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Paying Employee Debt in Bankruptcy

February 24th, 2020 at 8:00 am

If you prefer to pay back wages to a present or prior employee, bankruptcy can help you do so if you use the law in that employee’s favor.  

 

Our last two blog posts were about debts owed to your employees or independent contractors. Specifically we discussed the conditions in which past wages, commissions, or benefits qualify as “priority” debt. Two weeks ago we got into the conditions that apply to both employees and independent contractors. Last week the focus was on a special additional condition that only independent contractors must meet.

Whether a debt qualifies for priority status is often crucial. That’s because this can determine whether or not you pay that debt in the bankruptcy case.   In a no-asset Chapter 7 case none of the debts receive any payment within the case. So whether an unpaid wage or commission qualifies as priority or not doesn’t matter in this situation. But in an asset Chapter 7 case it makes all the difference. It’s common that priority debts receive payment in part or in full, while the rest of the debts receive little or nothing. There’s a similar result in a Chapter 11 business reorganization or 13 adjustment of debts case. Priority debts generally receive payment in full while other debts receive little or nothing.

Assume that you’d prefer that your past or present employee/independent contractor receive payment for what you owe him or her at the time of your bankruptcy filing. If so, you need to know the conditions for making that debt a priority debt, and how to apply them. Today we’ll review the conditions and then apply them an asset Chapter 7 example. Next week blog post will demonstrate an example in a Chapter 13 case.

The Conditions

We covered the conditions that an unpaid wage or commission is a priority debt the last two blog posts. We’ll review them very briefly here.

For a debt you owe either an employee or independent contractor:

If you owe the debt to an independent contractor, he or she needs to meet an additional condition. The debt is a priority debt ONLY if

during the 12 months preceding that date [of bankruptcy filing or cessation of business], at least 75 percent of the amount that the individual or corporation earned by acting as an independent contractor in the sale of goods or services was earned from the debtor.

Section 507(a)(4)(B) of the Bankruptcy Code (bold added).

Our Chapter 7 Asset Case Example

Assume you owe a prior employee $7,500 for wages and benefits. Your employee earned these wages and benefits over a period of four months, from 150 to 30 days ago, when you had to lay her off.

Your sole proprietorship business is still operating. You intend to close it and file a Chapter 7 bankruptcy soon.

Your bankruptcy lawyer has advised you that your business equipment is not exempt. This mean it’s not protected from collection and liquidation by the Chapter 7 bankruptcy trustee. He or she will take it from you, sell it, and use the proceeds to pay your creditors.

This equipment has a liquidation value of about $10,000. You don’t need the equipment after closing the business because you don’t intend to be in this kind of business ever again. But you do wish you could put it’s value to some good use.

You owe $150,000 on all of the rest of your debts. These consist of unsecured trade debt, business and personal unsecured credit cards, and medical bills. These are all considered “general unsecured” debts. None are priority debts except potentially the $7,500 you owe to your prior employee. You have a home mortgage but you’ve managed to keep current on it. Your home has a bit of equity but it’s protected by the homestead exemption.

Timing the Filing of Your Chapter 7 Case

You may have reasons to delay filing your case. You may have new employment lined up but it doesn’t start for several months. You may have business customer paying you soon and you’ll need the money for your home mortgage in the meantime. There can be countless legal and/or practical reasons for filing your case later.

However, your prior employee would likely really benefit from you filing your case within about a month. Then, because of the 180-day condition cited above, there’s a good chance she’d receive all or most of her $7,500.

How? The Chapter 7 trustee would liquidate your business equipment. The trustee would receive a fee—likely about $1,750. (By law, no more than 25% of the first $5,000 liquidated and 10% on the second $5,000. Section 326(a) of the Bankruptcy Code.) $10,000 minus $1,750 leaves $8,250. (25% for the first $5,000 is $1,250, plus 10% for the second $5,000 is $500, totaling the trustee’s $1,750 fee.) The remaining $8,250 would go to pay priority debts first, before paying anything to the general unsecured debts.

The $7,500 debt to your prior employee would all be priority debt. That’s because in our scenario it was all earned within the 180-day period before your simultaneous business closure and bankruptcy filing. Plus the $7,500 amount is less than the $13,650 limit referenced above.

So in this example your prior employee would receive her $7,500 in full.

Of course if the business equipment sold for less, your employee would receive only partial payment. Assume it sold not for $10,000 but rather only $7,000. $7,000 minus the trustee’s $1,450 would leave $5,550 for the trustee to distribute. Likely all of this would go to your employee. So she’d receive at least a significant portion of her debt.

