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Avoiding Paying Prior Employee Debt

March 9th, 2020 at 7:00 am

If you prefer NOT to pay back wages to a present or prior employee, bankruptcy can help you use the law to prevent it being a priority debt.


Imagine that in the near future you’re closing down a business and filing bankruptcy.  You owe an employee or independent contractor back wages or commissions. But you’d rather not pay that debt because you believe that employee had a major role in the business failing. You’d much rather have your scarce money go towards, for example, paying your income taxes. How do you use the law to your advantage to accomplish this?

Our last blog post showed how to use the law to pay a favored prior employee or independent contractor. Today we show how to avoid doing so.

It’s All about the Timing

We fully laid out the rules about “priority” wage/commission debts in our blog posts of 3 and 4 weeks ago. Briefly, a wage or commission is a priority debt if it meets two conditions. One’s a timing condition and the other a dollar-amount one. The wage/commission money owed:

  1. must have been “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;  and
  2. the amount earned can be no more than $13,650. Section 507(a)(4) of the Bankruptcy Code, with a cost-of-living adjustment of the $10,000 stated there.

Assume that the amount you owe your prior employee or independent contractor is less than $13,650, thus meeting that condition. So the other, timing condition is what we’re focusing on.

A wage/commission is a priority debt if it was earned within the indicated 180-day period. If it wasn’t earned within that period, the wage/commission is instead a “general unsecured” debt. As we’ll show in our two examples below, general unsecured debts are much less likely to get paid in bankruptcy.

Some Facts for Our Example

Imagine the following basic facts.

You owe your prior employee $7,500 for wages and benefits. He earned these wages and benefits over a period of four months, from 180 to 60 days ago. That’s when you laid him off, suspecting embezzlement or other inappropriate behavior.

Your sole proprietorship business is still operating, but you intend to close it and file personal and business bankruptcy soon.

You owe $10,000 in last year’s personal income taxes. In addition you owe $150,000 more 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.

Not Paying Employee in Asset Chapter 7

An asset Chapter 7 case is one in which you have some assets which are not protected. They are not protected from a Chapter 7 trustee taking and liquidating them to pay your creditors. The crucial fact is that the trustee pays any priority debts in full before paying a dime of general unsecured debts. Often there’s only enough money to pay priority debts—in full or pro rata—with nothing or very little left for the general unsecured debts.

In our example assume that your bankruptcy lawyer has advised you that your business equipment is not protected. It’s not “exempt.” It has a liquidation value of $10,000. If you file a Chapter 7 case it’s the asset that your bankruptcy trustee would use to pay your creditors.

This equipment has a liquidation value of about $10,000. You won’t need the equipment after closing the business. But you do want to put its value to the best use possible.

The point is to use the above timing condition to turn this prior employee debt into a general unsecured one. You do that by either closing your business or filing the Chapter 7 case so that the $7,500 wage debt was not earned during the 180 days before either of those two events. Under our facts the wages were most recently earned 60 days ago. So wait 120 more days to either close down the business or file the Chapter 7 case. That way none of the wages would have been earned within the 180-day period  (It’s the earlier of those two events that counts so you can’t do either for 120 days. But once you do one—such as close down the business—you can file the bankruptcy case at any point later.)

The Result in the Asset Chapter 7 Example

Under our facts the trustee would do the following with the $10,000 from sale of the business equipment. After paying his or her legally-allow fee, all the rest would go to your income tax debt. None would go to your disfavored prior employee.

The trustee’s fee would likely be no more than $1,750. It’s calculated at a maximum of 25% of the first $5,000 liquidated amount and then 10% on the second $5,000. Section 326(a) of the Bankruptcy Code. $10,000 minus $1,750 leaves $8,250. That remaining $8,250 would go to pay priority debts first, before paying anything to the general unsecured debts. In our example the wage debt is all general unsecured debt, not priority debt. So all of the remaining $8,250 would all go to your last year’s income tax debt of $10,000. You’d owe the rest—about $1,750. But you would have used most of your equipment value towards a debt you would have otherwise had to pay anyway, leaving a relatively low balance. And again, you met your goal of having none of your equipment value go to your prior employee.

