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June 09, 2016 Practice Point

Beyond the Three-Year, 240-Day, and Two-Year Rules: Bankruptcy Rules That Tax Practitioners Should Know

By Kenneth C. Weil, Law Office of Kenneth C. Weil, Seattle, WA

Beyond the three-year, 240-day, and two-year rules, there are other rules and traps for the unwary that should be on a tax practitioner’s radar. These include finding ways to make your client a non-consumer debtor, conversion of Chapter 7 cases to Chapter 11 under section 706(b) of the Bankruptcy Code, 1 denial of discharges under section 727(a)(2)(A), and filing too soon after a prior bankruptcy discharge has been granted. The following provides a brief discussion of each of these topics.

I. Calculating Non-Consumer Debt

Tax debt is non-consumer debt.2 The issue arose in cases where tax debtors filed a Chapter 13 case and co-debtors did not file. The government wanted to pursue the nonfiling co-debtor. It argued successfully that the tax debt in question was non-consumer debt and not subject to the co-debtor stay of section 1301, which applies only to consumer debt.

Fast forward to passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA).3 BAPCPA added means-testing rules to section 707: these rules apply only to debtors who have primarily consumer debt.4 Consumer debt is “debt incurred by an individual primarily for a personal, family, or household purpose.”5 In this context, “primarily” means one dollar more than half.6

When the means test does not apply, the path to a completed bankruptcy is considerably less bumpy. Tax debtors have a great “head start” in the calculation of non-consumer versus consumer debt. Here are some rules to keep in mind when making those calculations.

Section 101(8) states that consumer debt “means debt incurred by an individual primarily for a personal” purpose.7  “Incurred” implies that the question asked is why the debt was originally undertaken. One does not look to the day of filing; instead, one looks to the date the loan was incurred.8

Consider a client that has a personal residence, a rental property, and tax debt. The debt on the personal residence exceeds the tax debt plus the debt on the rental. If the debtor disposes of the personal residence and moves into the rental prior to filing, the debtor now has primarily non-consumer debt.

Given the tax rule that educational expenses are not deductible if the education qualifies the taxpayer for a new trade or business,9 one might think that tuition is a consumer debt for means-testing purposes. That is not necessarily the case. The court in In re Rucker found that there is no per se rule for determining whether education expenses are consumer or non-consumer debt.10 The court in In re Palmer, however, took a more restrictive view: “the debtor must demonstrate a tangible benefit to an existing business, or show some requirement for advancement or greater compensation in a current job or organization.” 11 Still, if the tuition were spent on an education for a new field and the debtor takes a job in that field, the tuition should be considered non-consumer debt. The key is not to be greedy. The parts of the loan that are used for living expenses and not tuition should be treated as consumer debt.

Consider also In re Cherett, in which a housing loan made by a company to entice a debtor to work for it was held to be non-consumer debt because it was debt incurred in connection with obtaining a new job.12 Also consider In re Mohr, in which a creditor’s claim for unpaid rent was capped under section 502(b)(6), but the debtor could use the full amount of unpaid rent in the consumer/non-consumer determination.13

II. Non-Consumer Treatment Too Good to Be True:  Section 706(b)

Even though the means testing rules do not apply, non-consumer debtors are not totally safe from conversion or dismissal. Section 706(b) provides:

On request of a party in interest and after notice and a hearing, the court may convert a case under this chapter to a case under chapter 11 of this title at any time.

This means that the United States Trustee (UST) or a creditor can force a debtor out of Chapter 7 and into Chapter 11. This is the tool used by the UST when the debtor has considerable income and the concomitant ability to pay a considerable portion, if not all, of the outstanding debt.14 A good example is In re Parvin, where the debtor’s projected monthly income exceeded $51,000. After deducting expenses, the debtor still had over $34,000 in net monthly disposable income.15

Large monthly income will most certainly catch the UST’s eye. What is unclear is the threshold amount that will cause trouble. It appears that $5,000 a month will be sufficient, because this will result in an ability to pay $300,000 of debt with a five-year plan.16 How much less monthly income would still cause trouble is unclear.

No grounds for conversion are specified in the statute. The common law rule, which has been adopted by bankruptcy courts, is that “a court ‘should consider anything relevant that would further the goals of the Bankruptcy Code.’”17

The major factor is the debtor’s ability to pay.18 Another factor, certainly when dealing with tax debt, is whether the tax debt is dischargeable. If the debt is non-dischargeable, the debtor benefits from a plan because it establishes a repayment schedule.19

Other factors, as set forth in Decker, include (i) whether there is cause for conversion or dismissal under section 1112(b), making conversion a futile and wasted act; (ii) whether the debtor can propose a confirmable Chapter 11 plan; and (iii) whether the purpose of the conversion is solely to liquidate the debtor’s estate, which makes Chapter 7 more sensible.20

One case found conversion to be in the best interest of the debtor, as the debtor was “a pawn between two companies which [sic]. . . have seen fit to manipulate this Debtor and ruin his credit, rather than resolve their issues.”21 Another case denied conversion, as the debtor had worked assiduously to pay off debt and there was only one recalcitrant creditor remaining.22 Constitutional challenges, e.g., claiming that a conversion to Chapter 11 is a form of indentured servitude and in violation of the Thirteenth Amendment, do not seem to work.23

The standard of review is abuse of discretion.24 This means the battle will be won or lost in the bankruptcy court.

