Chapter 11 for Individuals & Married Couples

Absolute Priority Rule (1)Some time ago I wrote in great detail about personal Chapter 11 bankruptcy.  In that post I discussed the application of one of the complexities of Chapter 11 bankruptcy to individual (as opposed to business) cases.  That complexity is the absolute priority rule.  At the time of the post, we had a patchwork of inconsistent case law on the topic, making the success of a personal Chapter 11 case dependent, in part, on the identity of the judge assigned to the case.

Things have been resolved ― at least in the Ninth Circuit ― and not in favor of individuals.  Let’s recall the setting:

I.  The Absolute Priority Rule

The absolute priority rule is an important idiosyncrasy of Chapter 11 that has no analogue in either Chapter 7 or Chapter 13 bankruptcy.  We’ll begin by describing the absolute priority rule in the business Chapter 11 context.

A.  The Business Chapter 11 Absolute Priority Rule

In bankruptcy not all debts are treated equally.  For example, the law distinguishes between secured debts ― debts that are secured by collateral that can be repossessed in the event of a default ― and unsecured debts.  Secured debts are not treated the same as unsecured debts because the secured creditor has special rights attached to the collateral securing the debt.

Even among unsecured debts there are distinctions.  Some are given priority over others.  The various priority classes are listed in 11 U.S.C. § 507(a).  This distinction sets the stage for the so-called absolute priority rule for Chapter 11.
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tax return with hundred dollar billsSome time ago I wrote about discharging income taxes in bankruptcy.  I subsequently wrote about discharging income taxes in bankruptcy for a tax year in which the debtor filed a return after the taxing authority ― for simplicity I will generically label the authority as the IRS, though the discussion applies to other taxing authorities ― filed a substitute for return and assessed the tax.

A fellow bankruptcy attorney of the highest caliber, who is also a good friend, read the substitution for return post ― Yippee!  I always love hearing that people are reading the blog ― and drew my attention to a brand new decision of the Bankruptcy Appellate Panel for the Ninth Circuit (the “BAP”) in the appeal of one of the cases I discussed in substitute for return post.  He suggested that I write a follow up post.  Following the rule always to take requests from the audience (please try the veal piccata, and be sure to tip the wait staff), I offer the following update.

To set the stage for this post I will begin with a précis of the aforementioned (does anyone other than an attorney use the word “aforementioned”?) two previous posts.  If you want more detail, read those two posts.

I.  The Three-Part Tax Dischargeability Test

For a tax to be dischargeable in bankruptcy, it must satisfy three requirements:

1.  (The three-year rule) The tax return for the tax year in question must have been due (including extensions) – but not necessarily actually filed – at least three years before the filing of the bankruptcy papers,

2.  (The two-year rule) The debtor must have actually filed a legitimate, nonfraudulent tax return for that tax year at least two years before the filing of the bankruptcy papers, and

3.  (The 240-day rule) The taxing authority cannot have assessed the tax during the 240 days prior to filing the bankruptcy papers.

The second requirement, the so-called two-year rule, has been the subject of extensive litigation throughout the country, with a wide range of inconsistent outcomes.  It is the afflatus for this post.
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Christmas presents under the treeIn this Christmas season children are eagerly awaiting prepackaged presents.  That’s an odd locution, isn’t it?  We usually refer to the gifts as wrapped rather than prepackaged.  I chose the word “prepackaged” because when something is prepackaged it’s all wrapped up.  What does this have to do with Chapter 11 bankruptcy?  A little background will help to put the answer in perspective.

I.  Chapter 11 Bankruptcy

The Bankruptcy Code (title 11 of the United States Code) is divided up into chapters.  The first three chapters (1, 3, and 5) are foundational chapters.  Their content comes along for the ride no matter which chapter under which the case is ultimately filed.  The remaining chapters (7, 9, 11, 12, 13, and 15) are the chapters under which bankruptcy cases are actually filed.

Side Note:  Why The Shortage Of Even-Numbered Chapters?

