The issue of whether a debtor is a “consumer debtor” or a “business debtor” occasionally comes up in an individual debtor’s bankruptcy case. First of all, why does it matter? And the answer is that, in certain cases, this determination can make all the difference in determining whether the debtor can ultimately get a chapter 7 discharge.
The issue revolves around the “means test” in bankruptcy. Simply put, the means test looks at a debtor’s income to determine whether that particular debtor’s income is above or below the “mean” income for other debtors in a similar situation – i.e., the same geographic region and the same number of dependents.
The means test entered the Bankruptcy Code with the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), a legislative act of Congress that was largely driven by banks and other financial institutions who believed that the bankruptcy system was being abused on a wide scale. One of the primary goals of BAPCPA was to prevent such “abuse” and encourage individual debtors to file Chapter 13 instead of Chapter 7. Chapter 13 requires a debtor to enter into a “plan” – not entirely different than a chapter 11 plan for businesses – whereby debtors must pay back at least some amount to their unsecured creditors.
Enter the means test. BAPCPA created the means test as a method for determining whether individuals filing for bankruptcy can file for Chapter 7—which discharges many debts in full in a fairly short period of time—or whether they must opt for Chapter 13, which requires at least partial repayment of debts. The means test compares the debtor’s monthly income to the median income (which depends on the size of the household) in their state of residence and provides an allowance for certain monthly expenses at rates determined by the Internal Revenue Service. If the individual’s income is less than the applicable median income, then that debtor automatically qualifies as a chapter 7 debtor. However, if the individual’s income is above the applicable median income, then that debtor will usually be forced to file for chapter 13 bankruptcy.
So back to the original question of why the determination of the debtor’s status as a “consumer debtor” versus a “business debtor” matters. And the reason lies in one clause of the Bankruptcy Code statute addressing the means test. That statute, 11 U.S.C. 707(b)(1), states as follows:
“After notice and a hearing, the court, on its own motion or on a motion by the United States trustee, trustee (or bankruptcy administrator, if any), or any party in interest, may dismiss a case filed by an individual debtor under this chapter whose debts are primarily consumer debtsor, with the debtor’s consent, convert such a case to a case under chapter 11 or 13 of this title, if it finds that the granting of relief would be an abuse of the provisions of this chapter.”
Put simply, the means test only applies if a debtor’s debts are deemed to be “primarily consumer debts.”
So the follow-up questions that must be addressed include:
- Which debts are consumer debts? And
- What does it means for debts to be “primarily” consumer debts?
What debts are consumer debts?
The Bankruptcy Code defines “consumer debt” in 11 U.S.C. § 101(8) to mean “debt incurred by an individual primarily for a personal, family, or household purpose.” Some debts, including home mortgages and most medical bills, are obviously consumer debts. Other debts, such as a loan to buy business equipment or a lease of commercial space, or clearly business debts. However, other debts can be a closer call. Student loan debt can often go either way. Credit cards can be either consumer or business debts (e.g., an individual uses their personal credit card to finance their business). Similarly, taxes are frequently deemed to be non-consumer debt.
Once again, the means test only applies if a debtor’s debts are determined to be primarily consumer debts. The Bankruptcy Code does not provide a specific definition of “primarily consumer debts,” but most courts have interpreted this phrase to require a debtor’s consumer debts to be 50% or more of the debtor’s total debt in order for the means test to apply.
In practice, a careful analysis of the principals above is necessary when dealing with a prospective debtor whose income exceeds the median, and therefore would fail the means test unless that debtor’s debts can be classified as primarily business debts (or, in case there is a distinction, if the debtor’s debts are not primarily consumer debts).
Of course, all hope is not lost if a debtor’s debts are determined to be consumer debts, and the debtor fails the means test. At that point, the Bankruptcy Code imposes a “presumption of abuse.” But that presumption can be overcome by facts and circumstances test supporting why a particular debtor’s situation is not an abuse. Such facts can include substantial life events, such as a death of a close family member, divorce, etc.
But overcoming a “presumption of abuse” can be quite an undertaking. It involves a very fact-intensive analysis and ultimately a hearing in front of a bankruptcy judge, which can be quite expensive and stressful to the typical individual debtor. Therefore, if the means test can be avoided altogether, then a debtor’s path to a chapter 7 discharge will be much smoother.
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