Many Americans are questioning the future solvency of the Social Security program and, although its severity is inconclusive, many doubt that they will receive Social Security payments, causing them to seek additional financial arrangements. Congress has expressed a desire to encourage responsible retirement planning by granting favorable tax treatment to a wide variety of retirement savings plans, including 401(k) plans.[1] Thus, debtors who seek release from personal liability for certain debts through chapter 7 of the Bankruptcy Code continue to make qualified payments to their 401(k) accounts because participation in a 401(k) plan is an ongoing endeavor, and they claim that these voluntary contributions should not be taken into consideration while determining one’s eligibility for chapter 7 relief.
Prior to the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA),[2] the majority of bankruptcy courts did not allow debtors to make voluntary 401(k) contributions in chapter 7 cases.[3] Interestingly enough, the pre-BAPCPA question of whether voluntary retirement contributions should be considered part of a chapter 13 debtor’s projected disposable income was not settled.[4] Some courts allowed retirement contributions on a case-by-case basis, while others adopted a per se rule that retirement contributions were always included in the debtor’s disposable income.[5] However, with the addition of §§ 541(b)(7)[6] and 1322(f)[7] to the Bankruptcy Code in 2005, Congress placed retirement plans, including 401(k) contributions, outside the realm of chapter 13 plans.[8] It is unclear as to whether the protection that was afforded to chapter 13 debtors by the 2005 amendments extends to chapter 7 debtors. This article discusses case law addressing this issue, which has broad social implications and affects the economic well-being of future retirees receiving chapter 7 discharges.
Chapter 7 Framework
The issue of permissibility of 401(k) contributions or repayments of 401(k) loans[9] in chapter 7 usually arises once a motion to dismiss the case is filed. The conditions mandating dismissal of a chapter 7 case are set forth in 11 U.S.C. § 707. Specifically, § 707(b)(1) provides for the dismissal of a case upon a finding of abuse, and § 707(b)(2) and (3) provide methodologies for assessing whether abuse exists. Under § 707(b)(2), “the court shall presume abuse” of chapter 7 if the debtor runs afoul of the “means test,” which quantifies what is considered abuse through a mathematical calculation accounting for a number of factors.[10] If a presumption of abuse arises under the means test and is not rebutted upon a showing of “special circumstances,” the court may dismiss or convert the chapter 7 case.[11]
Section 707(b)(3) comes into play when the presumption of abuse under § 707(b)(2) does not arise or is rebutted. Section 707(b)(3) is a subjective test, which sets forth two additional and distinct grounds for determining abuse: (1) where the court finds that the debtor filed the petition in bad faith, or (2) where the totality-of-the-circumstances of the debtor’s financial situation demonstrates abuse.[12]
Section 707(b) represents a balance between the fundamental concept that is embodied in U.S. bankruptcy laws: Debtors who cannot meet debts as they come due should be able to relinquish nonexempt property in exchange for a fresh start and the creditors’ interests in obtaining repayment where such repayment would not be a burden.[13] Historically, Congress’s intent behind § 707(b) has been to require a debtor with the ability to repay at least a portion of his/her debts from future post-petition disposable income to convert his/her case to chapter 13 rather than simply receiving a chapter 7 discharge.[14] For this reason, it is important to know whether the funds reserved for a debtor’s monthly 401(k) contributions should be taken into consideration when determining the debtor’s ability to pay and his/her disposable income.
401(k) Contributions May Warrant Dismissal
The majority of case law addressing this issue has consistently held that 401(k) contributions by a chapter 7 debtor may warrant dismissal or conversion as one of the contributing factors to the totality-of-the-circumstances test under § 707(b)(3)(B).[15] The Bankruptcy Code does not provide a definition of the phrase “totality of the circumstances”; rather, a judicially created standard has emerged for determining whether dismissal for abuse is appropriate under this provision. The core inquiry of the totality-of-the-circumstances test is whether a debtor has a meaningful ability to repay the unsecured debts based on actual current and future income and expenses.[16] In In re Jacob, the court stated that a “debtor’s ability to repay their debts is normally ascertained by reference to the amount of ‘disposable income’ the debtor has available.”[17]
Bankruptcy courts generally borrow a definition of this term from 11 U.S.C. § 1325(b)(2),[18] which provides that “disposable income” is income that is received by a debtor that is not “reasonably necessary” to be expended for the maintenance or support of the debtor or his/her dependents. Neither the Bankruptcy Code nor its legislative history defines the phrase “reasonably necessary.”
Nevertheless, while recognizing that saving money for retirement is certainly a prudent investment, courts finding abuse concluded that 401(k) contributions are unnecessary for the maintenance or support of the debtor, thereby including them in disposable-income calculations.[19] This line of cases reasoned that lack of any “express” 401(k) protection, similar to §§ 541(b)(7) or 1322(f) applicable in chapter 7, illustrates that Congress did not intend to allow chapter 7 debtors to deduct their 401(k) contributions from their disposable income.[20] This conclusion is supported by the applicability of one of the rules of statutory construction (i.e., if Congress includes particular language in one section of a statute but omits it in another, it acted intentionally in that exclusion).[21] Accordingly, in order to explain the statutory status quo, courts claim that “Congress intended to steer many would-be Chapter 7 debtors toward Chapter 13.”[22] That way, debtors having disposable income will be subject to the longer period of bankruptcy supervision of chapter 13 rather than the relatively short tenure of a chapter 7 case.[23] Such construction of the Bankruptcy Code addresses the courts’ sensitivity to filings of chapter 7 cases with the purpose of gaming the system at the creditors’ expense.