You may wonder why almost all of the chapters have odd numbers.  The answer lies with Congress.  Congress has been wrestling with budgetary problems for some time, and has been unable to afford even numbers, which are more expensive than odd numbers.  As a special treat it got one even number, 12, but for now that’ll have to do.  And if you believe that, I have some real estate on the moon I would like to sell you.

The real reason has to do with the passage of the Bankruptcy Reform Act of 1978.  Prior to that, the bankruptcy statute had even-numbered chapters.  However, Congress felt that some of them had been abused (i.e., sections of the Uniform Bankruptcy Act of 1898, not members of Congress), in some cases by creditors, in others by debtors.  Therefore, it jettisoned the offending sections, which turned out to comprise all of the even-numbered chapters.  In the 1980s the need of family farmers for bankruptcy relief was not being satisfactorily addressed with the remaining chapters, so Chapter 12 was temporarily added.  But it had to be reauthorized every two years.  Then in 2005 the entire Code underwent revision.  As part of that revision, Chapter 12 was made permanent, and its ambit was expanded to include, not only family farmers, but also family fishing operations.

Back To Chapter 11:

Chapter 11 was originally envisioned as a corporate restructuring provision, though it is now available, not only to businesses, but also to individuals and married couples.

The big picture goal in a Chapter 11 is to deal with debt in a way that allows the debtor to reorganize so that is can continue to participate in the economy.  Some debt may be wiped out, some may be reduced to pennies on the dollar, some assets may be liquidated, and the debtor reorganizes its financial affairs.  The main vehicle for Chapter 11 restructuring is the Chapter 11 plan.  (I am ignoring the idea of a total liquidation Chapter 11 plan.)
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IRS From 1040Some time ago I wrote about discharging income taxes in bankruptcy.  I stated that there is a three-part test for determining their dischargeability, and started with the following executive summary:

For a tax to be dischargeable in bankruptcy, it must satisfy three requirements:

  1. (The three-year rule) The tax return for the tax year in question must have been due (including extensions) – but not necessarily actually filed – at least three years before the filing of the bankruptcy papers,
  2. (The two-year rule) The debtor must have actually filed a legitimate, nonfraudulent tax return for that tax year at least two years before the filing of the bankruptcy papers, and
  3. (The 240-day rule) The taxing authority cannot have assessed the tax during the 240 days prior to filing the bankruptcy papers.

The second requirement, the so-called two-year rule, has been the subject of extensive litigation throughout the country, with a wide range of inconsistent outcomes.  Therefore, I suspect that the Supremes will eventually be asked to consider the matter.

My focus today is on what happens if the taxing authority files something called a substitute for return on behalf of the debtor/taxpayer.  For linguistic simplicity, I will refer to the taxing authority as the IRS, though the discussion applies, mutatis mutandis, if the taxing authority is a state taxing authority such as California’s Franchise Tax Board.
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Home equityLast Sunday, July 20, 2014, Liz Weston of the L.A. Times gave an interesting answer to a question posed by a reader of the newspaper’s Money Talk feature.  Today’s post adds to Liz’s advice.

The reader had accumulated $28,000 in credit card debt over the previous eight years, and had considerable law school debt and a home mortgage.  He wanted to know whether a home equity loan was a smart choice to solve his problems.

Liz gave a good answer, but the LA Times’ space constraints made it impossible for her to cover things in detail.  Her response included the statement:  “Bankruptcy probably isn’t in the cards for you, of course, given your resources.”  This led me to today’s post.

But first, a caveat:  In order to give the reader an accurate analysis of the application of bankruptcy to his problems, I would need a lot more information.  Thus, what I am about to say focuses on general principles, and is not a substitute for a thorough evaluation of the case using detailed documentation.

I.              Chapter 7 Bankruptcy

I suspect that Liz had Chapter 7 bankruptcy in mind when she made her comment.

In a Chapter 7 bankruptcy, the debtor’s dischargeable debts are discharged without the creditors getting anything.  Since this is such a big hit on the creditors, there are some limitations.  One such limitation is on what the debtor gets to keep.  The debtor keeps exempt assets,  but the Chapter 7 Trustee assigned to the case seizes and liquidates the nonexempt assets for the benefit of the creditors.