III. Planning to Escape an IRS Levy Can Result in Non-Dischargeability

Suppose that your client has an IRA. You are aware that the IRS can levy the IRA and force distribution of the entire account. As a result, you advise your client to convert the IRA to an annuity, because a levy cannot force a distribution of the entire annuity. Suppose, instead, that your client moves money from one bank account with which the IRS is familiar to one with which it is not familiar. In both situations, your client may be ineligible for a discharge.

Section 727(a)(2)(A) denies a discharge if “the debtor, with intent to hinder, delay, or defraud a creditor” ... “has transferred” ... “property of the debtor, within one year before the date of the filing of the petition.” Thus, the elements of the non-dischargeability claim are transfer, within a year, and intent to hinder, delay or defraud. The courts make clear that the “discharge provisions are liberally construed in favor of debtors and strictly against the person objecting to the discharge.”25 Proof must be by a preponderance of the evidence.26

Transfers are broadly defined under section 101(54)(D) to include “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with” property or an interest in property. Bank deposits and withdrawals satisfy the meaning of transfer.27 In other words, a transfer is easily proved.

Discharge is denied if there is an intent to hinder, delay, or defraud. The majority position is that the use of the word “or” means that an objecting party need only prove one of the three.28 The minority position, set forth in Wreyford, is an interpretation of an old English statute holding that hinder, delay, or defraud is a term of art that refers to actual fraud.29 Under the minority position, actual fraudulent intent must be shown.30

Under the majority position, the party seeking to deny discharge need not prove intent to defraud because proof of intent to hinder or delay is sufficient.31 The only useful definition of “hinder or delay” was found under the Wreyford minority position test, and it is as follows: “Fraudulent intent to hinder or delay a creditor means ‘an intent to improperly make it more difficult for creditors to reasonably collect on their debts.’”32 The concept of making it difficult for creditors to reasonably collect makes sense under both the majority and minority positions.

In re Rachel, a 2015 case, has facts that are analogous to the hypotheticals introducing this section.33   The debtor received insurance proceeds after her father died. She held the check for more than four months before depositing it into an account in her daughter’s name. In so doing, the debtor concealed the receipt of the check from the IRS, and she testified at trial that was a purpose of the transfer. Although other grounds existed to deny discharge, the Court found that her testimony was sufficient to show an intent to hinder or delay IRS collection efforts. Her discharge was denied.34

IV. Current Discharge Blocked by Prior Bankruptcy Discharge

Practitioners should be aware of a series of rules that deny discharge if the second case is filed too close in time to a prior case where a discharge was entered.

•   If Chapter 7 then and Chapter 7 now, add eight years from the prior file date under section 727(a)(8).

•   If Chapter 13 or 12 then and Chapter 7 now, add six years from the prior file date under section 727(a)(9).

•   If Chapter 7, 11, or 12 then and Chapter 13 now, add four years from the prior file date, under section 1328(f)(1).

•   If Chapter 13 then and Chapter 13 now, add two years from the prior file date, under section 1328(f)(2).

Do a Pacer search. As a tax practitioner, you are likely to have a social security number available.  For one ten-cent search, you can look for a prior bankruptcy filing in the entire country. Such a search may save you much grief later.


1 Section references herein are to the Bankruptcy Code unless otherwise stated.

2 See, e.g., IRS v. Westberry (In re Westberry), 215 F.3d 589 (6th Cir. 2000); In re Brashers, 216 B.R. 59 (Bankr. N.D. Okla. 1998) (United States Trustee's motion to dismiss denied because case involved primarily tax debt, which is not consumer debt).

7 11 USC §101(8) (emphasis added).

9 IRS Publ. 17, Chapter 27.

14 Proudfoot Consulting Co. v. Gordon (In re Gordon), 465 B.R. 683, 694 (N.D. Ga. 2012) (“Conversion to Chapter 11 is an appropriate remedy provided by Congress for a non-consumer debtor with an ability to pay to avoid the same abuses of the bankruptcy system identified in the consumer area.”).

16 See, e.g., In re Decker, 535 B.R. 828 (Bankr. D. Alaska 2015) (facts showed that debtor’s net monthly disposable income could be anywhere from $4,500 to $11,200; case converted).

17 Proudfoot Consulting Co., supra 14 (decision to convert is left to the court based on what will best benefit all parties).

18 In re Decker, supra n. 17, at 839 (the ability to pay “is an exceedingly relevant, if not necessary, factor and the obvious starting point for any analysis under §706(b)”).

19 In re Baker, 503 B.R. 751, 759 (Bankr. M.D. Fla. 2013) (“Debtor may reduce or satisfy the debts owed to the IRS and the Bank through the Chapter 11 process, a result that may not be possible in a Chapter 7 case”).

20 In re Decker, supra n. 17 , at 840.

27 Bernard v. Sheaffer, (In re Bernard), 96 F.3d 1279, 1281–1283 (9th Cir. 1996), citing, S.Rep. No. 989, 95th Cong., 2d Sess. 27 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5813 (“A deposit in a bank account or similar account is a transfer”).

34 Id. at *3.  See also Standefer v. Kent (In re Kent), 397 B.R. 438 (Bankr. C.D. Ill. 2008) (discharge denied when debtors transferred property to relatives for no consideration after notice of intent to levy served and unsuccessful meeting thereafter with IRS).

Note: This article is adapted from an earlier version presented to the ABA Tax Section Midyear 2016 meeting.