Circuit Split Emerging on Dischargeability of Late Returns

There is an emerging circuit split as to whether late filed tax returns can ever be considered to be “returns.”   The issue arises because BAPCPA included a paragraph stating that a return “means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements.”    This is known as the hanging paragraph of section 523(a) because it appears following section 523(a)(19) without any other designation.

Schwab v. Reilly Places Homesteads at Risk Years After Filing

A new opinion from the Ninth Circuit illustrates the practical implications of Schwab v. Reilly, 130 S.Ct. 2652 (2010). In Matter of Gebhart, No. 07-16769 (9th Cir. 9/14/10), the Court held that the Trustee was entitled to reap the benefits of post-petition appreciation in the Debtor’s homestead. The opinion can be found here.

Two Homesteads Going Up Over the Years

Gebhart involved two consolidated appeals. In the first case, the Debtors filed chapter 7 in August 2003 and claimed the Arizona homestead exemption. On the petition date, the Debtor’s equity was less than the $100,000 exemption. The Trustee did not object. In November 2006, the Trustee sought to employ a broker to sell the home, contending that its value had appreciated beyond the exemption amount. In the second case, the Debtor filed bankruptcy in June 2004 and claimed the Washington homestead exemption. Two years later, the Trustee sought to sell the home, which had appreciated in value. Both Debtors cried foul. The Arizona court ruled that the property remained in the estate, while the Washington court ruled that the unopposed exemption removed the property from the estate.

It's Exempt But What Is "It"?

The Ninth Circuit acknowledged that “{q]uite simply, property that has been exempted belongs to the debtor.” However, the question is, just what was exempted and passed out of the estate? Following the Supreme Court, the Ninth Circuit stated that where an exemption was limited to a dollar amount (as was the case with both the Arizona and Washington exemption statutes):

Instead, what is removed from the estate is an “interest” in the property equal to the value of the exemption claimed at filing. (citation omitted). The implication for the cases at issue here are clear: the fact that the value of the claimed exemption plus the amount of the plus the amount of the encumbrances on the debtor’s residence was, in each case, equal to the market value of the residence at the time of filing the petition did not remove the entire asset from the estate.

Opinion, at 14071-72.

A Bad Result They Admit

The Ninth Circuit did not shy away from the implications of its decision.

The debtors argue that the result we reach today will lead to uncertainty about the status of exempt property and abuses by trustees. The facts of the Gebhart bankruptcy suggest that some of these concerns are legitimate. Gebhart remained in his home for five years after filing for bankruptcy, paying his mortgage and believing that his bankruptcy was finished when he received his discharge. Gebhart may have been mistaken in his belief, but his misapprehension was shared by his mortgage lender, which refinanced the home, apparently unaware of any claims on the property by the Trustee. A Chapter 7 debtor will not be certain about the status of a homestead property until the case is closed (something that may not happen for several years after bankruptcy filing) or the trustee abandons the property.

Opinion, at 14074.

Notwithstanding these concerns, the Court held that the Trustee was not stopped to claim the homestead property and could not be compelled to abandon the property.

Opening Pandora's Box

This case illustrates the Pandora’s box opened by Schwab v. Reilly. While that case involved a dispute over the value of property as of the petition date, these cases involved post-petition appreciation. Debtor’s attorneys cannot assume that an unobjected to exemption means that the debtor gets to keep the property. If the exemption is defined by a dollar amount, the Trustee can sit back and wait for appreciation.

How serious is the risk for Texas debtors? Texas is one of the minority of states which allow use of federal exemptions. Most of these exemptions are dollar limited. On the other hand, Texas law allows unlimited exemptions for the homestead, tax qualified retirement accounts, annuities and cash value of life insurance. Texas law allows an aggregate exemption of $60,000.00 for certain categories of personal property.

How could this issue arise in Texas? Here are a few possibilities:

1. The Debtor uses federal exemptions to claim a homestead with no equity and a business under the wildcard exemption. Subsequently, either real estate prices rebound or the debtor makes a success of the formerly languishing business. At that point, the Trustee could sell the now valuable asset.

2. The Debtor takes federal exemptions and undervalues an asset, such as tools of the trade. If the Trustee subsequently finds out that the asset had more value, he could sell it. That was the fact scenario in Schwab v. Reilly.

3. The Debtor claims Texas exemptions and claims $5,000 worth of jewelry. Subsequently, it turns out that the jewelry was worth $45,000. While that would still be under the $60,000 cap, Texas law limits the jewelry exemption to $15,000. Again, under-valuation can be remedied without a timely objection.

4. If the Debtor claims Texas exemptions, but acquired their homestead within 1,215 days, then the homestead is subject to a cap under Sec. 522(p). If the homestead subsequently appreciates, the Trustee could move to sell even though the property was under the cap on the petition date.

