The “Best Interest of the Creditor” Test
This is an analysis that we must do on every chapter 13 that we plan on filing with the bankruptcy court. The “best interest of the creditor” test is in place to make sure the creditor will be no worse off by the debtor filing for relief under chapter 13 of the code.
Chapter 7 Liquidation
To properly understand how this works, it is important to first review the nature of a chapter 7 filing. A Chapter 7 bankruptcy is a liquidation of the debtor’s property in theory. I say in theory because the overwhelming majority of the chapter 7s filed do not actually undertake in the liquidation of the debtor’s estate. These cases are labeled as no assets cases after an investigation by the interim trustee selected to review the filing. It is not that he debtor has absolute no assets, but what assets the debtor does have are protected from liquidation. A debtor is allotted a certain amount of statutory exemptions that he can utilize to protect a base level of his property. The public policy in the exemptions is to not strip the debtor of everything, but to allow him a reasonable foundation to begin his “fresh start”. Otherwise, a debtor who has been stripped of everything may face an insurmountable task as he embarks on life after bankruptcy.
Should there be a liquidation of the debtor’s estate, than each of his creditors will share in distribution after the costs of administrative are paid. The creditor’s will be classified under the code and will rank in priority to determine proper allocation of the estate funds. The first creditor class that will receive distribution would be any creditors that were secured by the collateral that was liquidated. The second class of creditors to receive payment in a liquidation case would be those that have a priority status. A common example of this class will be taxes owed to the IRS. Finally the remaining creditors who fall in the non-priority unsecured class will share pro-rata the remaining proceeds under the estate’s liquidation.
Best Interest of the Creditor Test
Every Chapter 13 plan that is confirmed by the bankruptcy court must comply with the best interests of the creditor test. What this means is that the creditor must receive under the proposed chapter 13 plan an amount at least equal to that in which they would have received in a chapter 7 liquidation of the debtor’s estate. For example, if the unsecured non-priority creditors would have received a pro-rata distribution equal to 50% of the their total claim, the same class of unsecured creditors would need to be treated with the same by a plan that proposed to pay them the minimum 50% dividend.
Likewise, if a secured creditor would have been paid in full under the liquidation of particular piece of property in the state, than that same creditor must be paid accordingly under the chapter 7 plan. There is an exception, if the debt owed to the secured creditor is under a contract that exceeds the duration of the 5-year chapter 13 plan. In this case, it is sufficient that the plan continues to pay the secured creditor according to the terms in the contract. These payments often are paid “outside the plan” by the debtor directly to the secured creditor. The plan will have a provision that describes this arrangement and will be contingent on the debtor’s compliance in order for confirmation.
Ironically, the best interest of the creditor test is inherently flawed because it truly does not equate to putting the creditor in the same shoes that they would be in under a chapter 7 plan. This is because in a Ch 7 liquidation, the funds are dispersed after a sale and payment is almost always paid in a lump sum. Alternatively, a creditor must accept a repayment plan of the same amount of money in structured plan that lasts anywhere from 36 to 60 months. This payment plan often does not include any additional interest or compensation for the spread out repayment. Thus, based on the simple principle of the time value of money, the “best interest of the creditor” is not truly achieved in a chapter 13 but stands as a clear and measurably benchmark for the Chapter 13 trustee’s to utilize in performing their duties.
Paying your taxes with a credit card
I think it is common knowledge that most recent governmental tax liabilities are not dischargeable in a bankruptcy filing. Theses debts are given a priority status and will survive a debtor’s discharge in a chapter 7. In a chapter 13, the debtor will be required to pay the priority tax liability inside the plan.
With this information, there are many clients that look to clear this priority debt by using credit cards to pay off the taxes. The debtors then wait 60 to 90 days to file because they were told they cannot have any recent purchases on their card prior to filing. Then when the petition is filed, there is no priority debt left and what remains is the dischargeable credit card debt. Sound pretty smart? Not so fast.
