Pernell W. McGuire
Partner at Davis Miles McGuire Gardner, PLLC; Flagstaff, Arizona
Aubrey L. Thomas
Associate Attorney at Davis Miles McGuire Gardner, PLLC;Flagstaff, Arizona
Allowing a chapter 13 debtor to continue making reasonable contributions to a qualified retirement plan—such as a 401(k)—has, for many years, been taken as a given. It is properly understood as an integral part of the debtor’s “fresh start.” With the amendments to the Bankruptcy Code through BAPCPA, the protection of retirement plans became explicit under 11 U.S.C. § 541(b)(7), but the ability of a debtor to continue making 401(k) contributions during the life of a Chapter 13 plan has recently come under fire. This article addresses the statutes that govern whether 401(k) contributions are allowable during the course of a Chapter 13 case, the case law that has developed to interpret those statutes, and an argument to allow 401(k) contributions that debtor’s attorneys could make in response to recent decisions denying such contributions.
I. The Statutory Context
Before examining how the courts have addressed this issue, it is helpful to set out the relevant statutory provisions. Section 1325(b)(1) provides, in part that “if the trustee or the holder of an allowed unsecured claim objects,” then the court may not confirm a plan unless “all of the debtor’s projected disposable income [is] received in the applicable commitment period.” There is no definition of “projected disposable income,” but the U.S. Supreme Court has held that, in applying a “forward-looking approach,” projected disposable income is first calculated by determining a debtor’s disposable income on the date of filing and then taking into account “other known or virtually certain information about the debtor’s future income or expenses” to modify the amount that the debtor must pay on a monthly basis.
A debtor’s disposable income is determined under 11 U.S.C. § 1325(b)(2). Essentially, disposable income is a debtor’s current monthly income less “amounts reasonably necessary” for “maintenance and support of the debtor or a dependent of the debtor,” charitable contributions, and certain business expenses. Subsection three, however, goes on to clarify that for debtors with above median income, “amounts reasonably necessary” under subsection two “shall be determined in accordance with subparagraphs (A) and (B) of section 707(b)(2).”
Considering section 1325 as a whole, two initial observations are important. First, a court may confirm a chapter 13 plan that includes a debtor’s deduction for a 401(k) contribution. Scrutiny regarding such an expense only arises when the trustee or an unsecured creditor objects on that basis. Therefore, if a debtor wishes to maintain a 401(k) contribution, there is no harm in continuing it with the debtor’s express understanding that, if challenged, the court may not allow the contribution to continue if objected to by the trustee or an unsecured creditor. Knowledge of the trustee’s position in your particular area is helpful when advising the debtor on that proposed strategy.
Second, and more importantly, there is a difference between above- and below-median income debtors. For below-median income debtors, the inquiry is simply whether the court believes that the 401(k) contribution is a “reasonably necessary” expense. For above median-income debtors, the analysis of whether the debtor’s expenses are “reasonably necessary” is strictly governed by section 707(b)(2)(A)-(B), also known as the “means test.” Thus, it appears that it will be easier for a below-income debtor to continue a 401(k) contribution than an above-median income debtor.
Unfortunately for above-median income debtors, under the means test, “reasonably necessary” expenses are restricted to those allowable expenses provided under the IRS guidelines set out in the Internal Revenue Manual 22.214.171.124-.10 (rev. ed. 2012). As several courts have noted, contributions to a 401(k) plan are not included in the IRS list of allowable, necessary expenses. Still, one remaining statutory wrinkle, which was created as part of the BAPCPA amendments to the Bankruptcy Code, comes into the analysis for above-median debtors who wish to continue modest contributions to their 401(k) plans.
In defining property of the estate in a Chapter 13 case, section 1306 incorporates all “property of the estate” as defined by section 541. In turn, section 541(b)(7)(A) provides, in part, that “any amount” that is “withheld by an employer from the wages of employees for payment as contributions” to a tax-qualified plan, i.e. a 401(k) plan, is not property of the estate. The statute continues with what some courts have labeled the “hanging paragraph”:
except that such amount under this subparagraph shall not
constitute disposable income as defined by section 1325(b)(2).
The problem with the hanging paragraph is that, on first read, it does not make grammatical sense. The words “except that,” which begin the hanging paragraph, would normally indicate an exception to that particular rule, but, instead, the statute continues to address a wholly unrelated topic, “disposable income” in a chapter 13 case. In a sense, in drafting subsection 541(b)(7)(A), Congress jumped from point A to point C; conflating distinct and arguably unrelated concepts (i.e. property of the estate and disposable income), without explaining the logical connection between the two. As one court aptly put it, “the hanging paragraph reflects its ambiguity” and attempts to divine its intended meaning have “split the courts nationwide.” The question then becomes whether the hanging paragraph functions to allow 401(k) contributions by above-median income debtors in spite of the omission of 401(k) contributions from the list of necessary expenses under the means test.