Given that the reader has enough equity that he was considering a home equity line of credit (“HELOC”), it may be that he has too much equity to fully exempt.  If that is the case, then a Chapter 7 bankruptcy might be a poor choice since he and his wife would lose their home to the depredations of the Chapter 7 Trustee assigned to the case.  Again, more detailed information about his assets and encumbrances against them are needed to say for sure.

However, two other chapters of the Bankruptcy Code may be worth considering because debtors filing bankruptcies under those chapters can keep their assets regardless of their value or exempt status.
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Multiple clocksI recently had an email exchange regarding statute of limitations tolling in bankruptcy, with a friend who is a fellow bankruptcy attorney.  My friend posed a couple of questions based on an interesting fact pattern.  Herewith I offer a slightly edited version of the exchange.

First, here is my friend’s email:

Salient Facts:   Chapter 7 case filed.  Debtor has some accounts receivable.   On the petition filing date, there are 4 months left on the Statue of Limitations to bring an action on the accounts receivable.  The Chapter 7 Trustee sold the accounts receivable to someone we’ll call, Doug.

Questions:

1.  How long does Doug have to bring suit on the accounts receivable he purchased from the Trustee?

2.  Section 108(a) gives the Trustee 2 years from the petition date to commence an action.  It also seems to extend the statute of limitations by some period, which I used to assume was the pendency of the bankruptcy case, ending when it closed.  But now that I read the language, it is not at all clear.  Section 108(a)(1) has the statement:  “[I]ncluding any suspension of such period occurring after the commencement of the case…”; What the heck does that mean?  Does there need to be a formal suspension, or is it automatic, and if so, for how long?

Before I give you my response, here is some helpful background.

I.              Statutes Of Limitations

At the risk of gross oversimplification, we can think of noncriminal law as a mechanism for resolving competing interests.  In particular, litigation is the means we use for resolving disputes without the parties resorting to duels.  If only Aaron Burr had resolved his dispute with Alexander Hamilton through litigation.

One of the goals in this process is to resolve disputes in a reasonably timely fashion, before the witnesses’ memories become distorted with the passage of time.  Therefore, the statutes under which plaintiffs bring their suits contain time windows during which the actions must be initiated.  If a plaintiff fails to take action within the relevant time window, the suit is time-barred.  The plaintiff is said to have “slept on his rights.”
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HomeIf you sell your home, can the cash proceeds be exempted using the homeowner’s equity exemption?  That was the subject of two questions that a fellow bankruptcy attorney recently asked me.  I found the exchange interesting, so I am posting it for your edification.

Question 1:

If the proceeds from the sale of the domicile are held in escrow or my client trust account — and the Debtor is required to seek further court approval before being allowed to touch them, would that mean the Debtor never “actually received” them in the sense of Cal. Civ. Proc. Code § 704.720, so that the statutory time did not begin to run?

I.          Exempt Status If Debtor Did Not Have Immediate Access To The Proceeds

We first turn to the statute (with emphasis added):

If a homestead is sold . . . the proceeds of sale . . . are exempt in the amount of the homestead exemption provided in Section 704.730.  The proceeds are exempt for a period of six months after the time the proceeds are actually received by the judgment debtor, except that, if a homestead exemption is applied to other property of the judgment debtor or the judgment debtor’s spouse during that period, the proceeds thereafter are not exempt.

Cal. Civ. Proc. Code § 704.720(b).

Based on this language, the California Supreme Court’s holding in Thorsby v. Babcock, 36 Cal. 2d 202 (Cal. 1950) answers the question.

Babcock was the judgment debtor in this case, and Thorsby was the judgment creditor.  Babcock sold his home on which he had a homestead exemption.  However, due to the litigation with Thorsby the sale proceeds were placed in an escrow account for eight months.  Thus, Babcock didn’t have access to the sale proceeds for eight months, so he couldn’t reinvest the proceeds in a new domicile during the six-month postsale period.  Thorsby challenged the legitimacy of the exemption based on the fact that the proceeds hadn’t been reinvested in a domicile during the six-month postsale period.
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The short answer to this is, yes.  But as you may suspect from the fact that this post is considerably longer than one sentence, there is a good deal more to a thorough answer than that monosyllabic response.  There are two possibilities regarding your previous bankruptcy:  (1) you received a discharge, and (2) your case was dismissed. Today’s post deals with the first situation.  The next post will deal with the second situation.