Not Paying Employee in Chapter 13

In a Chapter 13 case you must pay all priority debts in full during the 3-to-5-year court-approved payment plan. Usually you must pay general unsecured creditors only as much as you can afford to pay them. This is AFTER paying priority debts in full, and often after paying secured debts as well. General unsecured debts often receive little, sometimes nothing at all. So whether a debt is a priority debt usually has a huge impact on whether and how much you must pay it.

In our example, if you were to close down the business or file bankruptcy right away, the $7,500 prior employee wage would be a priority debt. During the course of the payment plan you’d have to pay it in full. That’s in addition to paying the $10,000 income tax priority debt in full.  What happens if your budget would not allow you to do that in 3 years? The payments could be extended as long as 5 years to accomplish that. That is, you could be in your case years longer if your employee debt was a priority one.

However, if you waited the 120 day mentioned in the Chapter 7 example above to close down your business and file the Chapter 13 case, the $7,500 wage debt would likely receive much less. It may receive nothing. It would be a general unsecured debt, mixed in with the other $150,000 of general unsecured debts. This pool of $157,500 of general unsecured debts would only get paid to the extent your budget allowed. It would receive something only after you paid the $10,000 priority income tax debt in full. Plus your bankruptcy lawyer fees and Chapter 13 trustee fees receive payment usually before the general unsecured debts receive anything.

The Result in the Chapter 13 Example

So, if you’d close the business or file the Chapter 13 case right away, you’d have to pay your prior employee’s prior wage debt in full. If you couldn’t do so (and pay the income tax debt, etc.) within 3 years, you’d have to pay as much as 2 years longer.

If instead you’d wait until the wage debt turned into a general unsecured debt, you’d likely pay it very little. There’s a decent chance (depending on your budget) that you’d pay nothing on it at all.

 

Paying Employee Debt in Chapter 13

March 2nd, 2020 at 8:00 am

If you prefer to pay back wages to a present or prior employee, you can do so in Chapter 13 especially well if that debt is a priority one.

 

Our last three blog posts have been about debts you owe to your employees or independent contractors. Specifically, we discussed the conditions under which past wages, commissions, or benefits qualify as a“priority” debt. These posts covered:

  • the conditions that apply to both employees and independent contractors (3 weeks ago)
  • the special additional condition applicable only to independent contractors (2 weeks ago)
  • an example of paying an employee’s wages as a priority debt in an “asset” Chapter 7 case (last week)

Today, we’ll show how you could pay an employee/independent contractor in full in a Chapter 13 “adjustment of debts” case.

Why Priority Matters under Chapter 13

Assume you’d really like your former (or ongoing) employee/independent contractor to receive payment on what you owe. Whether that debt qualifies for priority status often determines whether you’ll pay that debt or not. Or it may determine whether it’s paid in full, in large part, very little, or nothing at all.

Focusing on Chapter 13, whether or not a debt qualifies as a priority one is usually crucial. That’s because you are legally obligated to pay all priority debts in full. Debts that don’t qualify as priority usually receive much less, and sometime receive nothing.

Your Chapter 13 payment plan must show how you will pay all priority debts. The bankruptcy judge will otherwise not approve the payment plan. The U.S. Bankruptcy Code is straightforward:

(a) The plan—

(2) shall provide for the full payment, in deferred cash payments, of all claims entitled to priority under section 507

Section 1322 of the Bankruptcy Code.

(There’s an exception if the employee/independent contractor agreed not to receive “full payment.” But assume here that—as is almost always true—he or she does want to get fully paid and won’t agree not to be.)

So what happens under Chapter 13 if that wage/commission debt does not meet the conditions to be priority debt? That wage/commission is lumped in with all the other ordinary “general unsecured” debts. Very seldom do Chapter 13 plans pay general unsecured debts in full. (A so-called 100% plan.) Most often they receive significantly less than 100%. (Say, a 30% or 40% plan.) Quite often they receive payment of only pennies on the dollar. (For example, a 3% plan.) Finally, it’s not unusual that general unsecured debts—including a non-priority wage/commission debt—would receive absolutely nothing. (A so-called 0% plan.)

