Paying Employee Debt in Bankruptcy

If you prefer to pay employee debt, back wages, to a present or prior employee, bankruptcy can help you do so if you use the law in that employee’s favor.  

Recently, we posted two blog posts about debts owed to your employees or independent contractors. Specifically, we discussed the conditions in which past wages, commissions, or benefits qualify as “priority” debt. The first blog post reviewed the conditions that apply to both employees and independent contractors. The second blog post focussed on a special additional condition that only independent contractors must meet.

Whether a debt qualifies for priority status is often crucial. The status can determine whether or not you pay that debt in the bankruptcy case.   In a no-asset Chapter 7 case, the debts do not receive any payment within the case. So whether an unpaid wage or commission qualifies as priority or not doesn’t matter in this situation. But in an asset Chapter 7 case, it makes all the difference. It’s common that priority debts receive payment in part or in full, while the rest of the debts receive little or nothing. There’s a similar result in a Chapter 11 business reorganization or 13 adjustments of debts case. Priority debts generally receive payment in full while other debts receive little or nothing.

Assume that you’d prefer that your past or present employee/independent contractor receive payment for what you owe him or her at the time of your bankruptcy filing. If so, you need to know the conditions for making that debt a priority debt, and how to apply them. Today we’ll review the conditions and then apply them an asset Chapter 7 example. We will provide a Chapter 13 case example in a future blog post.

The Conditions To Pay Employee Debt 

We covered the conditions that an unpaid wage or commission is a priority debt in the two prior blogs. We’ll review them very briefly here.

For a debt you owe either an employee or independent contractor:

• The owed wage, commission, or benefit must have been “earned within 180 days before the date of the filing of the [bankruptcy] petition or the date of the cessation of the debtor’s business, whichever occurs first …”. Section 507(a)(4) of the U.S Bankruptcy Code (bold added).
• The maximum dollar amount that would qualify as a priority is $13,650. See Section 507(a)(4) of the Bankruptcy Code, the cost-of-living adjustment provision in Section 104 of the Bankruptcy Code, and the current $13,650 amount since April 1, 2019, in this notice in the Federal Register.)

If you owe the debt to an independent contractor, he or she needs to meet an additional condition. The debt is a priority debt ONLY if

during the 12 months preceding that date [of a bankruptcy filing or cessation of business], at least 75 percent of the amount that the individual or corporation earned by acting as an independent contractor in the sale of goods or services was earned from the debtor.

Section 507(a)(4)(B) of the Bankruptcy Code (bold added).

Our Chapter 7 Asset Case Example

Assume you owe a prior employee $7,500 for wages and benefits. Your employee earned these wages and benefits over a period of four months, from 150 to 30 days ago, when you had to lay her off.

Your sole proprietorship business is still operating. You intend to close it and file a Chapter 7 bankruptcy soon.

Your bankruptcy lawyer has advised you that your business equipment is not exempt. This means that it’s not protected from collection and liquidation by the Chapter 7 bankruptcy trustee. He or she will take it from you, sell it, and use the proceeds to pay your creditors.

This equipment has a liquidation value of about $10,000. You don’t need the equipment after closing the business because you don’t intend to be in this kind of business ever again. But you do wish you could put it’s value to some good use.

You owe $150,000 on all of the rest of your debts. These consist of unsecured trade debt, business and personal unsecured credit cards, and medical bills. These are all considered “general unsecured” debts. None are priority debts except potentially the $7,500 you owe to your prior employee. You have a home mortgage but you’ve managed to keep current on it. Your home has a bit of equity but it’s protected by the homestead exemption.

Timing the Filing of Your Chapter 7 Case

You may have reasons to delay filing your case. You may have new employment lined up but it doesn’t start for several months. You may have business customers paying you soon and you’ll need the money for your home mortgage in the meantime. There can be countless legal and/or practical reasons for filing your case later.

However, your prior employee would likely really benefit from you paying the employees debt by filing your case within about a month. Then, because of the 180-day condition cited above, there’s a good chance she’d receive all or most of her $7,500.

How? The Chapter 7 trustee would liquidate your business equipment. The trustee would receive a fee—likely about $1,750. (By law, no more than 25% of the first $5,000 liquidated and 10% on the second $5,000. Section 326(a) of the Bankruptcy Code.) $10,000 minus $1,750 leaves $8,250. (25% for the first $5,000 is $1,250, plus 10% for the second $5,000 is $500, totaling the trustee’s $1,750 fee.) The remaining $8,250 would go to pay priority debts first, before paying anything to the general unsecured debts.

The $7,500 debt to your prior employee would all be priority debt. That’s because in our scenario it was all earned within the 180-day period before your simultaneous business closure and bankruptcy filing. Plus the $7,500 amount is less than the $13,650 limit referenced above.

So in this example, your prior employee would receive her $7,500 in full.

Of course, if the business equipment sold for less, your employee would receive only partial payment. Assume it sold not for $10,000 but rather only $7,000. $7,000 minus the trustee’s $1,450 would leave $5,550 for the trustee to distribute. Likely all of this would go to your employee. So she’d receive at least a significant portion of her debt.

If You Delayed Filing Bankruptcy

Assume instead that you closed your business and filed your Chapter 7 case five months from now. At that point, all of her wages and benefits would have been earned more than 180 days earlier. So, none of the $7,500 would qualify as a priority. The debt would be a general unsecured one, lumped in with other $150,000 of such debt.

Then, your employee would receive very little. Assume again that the bankruptcy trustee sells your business equipment for $10,000, leaving $8,250 for payment of the debts. This would be distributed pro rata to the $157,500 in general unsecured debt (her $7,500 plus the other $150,000). $8,250 divided by $157,500 amounts to all debts receiving only about 5 cents on the dollar. So your prior employee would receive only about $375 on her $7,500 debt.

Conclusion

There are many factors that come into play for determining what day you file your bankruptcy case. Some of those factors may well be much more important than paying employee debt. But sometimes a business owner has some flexibility on timing. And getting an employee/independent contractor some money may be a high priority for various personal or business reasons. This would be especially true if that money would otherwise go to a debt you don’t care about getting paid. In such situations, you and your bankruptcy lawyer may well be able to put these priority laws to good use, as we showed in today’s blog post.