Code section 523a(14)-(14a) states that debts incurred to pay certain taxes are non-dischargeable as a matter of law. See 11 U.S.C. § 507(a)(8); In re Redmond, 399 B.R. 628, 633 (Bankr. N.D. Ind. 2008) (Charge made by debtor on bank’s credit card to pay property tax was nondischargeable.) A debtor cannot convert a nondischargable property tax to dischargeable debt by using a credit card to pay the tax debt. In re Gavin, 248 B.R. 464 (Bankr. M.D. Fla. 2008). “Defendant’s argument in response to nondischargeability is that the debt is now an unsecured debt owed to American Express. However, Section 523(a)(14) directly counters this argument. In MBNA America v. Chrusz, funds from a credit card check made to “Cash Deposit” were used to pay nondischargeable taxes. The Chrusz Court found that the funds traceable to payment of nondischargeable Section 523(a)(1) debt were nondischargeable under Section 523(a)(14).” Gavin, 248 B.R. 464, 465 (internal citations omitted); See also Arthur B. Federman, The Bankruptcy Reform Act of 1994, 51 J. Mo. B. 105, 106 (1995) (debtors cannot borrow funds with credit card to pay taxes that would be nondischargeable).” Also, I have attached a copy of the Redmond and Gavin decisions for your reference. These are merely instructive, not exhaustive, as there numerous cases on this issue from various jurisdictions. See also Oneida Ltd. V. Pension Benefit Guaranty Corp. (In re Oneida Ltd.) 383 B.R. 29, 42 n. 14 (Bankr. S.D.N.Y. 2008).”
To attorneys, because I think this is an often overlooked inquiry on the intake, ask your clients if they used their credit card to pay off any tax liabilities. Prepare them for the possibility of the creditor objecting to the discharge of the debt as non-dischargeable pursuant to 523.
Of course, the creditor has to raise this objection and probably 7 out of 10 times this charge is overlooked.
The sneaky cross collateralized claim
I spoke in recent posts about a debtor options when in a chapter 7. The debtor can decide to retain a house or car that is secured by a mortgage or car note, but to do so he will have to “reaffirm” the debt that he owes to the lender. As a refresher, when someone files for bankruptcy relief his debts are by default discharged outside of some exception. Although the debts are all discharged, any lender that has a secured claim against the debtor’s property can retrieve the pledged collateral (there are exceptions to this rule too). A debtor can, in most cases agree to repay the debt, and keep the collateral. This process is memorialized by filing a “reaffirmation agreement” with the court. This reaffirmation agreement has the effect of making the debtor again legal bound for the note. By placing him back on the hook for the debt, the creditor’s secured claim survives the chapter 7 discharge. If the debtor fails to pay as per the agreement, the lender has the same legal rights to retrieve the collateral by repossession or foreclosure and sue for any deficiency still owed on the note.
Clear? Well there is a creature out there that most credit unions and some small lending institutions work into all their contracts. This provision is called a cross collateralized claim. A “Cross collateralized claim” has the effect of allowing the particular note to be secured by any and all assets that the debtor has pledged with the credit union or bank. In addition, it has the power to make what appears to be a unsecured debt transform into a secured loan.
A common example I see with my clients is when they have a car loan and a credit card with their local credit union. Once they have a feel for the way a chapter 7 works, they are confident that they will be able to discharge their credit card debt. They believe the only decision is whether or not to reaffirm on the vehicle. They soon find out this is not the case. They learn that what they have actually done is actually quite different. Of course they realize that car loan was secured by the vehicle. However, they thought they were simply taken out an additional unsecured credit card debt. Because of the cross collateralized claim, the impact of the credit card turns out to be something similar to additional line of credit secured by the vehicle. The provision allows the credit union to take the vehicle as collateral, not only for the car note, but also for the credit card debt.
The impact. Quite a different decision is in front of the debtors. They are now faced with the dilemma of either surrendering the vehicle or reaffirming BOTH the car not and the credit card, and if you have read my posts with any frequency, you know what my advice is to them — surrender it all!! You will survive, start over, get the fresh start that the bankruptcy code offers, and devise a plan that will allow you to go forward without owing anyone a penny on credit.
Stephen Baldwin files chapter 11
Another celebrity has filed for bankruptcy protection. Stephen Baldwin and his wife Kennya Baldwin filed for Chapter 11 bankruptcy protection in New York a month ago.
What is a Chapter 11 bankruptcy? This filing is analogous to the chapter 13 filing that many Americans file. The reason for Mr. Baldwin filing a chapter 11 is because his debt limits, both secured and unsecured, exceed those allowed in the Chapter 13 arena. Also, Mr. Baldwin apparently has an income that would prevent the ability for him and his wife to seek relief under a Chapter 7.
The result? We will wait and see but a Chapter 13 will require Mr. Baldwin tom pay his disposable income to his unsecured creditors for a particular commitment period.
Mr. Baldwin’s name has been in the news quite a bit lately. First, participating in yet another reality TV show, Mr. Baldwin quit the show “I’m a Celebrity, Get Me Out of Here”. This show had him staying in a jungle. The reason provided was case of extreme bug bites. The Baldwin couple also had a homeless man staying with them who was arrested for possession of heroin. In June, the Baldwin’s home was listed for foreclosure.
According to the Baldwin’s petition, they have assets worth a value of $1.1 million and liabilities exceeding $2.3 million. Included in the Baldwin’s debt is over one million dollars in federal and state taxes.