The Uncertain World for Individual Chapter 11 Debtors

First, the Internal Revenue Code has always created a taxable estate for Chapter 11 debtors pursuant to 26 U.S.C. ' 1398(a). This taxable estate is easily dealt with in the context of a corporation or operating entity. However, for an individual who often receives income through the payment of wages from third parties, the dual estate presents some tax complications that are difficult for the most sophisticated of tax experts and are mind boggling to most bankruptcy counsel. In fact, many do not appreciate the complications until it is too late. These complications do not exist in Chapter 13 because the Internal Revenue Code does not create a separate taxable estate when a Chapter 13 case is commenced.

For example, which taxable entity, the individual or the estate or both, is taxed on wages paid by a third-party employer to the Chapter 11 debtor? The Internal Revenue Service has issued Revenue Notice 2006-83, which states that the W-2 should be issued to the individual so that self-employment taxes and other withholdings that apply only to individuals will continue to be withheld. See 2006-2 CB 596 (Sept. 18, 2006). On the other hand, Notice 2006-83 states that 1099s should be issued to the estate. The party receiving the W-2 or 1099, however, may not be the party that includes the income as taxable revenues. 26 U.S.C. ' 1398 sets forth the required treatment during the Chapter 11 case. However, post-confirmation treatment of the debtor's income is less clear. The confirmation of a plan typically vests the property of the estate with the debtor. But under ' 1115, post-confirmation income remains the property of the estate until the case is “closed, dismissed, or converted.” Over five years after the enactment of BAPCPA, the IRS has yet to provide guidance regarding the tax treatment of this post-confirmation income.

Another question is how post-petition earnings paid by a third-party employer of the debtor should be taxed when the bankruptcy court allows the debtor to retain this income to pay personal living expenses. The treatment is easier when the bankruptcy estate generates this income and pays the amounts to the debtor for the payment of administrative expenses. The estate would be able to deduct these payments as administrative expenses. An individual, on the other hand, is not be able to deduct personal expenses. Again, guidance on this treatment is lacking.

Second, Code ' 330(a)(4)(B) creates an exception in Chapter 12 and 13 cases, in which the debtor is an individual, that allows the debtor to use property of the estate to pay the fees of the debtor's attorney for services benefiting the debtor, even though those interests may not benefit the bankruptcy estate. This allows the debtor to compensate counsel using post-petition earnings for such services as divorce matters and defense of dischargeability actions under Code ' 523.

Unfortunately, Congress failed to amend Code ' 330(a)(4)(B) to include Chapter 11 cases. Thus, the debtor must show to the court some benefit to the estate in order to allow compensation to the debtor's counsel from post-petition earnings that constitute property of the estate. This has caused some attorneys, particularly in cases where a dischargeability action is contemplated or a divorce proceeding is pending, to use pre-petition paid-on-receipt retainers prior to accepting such cases. Because of the amount of cash that is required up front in such instances, the inability to use post-petition income to pay for the services needed for the debtor is a severe limitation in Chapter 11 cases.

Third, limitations exist in Chapter 11 as to how much post-petition income is permissible to be used by the debtor in the payment of personal expenses. Code ' 363(b)(1) authorizes a debtor to use property of the estate without court permission if it is in “the ordinary course of business.” In a Chapter 11 context, however, an individual may, but does not always, operate a business. Even when the debtor has a business, the debtor will undoubtedly have personal expenses for which this authorization under Code ' 363(b) would not apply. In such instances, the debtor will need to apply to the court for approval to pay these expenses, typically through a budget following notice and hearing the creditors. Although theoretically, the same issue would apply to individuals in Chapter 13 cases, the matter is not nearly as significant in Chapter 13 cases because a plan is usually proposed and confirmed in relatively short period of time following the commencement of the Chapter 13 case. In the Chapter 11 context, the length of time that it takes to confirm a Chapter 11 plan is typically months, thus requiring the debtor to operate under ' 363 prior to confirming a plan and enabling creditors to object to the use of property of the estate for a debtor's personal expenses.

Confirmation of the Plan

It does not get easier for individuals in Chapter 11 cases when trying to confirm a plan of reorganization. Similar to the Chapter 13 model, Code ' 1129(a)(15) requires the distribution of all “projected disposable income of the debtor that is received by the debtor during the five year period beginning on the date that the first payment is due under the plan ' .” This section refers to Code ' 1325(b)(2) in defining “projected disposable income.”

