is not voluntary on the part of the taxpayer. See Reiter, 126 B.R. at 964; see also Marshalek, 158 B.R. at 706 (stating that “volition is essential” to a classification as consumer debt in finding that a vehicular accident judgment was not consumer debt under Chapter 7). We may at least hope to choose to incur consumer debt; its certainty being nothing like death and taxes. See Letter from Benjamin Franklin to Jean-Baptiste Le Roy (Nov. 13, 1789).
Second, consumer debt is incurred for personal or household purposes, as stated in the statute, while taxes are incurred for a public purpose. See Stovall, 209 B.R. at 854 (stating that taxes are “imposed by a government for the public welfare” in the course of finding that unpaid personal property tax on the debtor’s car was not consumer debt for purposes of the codebtor stay). The Supreme Court has long noted, in other contexts, the public purpose of the imposition of taxes. See, e.g., Citizens’ Sav. & Loan Assoc. v. City of Topeka, 20 Wall. 655, 87 U.S. 655, 664, 22 L.Ed. 455 (1874) (“We have established . . . beyond cavil that there can be no lawful tax which is not laid for a public purpose.”).
Third, taxes arise from the earning of money, while consumer debt results from its consumption. See Greene, 157 B.R. at 497; Harrison, 82 B.R. at 558; Pressimone, 39 B.R. at 244. Different events give rise to tax debt than to consumer debt—Westberry’s obligation to the IRS arose from the earning of income, not from his expenditure on personal and family items.
Finally, unlike taxes, consumer debt normally involves the extension of credit.
In sum, tax debts are not consumer debts.
C. Student Loans
The question of whether a student loan is a consumer debt has the old weasel answer: It depends. According to the Bankruptcy Appellate Panel of the Tenth Circuit:
[S]tudent loans are not consumer debts per se. The primary purpose for which the debt was incurred must be determinative. There may be circumstances in which the debtor can demonstrate that the student loan was incurred purely or primarily as a business investment, albeit an investment in herself or himself, much like a loan incurred for a new business.
In re Stewart, 215 B.R. 456, 465 (B.A.P. 10th Cir. 1997) (emphasis added).
For example, in Palmer v. Laying, 559 B.R. 746 (D. Colo. 2016), the Court began with the profit-motive test, and held that because debtor had incurred his student debt while he was employed, to get a doctorate as a prelude to starting a business, the debt was a nonconsumer debt.
Indeed, much of the case law around the country focuses on the profit motive as the starting point for the consumer versus nonconsumer analysis. However, as the Garcia (supra) Court held, and as the tax debt classification illustrates, just because a debt was incurred without a profit motive does not make the debt a consumer debt. Of course, while most people incurring student loans can claim to be intending to get better employment by obtaining an advanced degree, courts have held that many of those loans are consumer debts.
For example, the debtor in In re Stewart, 175 F. 3d 796 (10th Cir. 1999) had a large student debt he incurred to go to medical school. The Court affirmed the lower courts’ holdings that the debt was consumer debt, in part, because a significant portion of the student debt went to cover the family’s living expenses.
In sum, if you can show a very clear profit motive, the Court may hold that the student loan debt is nonconsumer debt. But if your client took out student loans to get a degree in History, English Literature, or Drumming, the Court will probably reject the nonconsumer classification. To my amazement, there are schools that offer Drumming degrees.
D. Home Loans
If a debtor takes out a mortgage to buy a home that will serve as the principal residence — without additional facts — one would have to conclude that the debt was incurred primarily for a personal, family, or household purpose. This was the holding in In re Kelly, 841 F. 2d 908, 913 (9th Cir. 1988) (“It is difficult to conceive of any expenditure that serves a ‘family … or household purpose’ more directly than does the purchase of a home and the making of improvements thereon.”)
An overwhelming majority of courts that have considered the issue of whether debt secured by real property used as a debtor’s personal residence is consumer debt have held in the affirmative, as a personal residence is intended primarily for personal, family, or household use rather than for profit.
In re Woodward, 2009 WL 1651234, at *2 (Bankr. M.D. N.C. June 10, 2009).
Applying this principle, the Court in In re Grover, 12-01069 (Bankr. N.D. Iowa 2013) held that the mortgage on a home the debtor initially bought as a residence, and later rented out, was a consumer debt. The intention at the time the debt was incurred, rather than the changed intention much later, controlled the analysis.
What additional facts would change that conclusion?
The facts in In re Cherrett, 873 F. 3d 1060 (9th Cir. 2017) led the Ninth Circuit to conclude that the home loan Mr. Cherrett received from his employer was not a consumer debt.
