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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.

 

“Priority” Wages and Benefits Owed to Employees

September 14th, 2016 at 7:00 am

If you owe an employee wages or benefits, it’s likely a priority debt. Same if you are owed wages or benefits.  More likely to be paid.

 

We’ve been writing in recent blog posts about “priority” debts, such as child/spousal support and income taxes.

In a Chapter 7 case the bankruptcy trustee pays these in full ahead of paying anything whatsoever on other debts. See Section 726(a)(1) of the U.S. Bankruptcy Code. (That’s only if the trustee has any of your assets to liquidate, which is usually not the case.)

In a Chapter 13 case you have to pay priority debts in full during the life of the case. See Section 1322(a)(2).

Employee Wages and Benefits

There’s a type of priority debt that doesn’t come up nearly as often as child/spousal support or income taxes. But when it does it could be very important.

Under certain conditions a debt for unpaid employee wages, salaries, commissions, or benefits is a priority debt. If you’ve operated a business and owe this type of debt, it’s important to know how it’ll be treated.

Why It’s Important

Whether or not a debt for unpaid wages and benefits meets the conditions for being a priority debt especially matters if:

  • You are filing a Chapter 7 case in which the trustee is paying creditors, and you prefer that your employee(s) get paid ahead of other creditors. Then you want the wage/benefits debt to be a priority debt. That way it’s more likely your employee debt(s) will get paid.
  • You are filing a Chapter 13 case and you have very limited amount of money to pay your debts. Then you prefer the wage/benefits debt not to be a priority debt. That way you are not required to pay that debt in full. That makes your Chapter 13 plan less expensive to fund, perhaps turning an impossible situation into a feasible one.

The Conditions that Make a Debt to an Employee a Priority Debt

The basic rule:

  1. a debt for wages, salaries, or commissions (including vacation, severance, and sick leave pay)
  2. earned by an individual within 180 days of the bankruptcy filing or the closing of the business, whichever comes first
  3. up to $12,850

is a priority debt.

Chapter 7 Example

Let’s use two examples reflecting the scenarios mentioned above.

First, imagine you operated a business in your name that you closed the same day you filed a Chapter 7 case. You didn’t have the money to pay your single employee $3,000 for her final month of wages. You really want her to get paid. You also owe $100,000 in other personal and business debts.

You’re pleased to hear that $3,000 is a priority debt because it meets the 3 conditions listed above.

As your bankruptcy lawyer told you to expect, your Chapter 7 trustee asks you to turn over the last of your business equipment. The trustee liquidates the equipment, receiving $4,000. Out of that the trustee pays himself a fee of 25%, $1,000. (See Section 326(a).) The trustee pays your former employee the remaining $3,000, paying her off in full, because it’s a priority debt. Your other debts receive nothing, and are discharged (permanently written off).

Chapter 13 Example

Second, imagine you operated a business in your name that you just closed. Your single employer had quit 6 months ago. You suspect that one of the reasons your business failed is because that employee had been referring customers to a competitor, and getting paid a kickback fee. He started working for that competitor as soon as he stopped working for you. You have some evidence backing up your suspicions, but a lawyer has told you your legal case is weak against both your former employee and your competitor and simply not worth pursuing.

This employee’s regular salary was $4,000 per month. Because money was so tight during the final 6 months of working for you he agreed to let you hold back $1,500 of that salary monthly until you could afford to pay it back. The amount of back pay totaled $9,000. You feel like he owes you many times that amount of money for cheating you. And you certainly don’t want to pay him that $9,000 as a priority debt in the Chapter 13 case you’re filing.

So you’re happy to learn that this $9,000 debt is not a priority debt. It meets two of the 3 conditions listed above, but not the third one. Your former employee did not earn any of that $9,000 within 180 days of the close of the business or of the filing of your Chapter 13 case. So that debt is just a “general unsecured” debt. You pay it only to the extent you have enough disposable income to pay it, after living expenses and other more important debt. In many Chapter 13 cases the “general unsecured” debts are paid only pennies on the dollar. Sometimes they’re paid nothing.

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