5. The most unlikely scenario is one where the debtor owns an asset such as artwork which has negligible value on the petition date. Post-petition, the artist dies and acquires a cult following. As a result, the total value of the Debtor’s personal property exceeds $60,000. However, in this instance, the debtor should be able to take advantage of depreciation in other personal property assets, such as vehicles, to offset the appreciation of the artwork. The challenging aspect of the Texas personal property exemption is that the cap applies to the overall group of assets. As a result, the change in value of one asset may be offset by the decline in value of another.

Ninth Circuit BAP Finds Wells Fargo Freeze Policy Violates Automatic Stay

Breaking with judges in Texas and New Mexico, the Ninth Circuit Bankruptcy Appellate Panel has found that an administrative freeze policy utilized by Wells Fargo Bank violates the automatic stay. No. 09-1408, Mwangi v. Wells Fargo Bank, N.A. (Ninth Cir. BAP 6/30/10). The opinion can be found here.(PACER access required).

Wells Fargo's Policy

Every night, Wells Fargo compares cases filed in CM/ECF against its account holders. If one of its account holders files chapter 7 bankruptcy, Wells Fargo places an administrative freeze upon the account and sends a letter to the chapter 7 trustee requesting instructions on disposition of the funds. In the Mwangi case, the debtors initially disclosed that they had only $1,300.00 in their Wells Fargo accounts. After Wells Fargo froze the accounts, they amended their schedules to disclose $17,075.06 and claimed 75% of this amount as exempt. The Debtors then demanded that Wells Fargo release the funds based upon their claim of exemption. When Wells Fargo refused, the Debtors filed a motion for sanctions. By the date of the hearing, the exemption had become final. The Bankruptcy Court ruled that Wells Fargo had not violated the stay because the funds were property of the estate and that Wells Fargo had not attempted to collect a debt.

The BAP Doesn't Like the Bank's Policy

The Bankruptcy Appellate Panel disagreed. It held that once the Debtors claimed the funds as exempt, they had an inchoate interest in the funds. This gave them standing to assert a violation of Sec. 362(a)(3), which prohibits acts to "exercise control over property of the estate." The Court found that continuing to hold the funds constituted exercise of control over property of the estate. The Panel wrote:

Wells Fargo asserts that it did not exercise control over property of the estate. We disagree. Wells Fargo could have paid the account funds to the trustee; it did not. Wells Fargo could have released the account funds claimed exempt to the Appellants when demand was made; it did not. Wells Fargo could have sought direction from the bankruptcy court, by way of a motion for relief from stay or otherwise, regarding the account funds; it did not. Instead, it chose to hold the funds until a demand was made for payment that it alone deemed appropriate. If that is not "exercising control over" the funds, we don't know what is. (emphasis added).

. . .

The impact of Wells Fargo's national policy is to turn on its head the balance between rights of parties legislatively created. As a result of the policy, every party, except Wells Fargo, whose rights are impacted by the administrative freeze will need to take action.

Slip Op. at 19, 20.

The BAP remanded for a determination of whether the violation of the stay was willful and whether the debtors were entitled to damages.

The BAP Disagrees With Other Courts

The Ninth Circuit BAP's opinion contrasts with the decisions in Wells Fargo Bank v. Jimenez, 406 B.R. 935 (D. N.M. 2008) and In re Calvin, 329 B.R. 589 (Bankr. S.D. Tex. 2005). In each of those cases, the courts found that until the funds became exempt, they were property of the estate. As a result, the debtors lacked standing to complain that the bank was withholding funds from the trustee. Judge Jeff Bohm was sympathetic to the dilemma faced by the bank, writing:

Under the Bankruptcy Act of 1898, entities owing debts, such as the Bank were shielded from liability even if they paid a debtor post petition as long as the entities were "acting in good faith." (citation omitted). The Bankruptcy Reform Act of 1978 eliminated this provision with the passage of Sec. 542. Entities owing a debt now have exposure to Chapter 7 trustees if payment on the debt is made to the debtor because that debt is owed to the estate until such time as it is abandoned or any exemption becomes final. Under these circumstances, it makes good business sense for the Bank to have instituted a policy that freezes the accounts of depositors who file a Chapter 7 petition. In this manner, the Bank can shield itself from any liability to a trustee while that trustee determines whether the funds are exempt, or nonexempt (or, even if nonexempt, of inconsequential vale to the estate). It is its potential exposure to trustees, not to debtors upon which the Bank must properly focus.

In re Calvin at 604.

A Big Mess

These cases point out an enormous practical problem. Sec. 541 provides that money in the debtor's bank account is property of the estate. Sec. 542 provides that an entity holding property of the estate "shall deliver to the trustee" the property. However, as a practical matter, most funds held by debtors will be exempt or of inconsequential value to the trustee so that the trustee will not administer the asset. Debtors have the expectation that they will continue to be allowed access to the funds since the odds are that they will ultimately receive them. From the Trustee's point of view, it is burdensome to hold funds which will not be administered, but potentially more burdensome to recover those funds from the debtor once they have been spent.

