The Ninth Circuit Court of Appeals ruled today, in the case of In re Egebjerg, that 401k loans are not a debt as defined in the bankruptcy code and as such, the amount of any loan repayment cannot be considered in calculating a debtor’s budget/ability to repay his/her debts.

The basic rationale is that since a 401k loan is repaying funds to the owner of the 401k, it is not an actual debt, and the funds used to repay it are not a necessary living expense.

There are tax consequences for failure to repay a 401k loan, and these may be able to be argued as an offset, but the loan repayment itself cannot be used to determine eligibility to file a chapter 7 case.

This is not a means test

The means test in bankruptcy is not a test like you take in school based on your memory.   The means test is a budget analysis created by Congress to supposedly determine whether one has the ability (i.e. the means) to repay all or a portion of their debts, which determines whether one  is ineligible to file for bankruptcy relief under Chapter 7, as opposed to  Chapter 11 or Chapter 13.

I say “ineligible” as opposed to “eligible” because in most court districts,  even if you “pass” the means test it does not automatically mean you qualify to file a Chapter 7 case.   There are other eligibility factors that come into play even if the presumption of abuse does not arise on the means test.  This will be discussed more below.

The Means Test Only Applies to Consumer Debt Cases

The means test only applies if one’s debts are primarily (i.e. more than 50%) consumer debts.   Consumer debts include secured mortgage debt obligations on a personal residence, as well as most credit card-type debts. The means-test also only applies if the total income received in the 6 calendar months prior to filing the bankruptcy case (explained more fully below) is above the median income for your state, given your household size. See the means test flow chart created by Judge Maureen Tighe of the United States Bankruptcy Court, Central District of California, as presented in the informative blog of the Moran Law Group.

So, What is the Means Test Exactly?

The analysis for the means test is extremely complex and requires an experienced bankruptcy attorney to properly calculate.  The basic definition can be seen here.

The more detailed and technical answer is:   The means test takes all income received (and this means ANY income, regardless of whether it’s taxable income, so that includes gifts, withdrawals from a 401k, and almost any other type of income EXCEPT social security income) in the 6 calendar months prior to filing the bankruptcy case–including that of your spouse, if any (see why this gets included)– and subtracting out certain allowed expenses.  These “allowed expenses” are mostly IRS-based allowances for living expenses, food, clothing, shelter, etc. and have little connection with reality.  There are specific allowances for secured debt payments, such as mortgages and car payments, but almost every aspect of the means test has been, is being, or will be challenged in the courts, because it is frequently nonsensical, internally inconsistent, and confusing.

It is not as simple as determining that your income is below or above the median income for your area and household size (and determining your household size is another hotly contested issue).  You need a qualified bankruptcy attorney familiar with the court decisions in your area, to properly evaluate your eligibility for bankruptcy.  (For example, self-employment income is not analyzed exactly the same way as wage-earner income from a job)

Passing the Means Test is Just the First Step

Which brings me back to the point of eligibility.   Passing the means test is just the first step. It is possible to pass the means test but still be showing–for example–a surplus in your current monthly income and expenses.   For example, let’s say you were unemployed for the 6 months prior to filing your bankruptcy case, but you just landed a new job that pays you $100,000 per year. In that instance, you would likely pass the means test and show you are eligible to possibly file a Chapter 7 case. However, you would most certainly draw an objection (via a Motion to Dismiss your case) from the US Trustee’s Office as having too much income.

Please Don’t Try This At Home!

The means test and assessing eligibility to file bankruptcy is a field of land mines and evolving interpretations of law.  As they say on television ad disclaimers, “We are trained professionals. Don’t try this at home”

Image Courtesy of JamesNaruke

Earlier this month, the Ninth Circuit Court of Appeals in Maney v. Kagenveama (In re Kagenveama), 527 F.3d 990 (9th Cir. June 2008) held that where an above-median chapter 13 debtor has negative “disposable income” per the means test but a monthly surplus per schedules I and J, the debtor is NOT required to propose a five year plan and the plan payment need not be based on the surplus.

Since the new bankruptcy laws became effective in October 2005, the new means test was added as a requirement to determine eligibility for Chapter 7 vs. Chapter 13 as well as to determine–if a debtor was ineligible for Chapter 7–how much the Chapter 13 monthly plan payment would be, and how long it must last. While the means test admittedly bears little resemblance to reality, it is the test Congress chose. It uses an average of the debtor’s income received from ALL sources (including gifts) from the 6 calendar months prior to filing, and then subtracts out certain allowed expenses (e.g. mortgage payments, allowed IRS-standard living expenses, etc.). There are many times where, for whatever reason, the means test shows the debtor having a certain amount of disposable income, whereas the actual current monthly income and expenses, reflected on bankruptcy schedules “I” and “J” show a much higher amount. Up until this decision, the Trustees in Chapter 13 cases were requiring debtors to pay the amount of their current, actual surplus income, rather than what the means test showed.

As far as the plan term goes, if the means test shows negative income, then a 3-year plan term (which is the minimum allowed in Chapter 13) would suffice.

With its decision in Kagenveama, the Ninth Circuit has stated that the means test controls. However, it did point out in a quick sentence that nothing in the opinion prevents a creditor or Trustee from seeking a modification of the Chapter 13 plan after it is confirmed.

Share/Bookmark

Under certain circumstances, in California, junior liens (deeds of trust) can be removed from your home in a Chapter 13 bankruptcy case. This is known as “lien-stripping.”    The way it works is: If the fair market value of your home is less than the amount owed on your first mortgage, you can lien strip (remove) the junior liens on the property. This is also known as avoiding the lien in bankruptcy, but the term “avoid” is usually used in connection with judgment liens (involuntary/non-consensual liens) against your property, which can also be removed, but under different circumstances.

What does this really mean? If successful, it means that the debt you owe on any such junior liens will be discharged if you complete your Chapter 13 payment plan, which lasts for 36-60 months. How much your plan payments would be depends on a number of factors, primarily your disposable monthly income.

Lien stripping requires the filing of a Motion with the bankruptcy court (known locally as a LAM Motion) during the Chapter 13 case. It may also, depending on the judge in the case, require an additional “adversary proceeding” to remove the lien.

Schedule a consultation with a qualified bankruptcy attorney if you want to explore the opportunity of eliminating your junior mortgage liens.

Share/Bookmark