II. Divergent Approaches
In answering that question, courts have developed three distinct lines of interpretation of the hanging paragraph in subsection 541(b)(7)(A). In the first line of cases, which seems to have been the majority interpretation immediately following the enactment of BAPCPA, courts held that debtors “may fund 401(k) plans in good faith, so long as their contributions do not exceed the limits legally permitted by their 401(k) plans.” Under that interpretation, a debtor may contribute up to the full allowable contribution amount, even if the debtor did not make 401(k) contributions prior to filing bankruptcy. The cases that embrace this interpretation overwhelmingly focus solely on the phrase “shall not constitute disposable income” in the hanging paragraph of section 541(b)(7)(A) and, essentially, ignore the remaining statutory context.
The first real attempt at explaining the significance of the hanging paragraph in the greater statutory context—and also the case cited most frequently as clearly setting out the second interpretation of that paragraph—is In re Seafort, 437 B.R. 204 (6th Cir. B.A.P. 2010), aff’d on other grounds, 669 F.3d 662 (6th Cir. 2012). In Seafort, the court addressed whether a debtor, who had not made 401(k) contributions prior to filing bankruptcy, could begin doing so after filing and, thereby, decrease the amount of disposable income available to the debtor’s creditors. The court first acknowledged that continuing 401(k) contributions by a chapter 13 debtor was clearly allowable, citing Nowlin and Johnson. In explaining why it was allowable to continue such contributions but not to increase or begin in the first instance to make those contributions, the court noted that section 541 defines “property of the estate” at the commencement of the case and, therefore, “only 401(k) contributions which are being made at the commencement of the case are excluded from property of the estate under § 541(b)(7).”
The court then explained that, because property of the estate in a chapter 13 case includes “earnings from services performed by the debtor after the commencement of the case,” without a similar exclusion like that in section 541(b)(7) of income contributed to a 401(k) plan, a debtor was not allowed to divert income from creditors by beginning to make 401(k) contributions. Inherent in the court’s reasoning—although not explicitly stated—is that, by making pre-petition 401(k) contributions, section 541(b)(7) allows a debtor to, in essence, grandfather in all future 401(k) contributions throughout the chapter 13 plan, even though section 1306, as acknowledged by the court, does not provide for an exclusion of those contributions from “property of the estate.” The court described the policy underpinnings of that allowance, stating, “Congress clearly intended to strike a balance between protecting debtors’ ability to save for their retirement and requiring that debtors pay their creditors the maximum amount they can afford to pay.”
The final interpretation of the “hanging paragraph” —one which appears to be gaining significant traction in at least two circuits—is that first set out in In re Prigge, 441 B.R. 667 (Bankr. D. Mont. 2010). Under this line of cases, courts have held that section 541(b)(7) is inapplicable and, therefore, contributions to a 401(k) plan for an above-median income debtor must cease and those funds must be used to pay creditors through the debtor’s Chapter 13 plan.
Surprisingly, Prigge addressed section 541(b)(7) in only a brief footnote that is arguably dictum. Instead, the analysis of the court focused on the incorporation of the IRS standards into section 1325, which as explained above, specifically prohibit 401(k) contributions being treated as a necessary expense. The court also noted that, as part of the BAPCPA amendments, Congress included a specific exclusion from “disposable income” under section 1322(f), of 401(k) loan repayments. Section 1322(f) provides that “[a] plan may not materially alter the terms of a loan described in section 362(b)(19) and any amount required to repay such loan shall not constitute ‘disposable income under section 1325.” By not including a similar exclusion for actual contributions to 401(k) plans, the court reasoned, Congress exhibited an intent to not shelter that income from the equation of disposable income.
Cases that have followed Prigge directly address the issue of how to interpret the hanging paragraph of section 541(b)(7) and, in one of the cases—McCullers—the court made two important conclusions. First, the court held that, under section 541(b)(7), the only funds that are exempt from property of the estate are funds that the debtor earned pre-petition and were withheld for contribution to the debtor’s 401(k) plan but were still currently in the possession of the debtor’s employer. That is so, the court explained, because section 541 describes property of the estate “as of the commencement of the case” and prepetition wages earned but not yet paid are otherwise treated as property of the estate under 541(a). Second, the court posited that the purpose of the transitional phrase “except that,” was “merely to counteract any suggestion that the exclusion of such [401(k)] contributions from property of the estate constitutes postpetition income to the debtor.” In summary, courts that follow the third interpretive approach find the exclusion of 401(k) contributions from the list of necessary expenses in the IRS Manual to be conclusive and limit section 541(b)(7) to the most narrow meaning possible.