At first blush, the bank appears to be an officious intermeddler. It freezes the funds even when it has no claim to them. Instead of turning them over to the trustee, it holds them. However, Judge Bohm (who was a banker prior to attending law school), has a legitimate point. The Code says turn over the funds. Recognizing that the trustee might not want the funds, the Bank agrees to hold the funds pending direction from the trustee. Of course, trustees rarely provide that direction because it would be burdensome in administering large numbers of cases.

The Ninth Circuit BAP outlined what it believed to be the Bank's options in this situation:

1. It could have turned the funds over to the trustee. This would be appropriate under the Code, but would overwhelm trustees.

2. It could have turned the funds over to the debtor. This would violate the Code and expose the bank to liability.

3. It could have sought direction from the court. While this would be appropriate, it would be very burdensome to the bank when it had to be done in tens of thousands of cases.

Under the Ninth Circuit BAP's opinion, the only viable option for the bank is to transfer the funds to the trustee whether the trustee wants them or not. Of course, there is another option. Trustees could agree to hold banks harmless for allowing debtors access to funds unless directed otherwise. There is no chance that banks will be able to negotiate agreements with hundreds of panel trustees or the the U.S Trustee's office would allow them to agree to it.

Since all of the options under existing law are bad, it might make sense to go back to the "acting in good faith" standard under the Bankruptcy Act of 1898 and leave the bank out of the picture.

Ninth Circuit Joins Consensus: 401k Loans Not Deductible As Secured Debt Under Means Test

Joining what has become the consensus position, the Ninth Circuit has held that payments on a 401k loan may not be deducted under the chapter 7 means test. Egebjerg v. Anderson, 2009 U.S. App. LEXIS 11651 (9th Cir. 5/29/09). The opinion highlights a major inconsistency in the way that BAPCPA treats retirement plan loans.

The Ninth Circuit ruled that a loan from a retirement plan was not a debt and therefore was not a secured debt which could be deducted on line 42 of the means test. The crux of the ruling is found in the following language:

The reasoning behind these decisions is straightforward. Egebjerg’s obligation is essentially a debt to himself — he has borrowed his own money. (citation omitted). Egebjerg contributed the money to the account in the first place; should he fail to repay himself, the administrator has no personal recourse against him. (citation omitted). Instead, the plan will deem the outstanding loan balance to be a distribution of funds, thereby reducing the amount available to Egebjerg from his account in the future. (citation omitted). This deemed distribution will have tax consequences to Egebjerg, but it does not create a debtor creditor relationship.

Opinion, pp. 6386-87.

In my view, this is an area where the law has gone astray. I recently received a loan from my 401k plan. The document which I signed was entitled "Loan Agreement, Note and Pledge." In pertinent part, the document stated:

For value received the Borrower agrees to pay the Lender the amount of $________ principal and interest at an annual interest rate of ______%. The length of the loan shall be ___ months. Payment shall be made to the Trustee of the Plan in the amount of $_______ Semi-Monthly beginning ______ and ending _______. Prepayment of the unpaid principal and accrued interest may be made by the Borrower at any time without penalty.

Pledge to secure this loan: Borrower hereby irrevocably pledges his/her vested account balance under the Plan in satisfaction of any unpaid balance and associated costs due and payable upon default.

Thus, there is a Lender, a Borrower, a promise to pay and a security interest. The fact that the security interest is in funds contributed to a retirement plan should not make a difference. While the funds in the retirement plan originated from my contributions, they are no longer under my dominion and control. If I buy 1 share of Berkshire Hathaway and then borrow money secured by that stock, I have in essence borrowed my own money; my money has just taken the form of Berkshire Hathaway stock instead of cash. The pledge of the stock allows me to keep my money in the form of the stock while having access to it through the intermediary of the bank. The analogy of a pledge of stock is particularly appropriate, since I have the assets in my 401k plan invested in mutual funds.

Besides ignoring the form and substance of the transaction, the consensus position is inconsistent with the manner in which 401k loans are treated elsewhere by BAPCPA. BAPCPA included three provisions specifically aimed at protecting retirement plan loans. Section 362(b)(19) provides that retirement plan loans are not subject to the automatic stay, thus allowing their continued collection in a bankruptcy case. Section 523(a)(18) provides that a "debt" owed to a retirement plan is non-dischargeable, thus protecting a debtor from tax liability resulting from discharge of the loan. Finally, Section 1322(f) provides that a retirement plan "loan" may not be altered by a chapter 13 plan and may not be included in calculation of the debtor's disposable income. There are two important points here. The first is that since the Code refers to these obligations as "debts" and "loans" in other places, why would they not be a debt or a loan under the means test? Secondly, the purpose of the chapter 7 means test is to identify debtors who can afford to pay their debts under a chapter 13 plan. Therefore, it makes logical sense to interpret the chapter 7 means test in light of what would be deductible in a chapter 13 case.

Unfortunately, it looks like the train has left the station on this issue and the Ninth Circuit's position does reflect a consensus among courts. As a result, this may be an issue requiring a legislative fix.