While there remain some differences as to the distribution of projected disposable income in Chapter 11 cases as applied in Chapter 13 cases, the most significant difference is the continued application of the absolute priority rule under Code ' 1129(b)(2)(B)(ii). [Note, the most notable difference is that a Chapter 13 plan is limited to an "applicable commitment period" under 11 U.S.C. ' 1325(b)(4) while the Chapter 11 plan is limited only to the "value of property" received during a five-year period. See 11 U.S.C. '1129(a)(15).]

In Chapter 13 cases, there is no voting by classes of creditors and the absolute priority rule does not exist. As long as the debtor is able to demonstrate the payment of projected disposable income, the distribution of that income to unsecured claims in a Chapter 13 case is deemed fair and equitable. See 11 U.S.C. ' 1325(b). BAPCPA amended the cramdown provisions of Code
' 1129(b)(2)(B)(ii) in a manner that many presumed, when the statute was enacted, would create an exception for individuals to the absolute priority rule so that the focus would be on the projected disposable income in the same manner that exists in Chapter 13.

The Absolute Priority Rule

The existence of the absolute priority rule for individuals in Chapter 11 cases that existed prior to BAPCPA was a significant obstacle to confirmation of a successful plan of reorganization. See Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 108 S.Ct. 963 (1988) (absolute priority rule precludes debtor-farmer from retaining interest in farm operations). The absolute priority rule imposes an obligation on the debtor to pay all unsecured claims in full before the debtor can retain, without the creditors' consent, any property of the estate under a plan of reorganization. Corporations that cannot obtain the consent of unsecured creditors can still reorganize by terminating existing stock and transferring ownership of the entity to the creditors. This option does not exist for an individual. It is not feasible for an individual to surrender ownership of everything the individual owns to creditors. [Note, some courts have held that the individual debtor may retain exempt property and not violate the absolute priority rule. See In re Bullard, 358 B.R. 541 (Bankr. Conn. 2007); In re Steedley, 2010 WL 3528599 (Bankr. S.D. Ga. 2010) (debtor may retain exempt property).]

The 2005 Amendment

The 2005 amendment to Code ' 1129(b)(2)(B)(ii) created an exception to the absolute priority rule that allows the individual to retain property of the estate despite the fact that the debtor's plan is not paying the unsecured creditors the full amount of their claims and the unsecured creditors have not voted to accept this treatment under the plan. A split has occurred among the courts, however, as to how broadly to interpret this exception. The narrow view limits the retained property to post-petition income generated by the debtor pursuant to Code ' 1115. See In re Gbadebo, 431 B.R. 222 (Bankr. N.D. Calif. 2010) (Court held that ' 1129(b)(2)(B)(ii) means that the debtor may retain only the property added to the estate by ' 1115 and not all property under ' 541). Accord. In re Mullins, 435 B.R. 352 (Bankr. W.D. Vir. 2010); In re Gelin, 437 B.R. 435 (Bankr. M.D. Fla. 2010); In re Steedley, 2010 WL 3528599 (Bankr. S.D. Ga. 2010); In re Walsh, 2011 WL 867046 (Bankr. Mass. 2011); In re Kamell, 2011 WL 1760282 (Bankr. C.D. Cal. 2011).

However, the broader view allows the debtor to retain all property of the estate in the same manner allowed in Chapter 13 cases. See In re Tegeder, 369 B.R. 477 (Bankr. D. Neb. 2007); In re Roedemeier, 374 B.R. 264 (Bankr. D. Kan. 2007); In re Shat, 424 B.R. 854 (Bankr. D. Nev. 2010) (holding that Congress intended to make individual Chapter 11 cases more like Chapter 13 and since there is no “absolute priority rule” in Chapter 13 cases, the amendments were intended to have the same effect in Chapter 11).

Limiting the Retained Property

Limiting the retained property to post-petition income does not provide the debtor much relief from the absolute priority rule. Since this income would normally be used by the debtor to fund the Chapter 11 plan in paying the projected disposable income to claimants, a typical Chapter 11 debtor would not be retaining a significant portion of this income anyway. Thus, this narrow interpretation of this exception to Code ' 1129(b)(2)(B)(ii) effectively leaves the debtor in the same position that the debtor existed prior to BAPCPA.