I.          Your Received A Discharge In Your Previous Case

The big picture goal in personal bankruptcy is to receive a discharge of your debts.  This affords you the fresh financial start that is the raison d’être of a personal bankruptcy.  From a debtor’s perspective this is marvelously liberating.  However, from the creditors’ perspective it can be a hard hit.  As a result, Congress has put some time limitations in the Bankruptcy Code, meaning that you must wait a while between bankruptcy filings if you want to receive a discharge in the future bankruptcy case.  How much time?  That depends on which chapter you plan on using in your future bankruptcy case, and under which chapter you received your previous discharge.
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An ongoing source of distress for debtors is truly abusive debt collectors.  Many of these alleged humans ignore the due process rights of debtors, lie, and break the law in their efforts to shake down debtors.  Can anything be done?  Finally, the federal and state governments are starting to take some action.

I.          The Problems

A.        Collectors Fail To Follow The Due Process Rules

I regularly have clients show me abstracts of judgment from state court cases in which they knew nothing about the suit until receiving the judgment.  Are my clients lying?  I don’t think so.  In fact, a California state senator had the same thing happen to him.  According to Jim Puzzanghera, in the August 20, 2012 Los Angeles Times:

Several years ago, debt collectors began pursuing state Sen. Lou Correa (D-Santa Ana) for an unpaid Sears bill they said he owed.  He told them they had the wrong man, but the debt collectors never wavered.  “These folks are very aggressive,” Correa said. “They’ll call back repeatedly and say, `Tell us some personal information so we can tell it’s not you.’  When all of a sudden is the burden of proof on me?”  Last year, Correa discovered his Senate paycheck was being garnisheed [sic] because of a $4,329 lien for the Sears debt.  Brachfeld had obtained a default judgment in court, even though, Correa said, the lawsuit was never served on him and he knew nothing of the claim or the court hearing.  He later learned that the debt belonged to a Luis Correa from Santa Ana. The man had a different Social Security number, different address, even different first name — the senator is legally Jose Luis Correa.  “I always pay my bills on time.  Then to have somebody garnish my wages, I thought was pretty astounding,” the lawmaker said.  He later resolved the problem and stopped the wage garnishment.  Now Correa is supporting a bill by state Sen. Mark Leno (D-San Francisco) to require debt collectors to document that they are pursuing the right person for the correct amount of money.  The bill passed the Senate and is pending in the Assembly.

If these entities can abuse a state senator, where does that leave the average person without any political clout?
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A fellow attorney, but not a bankruptcy attorney, recently asked me this question because he had a business client who wanted to use an involuntary bankruptcy filing to collect money from a judgment debtor.  To answer my colleague’s question we need a little background.  Let’s start with the concept of a voluntary bankruptcy.

I.          Voluntary Bankruptcy

Almost all bankruptcies filed today are voluntary bankruptcies.  Regardless of the underlying chapter at the heart of the bankruptcy, a voluntary bankruptcy is filed either under 11 U.S.C. § 301(a), or § 302(a).  § 301(a) provides (with emphasis added):

A voluntary case under a chapter of this title is commenced by the filing with the bankruptcy court of a petition under such chapter by an entity that may be a debtor under such chapter.

The phrase, “by an entity that may be a debtor under such chapter,” appears because a business can file under § 301(a).  However, if the debtor is not a business, then the entity in question is one individual.  Section 301(a) cannot be used by a married couple.  Why?  The answer is found in § 302(a) (with emphasis added):

A joint case under a chapter of this title is commenced by the filing with the bankruptcy court of a single petition under such chapter by an individual that may be a debtor under such chapter and such individual’s spouse.

Notice the common thread in these two sections:  it is the debtor who files the bankruptcy petition.  The reason such bankruptcies are called voluntary bankruptcies is that the debtor voluntarily enters into bankruptcy.  Contrast this with the statutory language authorizing involuntary bankruptcies.
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