In summary, your plan must pay a priority debt in full. But the plan will very likely pay your general unsecured debts a fraction, or possibly even nothing.

Our Chapter 13 Case Example

Assume you owe a prior employee $5,000 for wages earned over a period of four months. This period was from 150 to 30 days ago, at which point you had to lay him off.

Your sole proprietorship business is still operating. You intend to close it and file a Chapter 13 bankruptcy soon. You have a decent job waiting for you as soon as you do, and have some flexibility when to start.

You owe $125,000 on all of the rest of your debts, which are all general unsecured. None are priority debts except potentially the $5.000 you owe to your prior employee.

Reminder about the Priority Conditions

As discussed in our last 3 blog posts, a wage is a priority debt if it meets two conditions:

  1. it was “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.
  2. the amount is no more than $13,650. Section 507(a)(4) of the Bankruptcy Code, plus a cost-of-living adjustment of the $10,000 stated there.

With the amount of the wage owed in our example being $5,000, this debt meets the second, dollar-limit condition. So we focus the rest of this blog post on the first, timing condition.

Timing the Filing of Your Chapter 13 Case

As you can see from the timing language in the statute above, a wage’s priority status turns on when the employee earned it.  The wage (or commission or benefits) must have been earned within a 180-day period. That period must be immediately before either the closing of your business or your filing Chapter 13, whichever of those happens first.

Back to the Example

To pay the $5,000 wage debt in full, you need to have it meet the conditions of priority status. Your business is still operating at the moment. You have control over when to cease operating, and when to file the Chapter 13 case.

In the real world you actually likely have limited control over these two events. You likely have various constraints on both. Timing when to shut down even a small business usually involves a variety of practical, and sometime tough, choices. Timing a Chapter 13 filing likely turns on the creditor collection pressures and there are often other legal timing considerations.

But let’s assume you have at least some flexibility. Under our facts, if you want this employee’s wage debt to be a priority debt you need to do one of two things within the next 30 days. You need to either close down your business or file your Chapter 13 case within that time.  After that some of this employee’s wages will start turning into general unsecured debt. (Recall it was all earned 150 to 30 days ago.) So after 30 days the oldest of the wages will be start being more than 180 days old. Then 210 days from now the last of the wages would turn into general unsecured debt.

If you can’t file your Chapter 13 within 30 days for practical or legal reasons, it’s enough to just shut down your business. As you see from the statute’s language, that triggers the 180-day period, even if you don’t file the Chapter 13 case until later.

What Happens in the Chapter 13 Case

Assume you either shut down your business or file your Chapter 13 case within the next 30 days. Then the $5,000 wage debt would be a priority debt. Simply put, Chapter 13 law requires the payment plan you and your bankruptcy lawyer put together to include enough money to pay that $5,000. The bankruptcy court would otherwise not approve the plan. Furthermore, you could not complete the case without actually paying off that $5,000.

Now assume instead that you don’t shut down your business and don’t file Chapter 13 until after 210 days from now. Then, as just discussed, none of the wage debt would qualify as priority. It would all be general unsecured debt. Assume that in the next 3 years you would afford to pay $200 per month on all of your debts. That’s a total of $7,200. Assume that you paid all your attorney fees when you filed your case (leaving none to pay in the plan). In your jurisdiction assume the Chapter 13 trustee gets 5% of everything that flows through the plan—$360. That leaves the rest—$6,840—to go to all of the creditors. The general unsecured debts total $130,000—$125,000 plus the $5,000 wage debt. The $6,840 would be divided among this $130,000, meaning that these debts would receive about 5% of the amounts owed. Your former employee would receive only about $250 on the $5,000 wage debt.

So, if the $5,000 wage debt would qualify as priority, your former employer would receive payment in full. If none of it would so qualify, your employee would receive only about $250

.

Wages Owed to an Employee

February 10th, 2020 at 8:00 am

If you owe wages to an employee when you file bankruptcy, that may or not be a priority debt. Here’s what determines this and why it matters.  

 

Our last dozen blog posts have been about “priority” debts. These are special unsecured debts that bankruptcy law treats better than the rest, called “general unsecured” debts.