Playing devil’s advocate, as bankruptcy courts utilize their “disposable income” definition from § 1325(b)(2) in chapter 7 cases in order to determine a debtor’s ability to pay, one could argue that Congress expressed its intent to protect chapter 7 debtors while enacting § 541(b)(7), which provides that contributions to a qualified plan do not constitute disposable income for purposes of § 1325(b)(2). That is presuming that when Congress legislates, it is aware of judicial interpretations and practices.[24]
Whether it is a dispositive or a prime consideration, the analysis in these cases has turned on whether a debtor could fund a hypothetical chapter 13 plan.[25] Some courts have gone as far as to make the ability to repay unsecured creditors dispositive in determining abuse under § 707(b)(3)(B), providing a straightforward message: “[D]ebtors who have the ability to pay their debts, should.”[26]
In addition to determining whether 401(k) contributions could effectively fund, or contribute to funding, a chapter 13 plan, these courts also consider a number of relevant pre- and post-petition circumstances and facts.[27] Such factors include: (1) the circumstances propelling the debtor into bankruptcy; (2) the nature of the debtor’s liabilities; (3) the debtor’s pre-petition behavior toward his/her creditors; (4) the accuracy of the debtor’s schedules; (5) the debtor’s age, health, dependents and other family responsibilities; (6) the debtor’s employment stability; (7) the debtor’s eligibility for chapter 13 relief and whether creditors would receive a meaningful distribution in a chapter 13 case; (8) the age of the debts for which he/she seeks a discharge and the period over which they were incurred; (9) whether the debtor incurred cash advances and made consumer purchases far in excess of his/her ability to pay; (10) whether the debtor made any payments toward debts or attempted to negotiate with creditors; (11) the accuracy of the debtor’s schedules and statement of current income and expenses; and (12) the debtor’s ability to reduce his/her living expenses without depriving himself/herself or the debtor’s family of basic necessities.[28] Courts that consider additional pre- and post-petition circumstances and facts have relied on equitable reasoning and held that 401(k) payments should be included in the calculation of a debtors income for § 707(b)(3) purposes because “[t]o hold otherwise would force a debtor’s creditors to fund the debtor’s retirement plan.”[29]
Factors that Militate against Dismissal
The prohibition on expensing 401(k) contributions to retirement accounts is not absolute due to the flexibility of the totality-of-the-circumstances test, which allows courts to take into account all relevant factors.[30] Consequently, bankruptcy courts may deny a request for dismissal if the replenishment of the debtor’s 401(k) account is necessary to his/her long-term “health and welfare” while leading a modest lifestyle.[31] This case-by-case approach, under which retirement contributions may be found to be reasonably necessary, provides for the subjective evaluation of factors that are pertinent to a debtor’s personal situation, including “(1) age and time left until retirement; (2) level of yearly income; (3) overall budget; (4) amount of monthly contributions; (5) needs of any dependents; and (6) other constraints [that] make it likely that retirement contributions are reasonably necessary expenses for those debtors.”[32]
The unique circumstances of a particular case, especially any medical condition of the debtor that will prematurely end his/her ability to work, may compel a court to weigh heavily on these mitigating factors and hold in the debtor’s favor.[33] According to this line of cases, allowing a debtor’s 401(k) contributions is justified due to the precarious situations of when the denial of a motion to dismiss would rise to the level of penalizing a debtor. Moreover, courts following this view are unwilling to force a chapter 7 debtor into chapter 13 if the 401(k) contributions constitute the only basis of the debtor’s ability to pay:[34] Upon conversion, 401(k) contributions are not included in the debtor’s disposable income; thus, unsecured creditors would not receive a meaningful distribution unless disposable income derives from other sources. A finding of abuse wherein the very payments that are used to calculate the debtor’s ability to repay are the same payments that are not included as disposable income under a chapter 13 plan would lead to an absurd result.[35] Furthermore, these cases observed that Congress could have required dismissal based solely on a debtor’s “ability to pay,” but chose to refrain from drafting such a framework.
Conclusion
It has long been recognized that “[c]hapter 7 is not a device to be used by a debtor to secrete a meaningful stream of income to the detriment of their general unsecured creditor body.”[36] Thus, absent express congressional authorization, the majority of bankruptcy courts are reluctant to allow unsecured creditors to subsidize chapter 7 debtors’ retirements when there is sufficient room for financial maneuvering so as to pay at least a portion of the unsecured debt. A debtor has no constitutionally protected right to receive a discharge in bankruptcy, and post-BAPCPA, there is no presumption favoring chapter 7 relief, but rather more of an emphasis on repaying creditors.[37] On the other hand, bankruptcy courts are conscious that under certain circumstances, by providing for a debtor’s eventual retirement, retirement contributions can be viewed as becoming part of a debtor’s fresh start as many depend on this money to provide for their retirement years.[38] Accordingly, debtors should manage their expectations and proceed with caution while pursuing discharge under chapter 7, as 401(k) contributions may tip the scale under § 707(b)(3)(B) and be reflective of an abusive bankruptcy filing.
