Means Testing Dismissal and Conversion Under the New Law
The amendments to §707(b) of the Bankruptcy Code substantially modify the provisions of the current law with respect to cases filed on or after its effective date, Oct. 17, 2005. The old presumption that the debtor is entitled to relief under chapter 7 except upon a showing of "substantial abuse" will be discarded and replaced by a presumption of abuse through means testing. In addition to the introduction of means testing, the new law will allow a debtor to convert his or her case to chapter 11 or 13 as an alternative to having the case dismissed. Generally, U.S. Trustees (USTs), trustees, bankruptcy administrators (if any) and any party in interest may file a motion to dismiss a consumer debtor's case under §707(b).1
Current Monthly Income Defined
Means testing begins with the definition of "current monthly income" found in amended §101(10A). "Current monthly income" (hereinafter sometimes referred to as "CMI"2) is defined as the average monthly income from all sources that the debtor receives (or in a joint case the debtor and the debtor's spouse receive) in the six-month period ending on the last day of the calendar month prior to the commencement of the case.3 Section 101(10A)(A) specifically includes income without regard to whether such income is taxable income. Section 101(10A)(B) provides that CMI also includes any amount paid by any entity other than the debtor (or in a joint case the debtor and the debtor's spouse) on a regular basis for the household expenses of the debtor or the debtor's dependents. Social Security benefits and certain other payments will not be included to determine the debtor's CMI.4 Note that the definition of CMI is different from the definition of "disposable income" under §1325(b)(2), which excludes child support payments, foster care payments or disability payments for a dependent child.5 Note also that this new definition will not always be a sure indicator of the debtor's actual monthly income due to job losses, promotions, increased overtime and other factors.6
Median Family Income Defined
When a debtor seeks to file under chapter 7 of the revised Code, counsel will also need to determine under §707(b)(6) how the current monthly income7 of the debtor and the debtor's spouse combined8 multiplied by 12 (the "ACMI" or "annualized CMI") compares to the median family income for a family of the debtor's size residing in the applicable state. "Median family income" is defined in new §101(39A) as the median family income both calculated and reported by the Bureau of the Census in the then most recent year adjusted as necessary by the CPI. Pursuant to §707(b)(7), no judge or interested party may file a motion under paragraph (2) if the ACMI is equal to or less than the applicable median family income. Therefore, for debtors who are under the median income, the means-test analysis may end at this early stage in the process.
Chicago Bankruptcy Judge Eugene R. Wedoff reports the detailed methodology for determining median family income (a.k.a. "median income") through a custom search of the Census web site in an excellent article on BAPCPA.9 However, he also states that "it can be expected that the Executive Office for U.S. Trustees will publish median income tables."10 Moreover, median income tables have already been published by others.11 Section 101(39A)(B) requires that if the median family income is not both calculated and reported in the then-current year, it must be adjusted annually after such most recent year until the next year in which it is both calculated and reported by the Bureau of Census.12
U.S. Trustee Role
USTs13 have always played an integral role in the filing of §707(b) motions to dismiss. While the amendments to §707(b) expand standing to file such motions, USTs will play an even greater role under the new statute. However, since the enactment of the amendments to the Code, the Executive Office of the U.S. Trustees (EOUST) has not, as of the date of this writing, addressed the many issues that arise with respect to the amendments to §707(b) and other provisions of the BAPCPA,14 most likely so that UST personnel can complete their review of BAPCPA and speak with one voice. Until the EOUST is ready to provide further guidance, information exchanged during consultation with various representatives of the EOUST in 2001 during the preparation of an earlier version of this article may prove instructive,15 with the understanding that current events, changes in statistical information and developments in EOUST policy may dictate different impressions, statistics or policies.
Commencing with the cases filed after the effective date of Oct. 17, 2005, it is expected that local offices of the UST will quickly review the ACMI stated by all individual debtors and divide the cases into two groups—those debtors who have an ACMI in excess of each state's applicable median income and those who do not. Those debtors who exceed the median income are initially expected to be approximately 15 percent of all filers.