III. Thoughts on Moving Forward
None of the three approaches described above provides a particularly satisfying analytical pathway to its conclusion. The first interpretive method, as typified by the Johnson case, fails to address the thorny statutory issues the other two methods have taken up. The second interpretive method, set out in Seafort, provides a somewhat more satisfactory answer, particularly because the result appears to be in harmony with the public policy behind bankruptcy—the allowance of a fresh start while still providing the fair treatment of creditors. Still, the Seafort court’s analysis breezes by the actual text of section 541. The interpretive method that will have any staying power must address the grammatically-perplexing beginning to the hanging paragraph: “except that.” That, we think, is why the third interpretation is gaining some traction.
The problem with the narrow interpretation of “except that” embraced by the third approach is that it renders the “hanging paragraph” ineffective. Specifically, McCullers provides that the words “except that” imply that the only purpose of the “hanging paragraph,” is to counteract any suggestion that funds withheld from a debtor’s paycheck by an employer to be contributed to a 401(k) plan but that are still in the employer’s possession on the date of filing are not “postpetition income.” Whether certain funds are “postpetition income,” however, is irrelevant—the Code focuses on “projected disposable income” and “disposable income.” There is no legal significance to treating those funds as “postpetition income” and, therefore, the exclusion that McCullers asserts that the hanging paragraph creates is really a meaningless one.
Furthermore, section 541(b)(7)(A) itself refers to those funds not being treated as “disposable income.” Thus, the statute requires that, in some way, the exclusion must factor into the disposable income analysis of section 1325(b)(2). Most courts have focused on whether 401(k) contributions are a reasonably necessary expense. That focus is misplaced. In fact, as courts have aptly noted, because 401(k) contributions are not an allowable IRS expense, it seems contradictory to allow the “hanging paragraph” to override that specific exclusion.
Instead, the focus should be on whether amounts contributed to a 401(k) plan are even “current monthly income” at all. Examining the statute in that context, there is a strong argument that the answer is no. Again, the “hanging paragraph” states that “such amount under this subparagraph” is not disposable income. The amount described “under this subparagraph” is “any amount” that is “withheld by an employer from the wages of employees for payment as contributions” to a qualified plan. There is no limitation in that subparagraph to amounts held on the date of petition. That limitation is under section 541(a) and irrelevant to the “hanging paragraph” itself; indeed, the creation of the property of the estate is irrelevant to the “disposable income” analysis, and courts should be wary to conflate the two concepts. Thus, when calculating current monthly income as the first step in determining “disposable income,” amounts contributed to a 401(k) plan should be excluded.
This approach seems attractive for several reasons. First, it has the result that below-median and above-median income debtors would be treated the same, as opposed to the allowance of a 401(k) contribution as a “reasonable expense” for below-median income debtors but not for above-median income debtors. Second, it is consistent with the policy throughout the Code of protecting the retirement contributions of debtors. Last, it actually gives effect to the “hanging paragraph” instead of rendering it meaningless as the interpretation of Prigge does. In summary, it is important for practitioners to be aware of the various approaches and, in those jurisdictions that do not allow such contributions, to argue for an interpretation that makes the most sense out of the perplexing “hanging paragraph.”
 Hamilton v. Lanning, 130 S. Ct. 2464, 2475 (2010).
 In re McCullers, 451 B.R. 498, 501 n.6 (Bankr. N.D. Cal. 2011). See also In re Hebbring, 463 F.3d 902, 907 (9th Cir. 2006).
 In re Egebjerg, 574 F.3d 1045, 1052 (9th Cir. 2009); In re Prigge, 441 B.R. 667, 676 (Bankr. D. Mont. 2010); IRM 126.96.36.199.
 Not to be confused with the “hanging paragraph” found in 11 U.S.C. § 1325(a)(5).
 In re Parks, 475 B.R. 703, 707 (9th Cir. B.A.P. 2012).
 In re Johnson, 346 B.R. 256, 263 (Bankr. S.D. Ga. 2006). See also In re Leahy, 370 B.R. 620, 623 (Bankr. D. Vt. 2009) (“These cases speak with one voice in concluding that, pursuant to § 541(b)(7), 401(k) or ERISA–qualified savings plan funds are not property of the bankruptcy estate.”); In re Nowlin, 366 B.R. 670, 676 (Bankr. S.D. Tex. 2007) (same).
 In re Seafort, 437 B.R. 204, 207 (6th Cir. B.A.P. 2010), aff’d on other grounds, 669 F.3d 662 (6th Cir. 2012).
 Id. at 209.
 Id. at 210.
 See also, In re Parks, 475 B.R. 703, 707 (9th Cir. 2012) (adopting Prigge reasoning); In re Seafort, 669 F.3d 662, 674 n.7 (6th Cir. 2012) (in dictum, adopting reasoning of Prigge); In re McCullers, 451 B.R. 498 (Bankr. N.D. Cal. 2011).
 In re Prigge, 441 B.R. 667, 677 n.5 (Bankr. D. Mont. 2010).
 Id. at 676.
 Id. at 677.
 McCullers, 451 B.R. at 503.
 Id.at 504.