Mr. Cherrett’s employer offered a home loan as part of his compensation package as a way to induce him to relocate to Aspen because the salary it offered was insufficient to allow him to buy even a small condo in Aspen. He viewed it as temporary housing, fully intending to return to his home in Jackson Hole, Wyoming. While he stayed in the condo, his family remained in Jackson Hole. He regularly visited them.
After the market crash in 2008, his employer made it clear that it would not relocate him to its new development in Jackson Hole, so he resigned.
Based on these facts, the Court affirmed the lower court’s denial of the employer’s motion to dismiss under § 707(b), holding that the loan was a nonconsumer debt:
[T]he bankruptcy court found that Cherrett primarily had a business purpose — not a personal, family, or household purpose — for incurring the Housing Loan. Cherrett testified that he accepted Aspen’s offer and the Housing Loan so that he could “grow in salary and responsibility” and have the opportunity to oversee expansion of the Little Nell Hotel brand. The bankruptcy court found that Cherrett incurred the debt “so he could work at a very prestigious, top of the line, equal to the Four Seasons, equal to the best hotels in the world,” resort. The record leaves little doubt that the Housing Loan helped entice Cherrett to “leave a secured position.”
Cherrett, at 1068.
(The hotel’s name reminds me of Oscar Wilde’s witticism about Charles Dickens’ novel, The Old Curiosity Shop: “One must have a heart of stone to read the death of little Nell without laughing.”)
This result is a bit unusual because, as in Kelly, Woodward, and Grover most home loans are clearly consumer debts that are incurred to buy the family home. But in this case Cherrett had a clear business reason for incurring the loan: It was for his professional development.
Another case in which the debtor won was In re Pedigo, 296 B.R. 485 (Bankr. S.D. Ind. 2003). There the debtor had a home that served as his principal residence. He later took out a mortgage to buy the adjacent property. The Court held that the mortgage was a nonconsumer debt because the debtor’s “primary intent for purchasing the property was to supplement his income during retirement by leasing the new property to tenants.” Pedigo, at 491. Once again the profit motive controlled the analysis.
E. Medical Debts
In spite of all the cosmetic surgery that actors and actresses have to improve their ability to get roles, I found no cases ruling on the consumer versus nonconsumer status of such debts. My guess is that if a thespian could show that the surgery was done solely to increase the likelihood of employment, a court would classify the debt as nonconsumer.
However, in spite of my speculation, there is a clear distinction between elective and emergency medical debts, viz.:
There is no doubt that most medical debts are considered consumer debts, as most are incurred voluntarily. See In re Martinez, 171 B.R. 264, 267 (Bankr. N.D. Ohio 1994) (finding that the debtors’ medical debts were consumer debts). Medical debts incurred through routine doctor’s visits and cosmetic surgery would be examples of medical debts that are consumer debts. … This is not so when it comes to emergency medical treatment. Emergency medical services are differentiated from ordinary medical services. … The UST argues that the Debtor incurred this debt because he voluntarily consented to treatment. And indeed he did; however, an act that leads to indebtedness may be undertaken voluntarily but the attendant debt may result involuntarily and is not the type of debt that a debtor would expect to incur in his daily affairs. In re Peterson, 524 B.R. 808, 813 (Bankr. S.D. Ind. 2015) (finding that an intentional tort judgment was not consumer debt because it arose involuntarily); In re White, 49 B.R. 869, 872 (Bankr. W.D.N.C. 1985) (stating that an automobile accident liability was not consumer debt because it occurred incidental to and not first and foremost to achieving a personal aim). As such, the Debtor’s medical debts arising from emergency medical services cannot be included in the limited class of consumer debts within the meaning of 11 U.S.C. § 101(8) that individuals willingly incur in their daily affairs.
In re Sijan, 611 B.R. 850, 856 (Bankr. S.D. Ohio 2020) (emphasis added).
Thus, as with a tax debt, a medical debt that was incurred involuntarily — an emergency medical debt — is a nonconsumer debt.
Perhaps the Sijan Court was also motivated by the grossly uneven bargaining power: If you don’t incur the debt, we won’t treat you, and you will die. An offer he couldn’t refuse.
While there are, undoubtedly, other types of nonconsumer debts, they will probably all fall within one or some combination of the key categories discussed above: Involuntarily incurred debts, business debts, and profit-motivated debts. Therefore, if you’re facing a § 707(b) motion to dismiss, see if you can fit your debts into these categories. If you can get to the point of having more than 50% of the debts classified as nonconsumer, you should prevail.
My next post will deal directly with § 706(b) motions to convert a Chapter 7 case to a Chapter 11 case.
(Note: James Selth and I made a presentation at a local bar association. These are the notes we used. Although I wrote the notes, some of the content came from a brief Jim filed in one of his cases.)
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