[1] 26 U.S.C. § 401. A 401(k) plan is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages, which are excluded from the employee’s taxable income, to individual accounts not to exceed $17,500 per year. See “Retirement Topics: 401(k) and Profit-Sharing Plan Contribution Limits,” Internal Revenue Service, available at www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topi… (last visited June 23, 2014).
[2] Pub. L. 109-08, 11 Stat. 23 (2005).
[3] In re Lipford, 397 B.R. 320, 329-30 (Bankr. M.D.N.C. 2008).
[4] In re Drapeau, 485 B.R. 29, 33 (Bankr. D. Mass. 2013).
[5] Id.
[6] Section 547(b)(7) provides that certain retirement contributions to a qualified plan do not constitute disposable income for purposes of § 1325(b)(2).
[7] Section 1322(f) provides that a chapter 13 plan may not materially alter the terms of a loan described in § 362(b)(19), and that any amounts required to repay such a loan shall not constitute “disposable income” under § 1325.
[8] In re Lavin, 424 B.R. 558, 564 (Bankr. M.D. Fla. 2010).
[9] “[R]epayment on a 401(k) loan is the equivalent of a contribution.” In re Burton, 379 B.R. 732, 737 (Bankr. N.D. Ohio 2007).
[10] 11 U.S.C. § 707(b)(2)(A)(i).
[11] 11 U.S.C. § 707(b)(1) and (2).
[12] 11 U.S.C. § 707(b)(3)(A) and (B).
[13] In re Skvorecz, 369 B.R. 638, 643 n.9 (Bankr. D. Colo. 2007).
[14] Id.
[15] In re Clary, 6:11-bk-04556-ABB, 2012 WL 868717, *19 (Bankr. M.D. Fla. March 14, 2012); In re Jacob, 447 B.R. 535, 543 (Bankr. N.D. Ohio 2010); In re Dowleyne, 400 B.R. 840, 847 (Bankr. M.D. Fla. 2008); In re Parada, 391 B.R. 492, 502-03 (Bankr. S.D. Fla. 2008); In re Burton, 379 B.R. 732, 737 (Bankr. N.D. Ohio 2007); In re Zaporski, 366 B.R. 758, 773-74 (Bankr. E.D. Mich. 2007).
[16] In re Dowleyne, 400 B.R. at 843.
[17] 447 B.R. at 542.
[18] This judicial practice is common in defiance of 11 U.S.C. § 103(i), which provides that “[c]hapter 13 of this title applies only in a case under such chapter.”
[19] In re Parada, 391 B.R. 492, 501-03 (Bankr. S.D. Fla. 2008).
[20] In re Turner, 376 B.R. 370, 376 (Bankr. D.N.H. 2007).
[21] KP Permanent Make-Up Inc. v. Lasting Impression I Inc., 543 U.S. 111, 118 (2004).
[22] In re Egebjerg, 574 F.3d 1045, 1050 (9th Cir. 2009) (internal quotations omitted).
[23] Id. (internal quotations omitted).
[24] Dewsnup v. Timm, 502 U.S. 410, 419 (1992) (“When Congress amends the bankruptcy laws, it does not write on a clean slate.”) (internal quotation marks omitted).
[25] See generally In re Clary, 2012 WL 868717, at 17-20; In re Dowleyne, 400 B.R. at 843-47; In re Henebury, 361 B.R. 595, 604-14 (Bankr. S.D. Fla. 2007); In re Glenn, 345 B.R. 831, 835-36 (Bankr. N.D. Ohio 2006).
[26] In re Masella, 373 B.R. 514, 518 (Bankr. N.D. Ohio 2007).
[27] In re Norwood-Hill, 403 B.R. 905, 912-13 (Bankr. M.D. Fla. 2009).
[28] Id.; In re Carney, No. 07-31690, 2007 WL 4287855, at *3, 7-10 (Bankr. N.D. Ohio Dec. 5, 2007).
[29] In re Clary, 2012 WL 868717, at *19 (quoting In re Pandl, 407 B.R. 299, 301 (Bankr. S.D. Ohio 2009)).
[30] In re Jacob, 447 B.R. at 543.
[31] In re Le Roy, No. 08-26263-svk, 2009 WL 357923, at *3-5 (Bankr. E.D. Wis. 2009).
[32] In re Beckerman, 381 B.R. 841, 848 (Bankr. E.D. Mich. 2008).
[33] In re Lavin, 424 B.R. at 565.
[34] Id.
[35] In re Skvorecz, 369 B.R. at 644.
[36] In re Glenn, 345 B.R. at 838.
[37] In re Jacob, 447 B.R. at 538.
[38] In re Seafort, 669 F.3d 662, 669 (6th Cir. 2012).