Conclusion

Chapter 11 cases for individuals will continue to be a limited option until Congress: 1) amends 26 U.S.C.
' 1398 eliminating double taxation for Chapter 11 individuals; 2) amends 11 U.S.C. ' 330(a)(4)(B) to allow the payment of attorney services to individual Chapter 11 debtors under ' 330; and 3) makes it clear that the exception to the absolute priority rule under Code ' 1129(b)(2)(B)(ii) includes all property of the estate. It is a shame that the effectiveness of BAPCPA for the benefit of individuals in Chapter 11 cases has been hampered by these provisions. In many instances, Chapter 11 is the only option for an individual to reorganize, and although there is no legislative history making this clear, it seems that the only logical purpose of BAPCPA for individual Chapter 11s was to provide individuals an avenue for paying projected disposable income and reorganizing in the same manner that existed in Chapter 13. Until there are statutory corrections, however, the existence of the complications created by the Internal Revenue Code, the lack of authority for compensation for debtor's counsel, and the narrow interpretation of the exception to the absolute priority rule will continue to limit the reorganizing options for individuals.

William L. Norton III is a partner in the Bankruptcy, Restructuring and Distressed Investing practice at Bradley Arant Boult Cummings LLP (Nashville, TN), where he focuses his practice on Chapter 11 business cases, representing debtors, secured creditors, unsecured creditors, committees and trustees. He can be reached at [email protected] or 615-252-2397.

Individuals have always had a difficult time reorganizing under Chapter 11, and many who represent individual debtors believed that the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA” or “2005 Amendments”) would make it easier for individuals to operate and reorganize under Chapter 11. Several amendments to the Chapter 11 provisions of the U.S. Bankruptcy Code were added and amended to create a similar path that individuals follow under Chapter 13. Unfortunately, either as an oversight or by design, certain provisions that exist under Chapter 13 were not included in the Chapter 11 provisions, and recent cases have made the reorganizations of individual Chapter 11s in those jurisdictions as difficult as prior to the BAPCPA. This article discusses the major uncertainties that currently exist in these types of cases.

Post-Petition Income

BAPCPA added Code ' 1115, which added to property of the estate under ' 541 all “earnings from services performed by the debtor after the commencement of the case.” This provision is identical to Code ' 1306 that exists for Chapter 13 cases, and one would expect it to operate in a Chapter 11 case with similar results. But because of the failure of Congress to also amend companion sections relating to post-petition operations, the Chapter 11 debtor must face obstacles that do not exist for the Chapter 13 debtor.

First, the Internal Revenue Code has always created a taxable estate for Chapter 11 debtors pursuant to 26 U.S.C. ' 1398(a). This taxable estate is easily dealt with in the context of a corporation or operating entity. However, for an individual who often receives income through the payment of wages from third parties, the dual estate presents some tax complications that are difficult for the most sophisticated of tax experts and are mind boggling to most bankruptcy counsel. In fact, many do not appreciate the complications until it is too late. These complications do not exist in Chapter 13 because the Internal Revenue Code does not create a separate taxable estate when a Chapter 13 case is commenced.

For example, which taxable entity, the individual or the estate or both, is taxed on wages paid by a third-party employer to the Chapter 11 debtor? The Internal Revenue Service has issued Revenue Notice 2006-83, which states that the W-2 should be issued to the individual so that self-employment taxes and other withholdings that apply only to individuals will continue to be withheld. See 2006-2 CB 596 (Sept. 18, 2006). On the other hand, Notice 2006-83 states that 1099s should be issued to the estate. The party receiving the W-2 or 1099, however, may not be the party that includes the income as taxable revenues. 26 U.S.C. ' 1398 sets forth the required treatment during the Chapter 11 case. However, post-confirmation treatment of the debtor's income is less clear. The confirmation of a plan typically vests the property of the estate with the debtor. But under ' 1115, post-confirmation income remains the property of the estate until the case is “closed, dismissed, or converted.” Over five years after the enactment of BAPCPA, the IRS has yet to provide guidance regarding the tax treatment of this post-confirmation income.