The remaining 85 percent of the cases will be provided to trustees prior to the first meeting of creditors so that they can carefully review the ACMI to confirm that it is below the applicable median income. Section 521(a)(1)(B)(iv) will require that trustees be provided evidence of payments received from any employer of the debtor within 60 days before the date of filing, and §521(e)(2)(A) will require the debtor to provide a copy of the debtor's last year's federal income tax return no later than seven days before the date first set for the §341 meeting. The UST will be required by §704(b)(1)(A) to review all materials filed by the debtor and, no later than 10 days after the §341 meeting, file a statement with the court as to whether the debtor's case would be presumed to be an abuse under §707(b). The court shall provide a copy of the statement to all creditors no later than five days after receiving the statement pursuant to §704(b)(1)(B). New forms and schedules will be required for debtors, trustees and USTs, but it appears that it will be unnecessary to review expense forms (if they are required to be filed) in approximately 85 percent of all chapter 7 cases.
Bad Faith and Totality of the Circumstances
Passing the means test will not always insure that a chapter 7 case will survive a motion to dismiss. Section 707(b)(3) provides that in a case where the presumption of abuse does not arise or is rebutted, the court shall consider (A) whether the debtor filed the petition in bad faith or (B) whether the totality of the circumstances of the debtor's financial situation demonstrates abuse. Only the court may dismiss, and the UST may move to dismiss a case on these grounds in cases in which the presumption does not arise or is rebutted. The court may dismiss and all parties in interest may move to dismiss if the presumption of abuse arises and is not rebutted. However, it remains to be seen what "bad faith" and abuse by the "totality of the circumstances" will mean in these contexts.
"Bad faith" and "totality of the circumstances" are standards that have been significantly developed in the case law with regard to other provisions of the Code. Analogies can and will be drawn to help determine what these terms will mean with respect to the new §707(b). Although amendments to BAPCPA now refer to a "presumption of abuse" as opposed to "substantial abuse," the analysis of "bad faith" and "totality of the circumstances" under the old law will be similar to future analyses to be made. While each appellate court has a slightly different interpretation of "bad faith" or "totality of the circumstances," it appears that an overall theme has been followed with respect to the determination of "substantial abuse" on these grounds.
Sixth Circuit case law provides an excellent illustration of "bad faith" and "totality of the circumstances." In In re Krohn, 886 F.2d 123 (6th Cir. 1989), the Sixth Circuit articulated a test meant to deny chapter 7 relief to the dishonest or non-needy debtor." Id. at 126, (quoting In re Walton, 866 F.2d 981, 983 (8th Cir. 1989)). The court went on to state that "a court should ascertain from the totality of the circumstances whether [the debtor] is merely seeking an advantage over his creditors, or instead is 'honest' in the sense that his relationship with his creditors has been marked by essentially honorable and undeceptive dealings, and whether he is 'needy' in the sense that his financial predicament warrants the discharge of his debts in exchange for liquidation of his assets." Id. at 126, (citing 4 Collier, supra, 707.07, at 707-20).
The court listed some factors that bear on the debtor's honesty. "Counted among them, however, would surely be the debtor's good faith and candor in filing schedules and other documents, whether he has engaged in 'eve of bankruptcy purchases,' and whether he was forced into chapter 7 by unforeseen or catastrophic events." Id. at 126.
As for whether a debtor is needy, the court stated that "among the factors to be considered in deciding whether a debtor is needy is his ability to repay his debts out of future earnings." Id. at 126, (citing Walton at 984-985). The court thought that this factor alone could be sufficient to warrant dismissal. Id. at 126. "For example, a court would not be justified in concluding that a debtor is needy and worthy of discharge where his disposable income permits liquidation of his consumer debt with relative ease." Id. at 126. The court also listed other factors that would be relevant to determine a debtor's need, including "whether the debtor enjoys a stable source of future income, whether he is eligible for adjustment of his debts through chapter 13 of the Bankruptcy Code, whether there are state remedies with the potential to ease his financial predicament, the degree of relief obtainable through private negotiations, and whether his expenses can be reduced significantly without depriving him of adequate food, clothing, shelter and other necessities." Id. at 126-127.