If You Delayed Filing Bankruptcy

Assume instead that you closed your business and filed your Chapter 7 case five months from now. At that point all of her wages and benefits would have been earned more than 180 days earlier. So, none of the $7,500 would qualify as priority. The debt would be a general unsecured one, lumped in with other $150,000 of such debt.

Then, your employee would receive very little. Assume again that the bankruptcy trustee sells your business equipment for $10,000, leaving $8,250 for payment of the debts. This would be distributed pro rata to the $157,500 in general unsecured debt (her $7,500 plus the other $150,000). $8,250 divided by $157,500 amounts to all debts receiving only about 5 cents on the dollar. So your prior employee would receive only about $375 on her $7,500 debt.

Conclusion

There are many factors that come into play for determining what day you file your bankruptcy case. Some of those factors may well be much more important than helping your employee/independent contractor receive payment. But sometimes a business owner has some flexibility on timing. And getting an employee/independent contractor some money may be a high priority for various personal or business reasons. This would be especially true if that money would otherwise go to a debt you don’t care about getting paid. In such situations you and your bankruptcy lawyer may well be able to put these priority laws to good use, as we showed in today’s blog post.

 

Commissions Owed to Independent Contractor

February 17th, 2020 at 8:00 am

If you owe sales commissions to an independent contractor when you file bankruptcy, it may be a priority debt. Here’s what determines this

 

Our last blog post was about conditions in which wages, commissions, or benefits owed to an employee are “priority” debt.

But what if your debt was not to an employee but an independent contractor? Especially in today’s “gig economy,” small businesses (and large ones, too) often have independent contractors instead of employees.

Why “Priority” Matters

As discussed last week, whether a debt qualifies as a priority debt can make a huge difference.

This most often matters in a Chapter 13 “adjustment of debts” case. You have to pay all priority debts in full during the 3-to-5-year court-approved payment plan. In huge contrast, usually you only pay the non-priority “general unsecured” debts to the extent you can afford to pay. The common result is that you pay priority debts 100%, while those that don’t qualify as priority little or nothing.

The distinction between priority and general unsecured also matters in an “asset” Chapter 7 case. That’s the relatively uncommon situation in which a debtor needs to surrender an unprotected asset to the Chapter 7 trustee. In that situation the trustee liquidates the asset and pays priority debts in full before paying any general unsecured debts. The result: priority debts often get paid in full or in part, while there’s nothing for any general unsecured debts.

The distinction between priority and general unsecured does not directly matter in a simple, “no-asset” Chapter 7 “straight bankruptcy” case. That’s the common situation when everything you own is “exempt”—protected from the Chapter 7 trustee. Many Chapter 7 cases are “no-asset” ones. (However, note that most priority debts can’t be discharged in a Chapter 7 bankruptcy. So while such debts won’t receive anything from the trustee, you’ll likely still have to pay the debt afterwards yourself.)

The Basic Amount/Timing Rule

Whether you owe an employee or an independent contractor, some of the conditions to make the debt priority are the same.

First is the maximum dollar amount. The maximum amount of a debt that would qualify as priority is $13,650. See the discussion in our last blog post about this amount. (Also see the original statute’s $10,000 amount in Section 507(a)(4) of the U.S. Bankruptcy Code, the cost-of-living provision in Section 104 of the Bankruptcy Code, and the current $13,650 amount since April 1, 2019 in this notice in the Federal Register.)

The second condition is the timing. The debt owed must be

earned within 180 days before the date of the filing of the [bankruptcy] petition or the date of the cessation of the debtor’s business, whichever occurs first

Section 507(a)(4) of the Bankruptcy Code.

So, any amount owed to an employee/contractor beyond $13,650 would be a general unsecured debt, not a priority one. Same with any amounts earned outside the specified 180-day period.

The Special Independent Contractor Rule

Beyond the above amount/timing conditions, there’s another significant condition especially for independent contractors. The debt is a priority debt ONLY if

during the 12 months preceding that date [of bankruptcy filing or cessation of business], at least 75 percent of the amount that the individual or corporation earned by acting as an independent contractor in the sale of goods or services was earned from the debtor.

Section 507(a)(4)(B) of the Bankruptcy Code.

So if your independent contractor earned less than 75% of its overall income during that one-year period from you, then none of what you owe it is priority.

Presumably the purpose of this condition is so that it applies only to independent contractors who are more like employees. It includes only those independent contractors who work mostly for you. It is not meant to apply to debts owed to suppliers of goods and services that serve many customers. Those are more like conventional payables, which are general unsecured debts, not entitled to priority.

 

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