Another question is how post-petition earnings paid by a third-party employer of the debtor should be taxed when the bankruptcy court allows the debtor to retain this income to pay personal living expenses. The treatment is easier when the bankruptcy estate generates this income and pays the amounts to the debtor for the payment of administrative expenses. The estate would be able to deduct these payments as administrative expenses. An individual, on the other hand, is not be able to deduct personal expenses. Again, guidance on this treatment is lacking.

Second, Code ' 330(a)(4)(B) creates an exception in Chapter 12 and 13 cases, in which the debtor is an individual, that allows the debtor to use property of the estate to pay the fees of the debtor's attorney for services benefiting the debtor, even though those interests may not benefit the bankruptcy estate. This allows the debtor to compensate counsel using post-petition earnings for such services as divorce matters and defense of dischargeability actions under Code ' 523.

Unfortunately, Congress failed to amend Code ' 330(a)(4)(B) to include Chapter 11 cases. Thus, the debtor must show to the court some benefit to the estate in order to allow compensation to the debtor's counsel from post-petition earnings that constitute property of the estate. This has caused some attorneys, particularly in cases where a dischargeability action is contemplated or a divorce proceeding is pending, to use pre-petition paid-on-receipt retainers prior to accepting such cases. Because of the amount of cash that is required up front in such instances, the inability to use post-petition income to pay for the services needed for the debtor is a severe limitation in Chapter 11 cases.

Third, limitations exist in Chapter 11 as to how much post-petition income is permissible to be used by the debtor in the payment of personal expenses. Code ' 363(b)(1) authorizes a debtor to use property of the estate without court permission if it is in “the ordinary course of business.” In a Chapter 11 context, however, an individual may, but does not always, operate a business. Even when the debtor has a business, the debtor will undoubtedly have personal expenses for which this authorization under Code ' 363(b) would not apply. In such instances, the debtor will need to apply to the court for approval to pay these expenses, typically through a budget following notice and hearing the creditors. Although theoretically, the same issue would apply to individuals in Chapter 13 cases, the matter is not nearly as significant in Chapter 13 cases because a plan is usually proposed and confirmed in relatively short period of time following the commencement of the Chapter 13 case. In the Chapter 11 context, the length of time that it takes to confirm a Chapter 11 plan is typically months, thus requiring the debtor to operate under ' 363 prior to confirming a plan and enabling creditors to object to the use of property of the estate for a debtor's personal expenses.

Confirmation of the Plan

It does not get easier for individuals in Chapter 11 cases when trying to confirm a plan of reorganization. Similar to the Chapter 13 model, Code ' 1129(a)(15) requires the distribution of all “projected disposable income of the debtor that is received by the debtor during the five year period beginning on the date that the first payment is due under the plan ' .” This section refers to Code ' 1325(b)(2) in defining “projected disposable income.”

While there remain some differences as to the distribution of projected disposable income in Chapter 11 cases as applied in Chapter 13 cases, the most significant difference is the continued application of the absolute priority rule under Code ' 1129(b)(2)(B)(ii). [Note, the most notable difference is that a Chapter 13 plan is limited to an "applicable commitment period" under 11 U.S.C. ' 1325(b)(4) while the Chapter 11 plan is limited only to the "value of property" received during a five-year period. See 11 U.S.C. '1129(a)(15).]

In Chapter 13 cases, there is no voting by classes of creditors and the absolute priority rule does not exist. As long as the debtor is able to demonstrate the payment of projected disposable income, the distribution of that income to unsecured claims in a Chapter 13 case is deemed fair and equitable. See 11 U.S.C. ' 1325(b). BAPCPA amended the cramdown provisions of Code
' 1129(b)(2)(B)(ii) in a manner that many presumed, when the statute was enacted, would create an exception for individuals to the absolute priority rule so that the focus would be on the projected disposable income in the same manner that exists in Chapter 13.