The bankruptcy judge in Krohn placed his focus upon Mr. Krohn's honesty and found sufficient evidence of bad faith to warrant a substantial abuse dismissal. Id. at 127. The court offered the following examples of bad faith by the debtor in this case:
There appear to be no 'eve of bankruptcy purchases' but rather a consistent pattern of living on credit or beyond the debtor's means. At no point in the debtor's history, either before or after filing for chapter 7 relief, has the debtor shown a sincere resolve to repay his obligations and/or to reduce his monthly expenses. The debtor admits to making only minimum monthly payments so as to keep the accounts current... As further evidence of his bad faith, the debtor seeks a discharge only of those unsecured debts held in his name alone and not a discharge of any credit cards held jointly with his wife... The debtor treats his creditors in a callous manner and indulges in a lifestyle in excess of a reasonable standard of living.Id. at 127. The court also found that although the goals of bankruptcy are intended to give an honest debtor a fresh start, the debtor in this case had not dealt with his creditors equitably and appeared to be seeking a "head start." The court further suggested that the debtor resort to "good, old-fashioned belt tightening." Id. at 128.16
Other Litigation Issues
The EOUST believed in 2001 that §707(b)(3) would be where the real §707(b) action would occur. At least one commentator believes this to be true, but also believes that other amendments to §707(b) will leave "plenty of room for legal disputes."17 Referring to §707(b)(2) (B)(i), which states that the presumption of abuse may only be rebutted by demonstrating special circumstances, she says as follows:
Making this aspect of the legislation interesting is the fact that the seemingly rigid and formulaic means test is littered with language that leaves plenty of room for legal disputes. An obvious example is the provision that allows a debtor to rebut the presumption of abuse "by demonstrating special circumstances that justify" deviation from the means test calculations if there is no "reasonable alternative." [FN77] It will be up to the courts to set the parameters of both "special circumstances" and "reasonable alternative," and it is fair to say this will be done on a case-by-case basis.
Section 102 of the legislation is replete with other language that invites litigation. Many allowable expenses are qualified by "actual," "reasonable" and/or "necessary." [FN78] Current monthly income is measured from a mysterious "date of determination" [FN79] and includes amounts paid by some other entity on a "regular" basis to the "household expenses" of the debtor or his dependents. [FN80] Where the presumption of abuse under the means test either does not arise or has been rebutted, the court may still find abuse if the petition was filed "in bad faith," or where "the totality of the circumstances...of the debtor's financial situation demonstrate abuse." [FN81] Case law interpreting similar language elsewhere in the Code will provide some guidance, [FN82] but not certainty. There is no way of knowing how the courts will treat these and other unclear terms within the specific context of the means test. As the case law develops in this area, some guidelines will emerge. In the meantime, it is fair to conclude that whether an argument is warranted by existing law will depend largely on the reasonableness of counsel's interpretation of the legislation's language.18
Abuse Through Means Testing: The Seven-step Method
1. Determine CMI and ACMI. The debtor's CMI should be calculated in accordance with the statute as set forth herein in the section entitled Current Monthly Income. Thereafter, CMI should be multiplied by 12 to yield the ACMI (annualized CMI).
2. Select the Applicable Median Income and Compare with the ACMI. The applicable median income should be determined by reliance upon EOUST tables to be published (or other tables), adjusted annually if necessary and compared to the ACMI. If the ACMI is equal to or less than the applicable median income, the means-test analysis will end here. Since it has been estimated that 85 percent of chapter 7 cases will be in this group, the large majority of chapter 7 debtors will be able to stop their analysis at this point.