(Secured debts are a third main category of debts, distinctive because they are attached to your assets as security. We’ve covered those before and will again later. But now we’re addressing priority debts, which are not secured by any of your assets.)

The most common priority debts in consumer bankruptcy cases are income taxes and child/spousal support. So our recent blog posts have focused on these two. But if you have been operating a business with employees or independent contractors there are other important potential priority debts. These involve unpaid wages, salaries, commissions and benefits owed at the time of bankruptcy filing. Our next few blog posts will focus on these.

The Conditions of Priority

If you owe a wage, salary, commission, or employee benefit when filing bankruptcy, that may or not be a priority debt. It depends on timing and the amount owed. The pertinent statute says that priority debts include those:

only to the extent of $13,650 for each individual or corporation, as the case may be, earned within 180 days before the date of the filing of the petition or the date of the cessation of the debtor’s business, whichever occurs first, for… wages, salaries, or commissions, including vacation, severance, and sick leave pay earned by an individual

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

The $13,650 Dollar Limit

This dollar limit is mostly self-explanatory. Any amount owed to an employee up to $13,650 is a priority debt. Any amount beyond that is just a general unsecured debt.

This amount may seem odd. That’s because it’s been adjusted for inflation every 3 years as mandated by law. Section 104 of the Bankruptcy Code. It was originally $10,000. It’s been $13,650 for bankruptcy cases filed since April 1, 2019 (and will likely increase on April 1, 2022). See this notice in the Federal Register of February 12, 2019.

Timing

The wage, commission, etc. must have been earned within a very strict time period of 180 days. This is 180 days before your bankruptcy filing date or before you stopped operating your business, whichever happens first. So for example if you stop operating your business on January 1 and then file bankruptcy on the following March 1, the pertinent period would be the 180 day period before January 1. Wages, etc. earned during that period would count as priority. Earnings outside that period would be general unsecured debt.

Why Priority Matters

Whether a debt is a priority or general unsecured one sometimes doesn’t matter. But often it matters a lot.

This distinction of itself does not matter in a simple, “no-asset” Chapter 7 “straight bankruptcy” case. That’s one in which everything you own is “exempt”—protected from collection by the Chapter 7 trustee. Most straightforward consumer Chapter 7 cases are “no-asset.” If you operated a business you may also have a “no-asset” Chapter 7 case although that’s less likely.

The priority-general unsecured distinction matters a lot in an “asset” Chapter 7 case. That’s because the trustee pays debts out of the collected and liquidated non-exempt assets. The trustee pays priority debts in full before paying anything to general unsecured debts. Often that means that priority debts are the only ones that receive any funds from the trustee. Or priority debts may be paid in full while general unsecured debts only receive a few pennies on the dollar.

The priority-general unsecured distinction also matters a lot in all Chapter 13 “adjustment of debts” cases. A 3-to-5-year court-approved Chapter 13 payment plan must pay all priority debts in full. In contrast, the plan usually pays general unsecured debts only if and only to the extent there’s any money left over after paying all priority (and often secured) debts first. The result is that priority debts stand a much better chance of getting paid. In contrast, general unsecured debts often receive only a small portion of the amount owed, and sometimes absolutely nothing. (This also largely applies to Chapter 11 business reorganizations and Chapter 12 farm reorganizations.)

So under “asset” Chapter 7s and all Chapter 13s, whether a wage, etc. meets the priority conditions or not usually makes a tremendous difference about whether and the extent to which it is paid.

Order of Priority

There’s one more important consideration in whether a wage, etc. gets paid and to what extent. The law doesn’t just make a distinction between priority and general unsecured debts. Some priority debts have higher priority than others. The higher priority debts receive payment in full before the lower priority ones receive anything.

This doesn’t matter so much under Chapter 13 in which you must pay all priority debts in full. Nor does it matter in an asset Chapter 7 case in which there’s plenty of money to pay all priority debts. But it does matter in an asset Chapter 7 case in which there are more than one type of priority debts and there’s only enough money to pay some of them.

The order of priority for wages and such is fourth out of the ten listed priority debts. Some of these ten are obscure ones that seldom apply. Focusing on the most common ones, the wage priority is lower than child and spousal support debts but higher than income taxes.

 

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