The Absolute Priority Rule

The existence of the absolute priority rule for individuals in Chapter 11 cases that existed prior to BAPCPA was a significant obstacle to confirmation of a successful plan of reorganization. See Norwest Bank Worthington v. Ahlers , 485 U.S. 197, 108 S.Ct. 963 (1988) (absolute priority rule precludes debtor-farmer from retaining interest in farm operations). The absolute priority rule imposes an obligation on the debtor to pay all unsecured claims in full before the debtor can retain, without the creditors' consent, any property of the estate under a plan of reorganization. Corporations that cannot obtain the consent of unsecured creditors can still reorganize by terminating existing stock and transferring ownership of the entity to the creditors. This option does not exist for an individual. It is not feasible for an individual to surrender ownership of everything the individual owns to creditors. [Note, some courts have held that the individual debtor may retain exempt property and not violate the absolute priority rule. See In re Bullard, 358 B.R. 541 (Bankr. Conn. 2007); In re Steedley, 2010 WL 3528599 (Bankr. S.D. Ga. 2010) (debtor may retain exempt property).]

The 2005 Amendment

The 2005 amendment to Code ' 1129(b)(2)(B)(ii) created an exception to the absolute priority rule that allows the individual to retain property of the estate despite the fact that the debtor's plan is not paying the unsecured creditors the full amount of their claims and the unsecured creditors have not voted to accept this treatment under the plan. A split has occurred among the courts, however, as to how broadly to interpret this exception. The narrow view limits the retained property to post-petition income generated by the debtor pursuant to Code ' 1115. See In re Gbadebo, 431 B.R. 222 (Bankr. N.D. Calif. 2010) (Court held that ' 1129(b)(2)(B)(ii) means that the debtor may retain only the property added to the estate by ' 1115 and not all property under ' 541). Accord. In re Mullins, 435 B.R. 352 (Bankr. W.D. Vir. 2010); In re Gelin, 437 B.R. 435 (Bankr. M.D. Fla. 2010); In re Steedley, 2010 WL 3528599 (Bankr. S.D. Ga. 2010); In re Walsh, 2011 WL 867046 (Bankr. Mass. 2011); In re Kamell, 2011 WL 1760282 (Bankr. C.D. Cal. 2011).

However, the broader view allows the debtor to retain all property of the estate in the same manner allowed in Chapter 13 cases. See In re Tegeder, 369 B.R. 477 (Bankr. D. Neb. 2007); In re Roedemeier, 374 B.R. 264 (Bankr. D. Kan. 2007); In re Shat, 424 B.R. 854 (Bankr. D. Nev. 2010) (holding that Congress intended to make individual Chapter 11 cases more like Chapter 13 and since there is no “absolute priority rule” in Chapter 13 cases, the amendments were intended to have the same effect in Chapter 11).

Limiting the Retained Property

Limiting the retained property to post-petition income does not provide the debtor much relief from the absolute priority rule. Since this income would normally be used by the debtor to fund the Chapter 11 plan in paying the projected disposable income to claimants, a typical Chapter 11 debtor would not be retaining a significant portion of this income anyway. Thus, this narrow interpretation of this exception to Code ' 1129(b)(2)(B)(ii) effectively leaves the debtor in the same position that the debtor existed prior to BAPCPA.

Conclusion

Chapter 11 cases for individuals will continue to be a limited option until Congress: 1) amends 26 U.S.C.
' 1398 eliminating double taxation for Chapter 11 individuals; 2) amends 11 U.S.C. ' 330(a)(4)(B) to allow the payment of attorney services to individual Chapter 11 debtors under ' 330; and 3) makes it clear that the exception to the absolute priority rule under Code ' 1129(b)(2)(B)(ii) includes all property of the estate. It is a shame that the effectiveness of BAPCPA for the benefit of individuals in Chapter 11 cases has been hampered by these provisions. In many instances, Chapter 11 is the only option for an individual to reorganize, and although there is no legislative history making this clear, it seems that the only logical purpose of BAPCPA for individual Chapter 11s was to provide individuals an avenue for paying projected disposable income and reorganizing in the same manner that existed in Chapter 13. Until there are statutory corrections, however, the existence of the complications created by the Internal Revenue Code, the lack of authority for compensation for debtor's counsel, and the narrow interpretation of the exception to the absolute priority rule will continue to limit the reorganizing options for individuals.

William L. Norton III is a partner in the Bankruptcy, Restructuring and Distressed Investing practice at Bradley Arant Boult Cummings LLP (Nashville, TN), where he focuses his practice on Chapter 11 business cases, representing debtors, secured creditors, unsecured creditors, committees and trustees. He can be reached at [email protected] or 615-252-2397.