3. Reduce CMI by IRS National and Local Standards—Allowances. For the remaining 15 percent of chapter 7 cases, the debtor may reduce his or her CMI by applicable monthly expense amounts specified under the National Standards and Local Standards issued by the IRS (allowances).19 These national and local standards are the collection financial standards used by the IRS to help determine a taxpayer's ability to pay a delinquent tax liability. The standards are commonly used in the negotiation of offers in compromise and can be found on the IRS web site.20 According to the IRS:
Allowances for food, clothing and other items, known as the National Standards, apply nationwide except for Alaska and Hawaii, which have their own tables. Taxpayers are allowed the total National Standards amount for their family size and income level, without questioning amounts actually spent.21
Maximum allowances for housing and utilities and transportation, known as the Local Standards, vary by location. Unlike the National Standards, the taxpayer is allowed the amount actually spent or the standard, whichever is less.22
While the National Standards for food, housekeeping supplies, apparel and services, personal care products and services and miscellaneous categories are the same for everyone except residents of Alaska and Hawaii, the Local Standards23 vary not only by state but also by county. Note that the Local Standards are further subdivided into two categories: (1) Housing and Utilities allowances for which the IRS publishes information by size of family and by individual county; and (2) Transportation allowances for which the IRS publishes both a National Standard for Ownership Costs and a Local Standard for which the IRS publishes information by Census Region and Metropolitan Statistical Area (MSA). Michigan is in the Midwest Census Region, and the MSA for Wayne, Macomb and Oakland counties (as well as seven other nearby counties) is listed under "Detroit." Moreover, the statute explicitly states that monthly expenses (including allowances) shall not include any payments for debts.24 A common example of the effect of the provision would be monthly car payment, which must be deducted from the aforementioned transportation allowance. (However, it appears that the car payments will be added back under payments on account of secured debts pursuant to §707(b)(2)(A)(iii).)
4. Reduce CMI by Actual Monthly Expenses. Certain actual monthly expenses25 may be used to further reduce monthly income and are specified for the categories listed as "Other Necessary Expenses" issued by the IRS for the area in which the debtor resides.26 After the amendments to §707(b) were drafted, the IRS issued more detailed expense information in Internal Revenue Manual - 5.15.1 Financial Analysis Handbook entitled "Other Expenses." The Other Expenses can also be found on the IRS web site.27 The expenses listed do not exhaust the category of necessary expenses. Other expenses may be considered if they meet the necessary expense test; health and welfare and/or the production of income.28 Additionally, §707(b)(2)(A)(ii)(I) states that such expenses shall include reasonably necessary health insurance, disability insurance and health savings account expenses for the debtor, the spouse of the debtor or the dependents of the debtor.29
Moreover, if it is demonstrated that it is reasonable and necessary, the debtor's monthly expenses may also include an additional allowance for food and clothing up to 5 percent of the food and clothing categories as specified by the National Standards.30 Logically, this potential additional allowance should be grouped with other allowances and not with actual expenses.
Additional expenses may include, if applicable, the continuation of actual expenses paid by the debtor, which are reasonable and necessary for care and support of an elderly, chronically ill or disabled household member or member of the debtor's immediate family who is unable to pay for such reasonable and necessary expenses.31
Actual administrative expenses of administering a chapter 13 plan for the district in which the debtor resides up to 10 percent of the projected plan payments (as determined under schedules issued by the EOUST) can also be deducted.32 There is some confusion over how to calculate the actual administrative expenses of administering a chapter 13 plan for this purpose, but the EOUST estimated in 2001 that such expenses would average approximately $100 per month.
Actual education expenses for each dependent child less than 18 years of age, not to exceed $1,500 per year per child, can also be deducted provided that the debtor can provide documentation and a detailed explanation of why such expenses are reasonable and necessary, and why they are not already accounted for in the National and Local Standards or Other Necessary Expenses.33
Actual monthly expenses for home energy costs in excess of the allowance specified by the Local Standards for housing and utilities may also be deducted if the debtor provides documentation and demonstrates that such actual expenses are reasonable and necessary.34
It appears that overlapping allowances and actual monthly expenses may exist that will only become fully known by the filing and reviewing of actual cases. Tax practitioners believe that basic to the understanding of allowances and actual monthly expenses is the concept that duplicate items cannot be counted twice. Despite this understanding, it is likely that actual cases will uncover issues not anticipated by Congress that will require examination by the court to resolve.
5. Reduce CMI by 1/60 of Secured Debts. The next step in the means test is to further reduce the debtor's CMI by the debtor's average monthly payments on account of secured debts.35 This average is calculated by adding those payments that are contractually due to secured creditors for the 60 months following the debtor's petition date and the arrearage that the debtor would have to pay to secured creditors under a chapter 13 plan to maintain possession of the debtor's primary residence, motor vehicle or other property necessary for the support of the debtor and the debtor's dependents.36 This sum is then divided by 60 to determine the amount that may be deducted from the debtor's CMI on account of secured debt.37 Debtors with an expensive mortgage38 or car payments would appear to benefit from this provision depending on the relative size of the actual payments as compared to the amounts to be deducted from allowances.
6. Reduce CMI by 1/60 of Priority Claims. Next, a debtor may reduce the CMI by the amount of the debtor's monthly payment of all priority claims including priority child support and alimony claims.39 The amount of those debts that are entitled to priority are added together and divided by 60.
7. Determine Whether a Presumption of Abuse Arises. Once the debtor's CMI is determined and reduced by all of the foregoing allowances, actual monthly expenses and secured and priority claim deductions,40 the number resulting from those calculations (net CMI) is multiplied by 60.41 Abuse is presumed if that number is not less than the lesser of 25 percent of the debtor's nonpriority unsecured claims or $6,000, whichever is greater; or $10,000.42
When applying the means test, it may be easier to use monthly numbers that are used in calculating allowances and actual expenses. In other words, if the debtor's net CMI is less than $100 per month ($6,000 divided by 60), no presumption of abuse arises. If the debtor's net CMI exceeds $166.66 per month ($10,000 divided by 60), a presumption of abuse always arises. If the net CMI falls in between those numbers, abuse is presumed if the net CMI is sufficient to pay at least 25 percent of the debtor's general unsecured debts in the next 60 months. Once the debtor has negotiated through this complex web of analyses, the debtor will be required to show the calculations that determine whether a presumption of abuse arises.43
Rebut by Special Circumstances
Once a presumption of abuse is found, it can only be rebutted through demonstrating the existence of special circumstances that justify additional expenses or adjustments of CMI for which there is no reasonable alternative.44 Examples of special circumstances noted in the Code include a serious medical condition or a call or order to active duty in the Armed Forces.45 Each additional expense must be itemized, and documentation must be provided by the debtor together with a detailed explanation of the special circumstances that make such expenses or adjustment to income necessary and reasonable.46 Note also that the debtor must attest to the accuracy of any information provided to demonstrate that additional expenses or adjustments to income are required.47
Hypothetical I is based on an actual case.48 It represents the case with the smallest actual earnings this author has previously referred to the UST for substantial abuse under old §707(b). However, a large tax refund was excluded from CMI in this hypothetical because it was received prior to the six-month period for determination of CMI. Similarly, the even-larger Social Security benefit was excluded from CMI by the explicit language of §101(10A)(B). Moreover, unemployment compensation was also excluded from CMI because it appears that it is a benefit received under the Social Security Act pursuant to 42 USCA Ch. 7, Subch. IX. Consequently, a debtor who would have been able to pay 100 percent of his or her unsecured claims of $13,167 in a three-year chapter 13 plan under the old law would be able to successfully defend a motion to dismiss49 and resist conversion to chapter 13 under the new law.
Hypothetical II is also based on an actual case. (download Hypotheticals I and II) It represents the case with the highest actual earnings this author has previously referred to the UST for substantial abuse under old §707(b). A full-blown analysis including all seven steps is required to come to the conclusion that this debtor will also pass the means test.50 Yet if the debtor in Hypothetical II had as little as $560 more income per month, the opposite result would have been achieved. The debtor would not have passed the means test, and a presumption of abuse would have arisen because the net CMI would have exceeded $166.66 per month.
Finally, with a slightly less additional income of $500 per month, the net CMI would have fallen to $108 per month (a number between $100 and $166.66 per month), and one final simple test would be required to determine whether a presumption of abuse exists, as follows:
- Multiply net CMI by 60
($108 per month x 60)
- Compare to 25 percent of the debtor's nonpriority unsecured claims of approximately $44,000
Since the debtor's net CMI multiplied by 60 would be less than 25 percent of the debtor's nonpriority unsecured claims, no abuse would be presumed.
1 See, also, §707(b)(6), which further provides that only a judge, UST or bankruptcy administrator (if any) may file a motion under §707(b) if the current monthly income when multiplied by 12 is equal to or less than the median family income for a family of the debtor's size in the applicable state. Return to article
5 Thus, it appears that a debtor may flunk the means test based on the receipt of child support payments and the like, convert to chapter 13 and not be required to use these funds to pay creditors in a chapter 13 plan. Return to article
7 Note that the "current monthly income" referred to in §§707(b)(6) and (7) is the CMI before deductions and not the "net CMI" arrived at after deducting the allowances and actual expenses authorized by §702(b)(2)(A)(ii),(iii) and (iv). Return to article
8 Section 707(b)(7)(B) provides that the CMI of the debtor's spouse will not be considered if the debtor and the debtor's spouse are separated and an affidavit is filed substantiating the same and specifying the aggregate amount of money received from the debtor's spouse attributed to the debtor's CMI in both joint and non-joint cases. Return to article
9 Wedoff, Hon. Eugene R., "Major Effects on the Consumer Provisions of the 2005 Bankruptcy Reform Legislation (2005)," available on ABI World at http://www.abiworld.org/pdfs/s256/mainpointa11.pdf. Return to article
11 Brown, Hon. William Houston and Ahern, Lawrence R. III, Appendix to 2005 Bankruptcy Reform Legislation with Analysis, 390-391 (2005). The tables take into account the requirement specified in the statute that in the case of a debtor in a household exceeding four individuals, $525 per month (increased or decreased in accordance with the cost-of-living adjustment made at three-year intervals pursuant to §104) should be added for each individual in excess of four. Return to article
12 Since the last year the Bureau of Census both calculated and reported the median family income was in 2000 (based on 1999 numbers), a CPI adjustment for the year s 2001 through 2004 will be necessary for cases filed in 2005 after the effective date of BAPCPA. Return to article
13 And bankruptcy administrators in the states in which the EOUST does not supervise the administration of cases (six judicial districts in North Carolina and Alabama). For purposes of this article, future references to USTs will be assumed to include bankruptcy administrators for those states. Return to article
15 The contents of this article are merely this writer's impressions of the generality of the discussions held and should not be quoted as definitive facts nor should this article be cited as representing the positions of the UST, the EOUST or the Department of Justice. Return to article
16 An excellent additional source for further analyses of what constitutes "bad faith" and "totality of the circumstances" as developed by the case law can be found in the American Law Report. Harrison, David B. J.D., Annotation, "Bankruptcy: When Does Filing of Chapter 7 Petition Constitute 'Substantial Abuse' Authorizing Dismissal of Petition Under 11 U.S.C. §707 (B)?," 122 A.L.R. Fed. 141 (2005). Return to article
17 Vance, Catherine E., "Attorneys and the Bankruptcy Reform Act of 2001: Understanding the Imposition of Sanctions Against Debtors' Counsel," Commercial Law Journal at 262 (footnotes omitted) (Fall 2001). Return to article
21 See National Standards for Allowable Living Expenses, available at http://www.irs.gov/businesses/small/article/0,,id=104627,00.html. Return to article
22 Internal Revenue Service, Collection Financial Standards, available at http://www.irs.gov/individuals/article/0,,id=96543,00.html. Tax practitioners advise that the IRS will frequently not permit a full allowance unless it can be demonstrated that actual expenses meet or exceed the allowance. USTs may take the same position. Return to article
23 The IRS Local Standards cited in this article are for Detroit, Wayne County, Michigan, which is the author's place of business. The Collection Financial Standards for any place in the country can be determined by a review of the IRS web site. Return to article
29 Reasonably necessary expenses incurred to maintain the safety of the debtor and the family of the debtor from family violence as identified under §309 of the Family Violence Prevention and Service Act or other applicable federal law shall also be included under §707(b)(2)(A)(ii)(I), but must be kept confidential by the court. Return to article
33 §702(b)(2)(A)(ii)(IV). Note, however, that educational expenses are almost never allowed by the IRS unless it is for a physically or mentally handicapped dependent, is not provided by public schools or is a condition of employment. Return to article
38 However, arguments are already being made that mortgage payments are acquisition costs while the Housing & Utility Allowance is comprised of both acquisition and maintenance costs. (See Judge Wedoff's article cited in footnote 9.) Consequently, deducting mortgage costs from a combined allowance may not be appropriate. Return to article
46 Additionally, §707(b)(2)(D) states that the court may not dismiss or convert a case based on any form of means testing if the debtor is a disabled veteran and the indebtedness occurred primarily during a period in which he or she was on active duty or performing a homeland defense activity. §707(b)(2)(B)(ii). Return to article