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Debtor's Ch. 13 Plan Unfairly Discriminates Against Other Unsecured Creditors

Monday, February 10, 2014
By Diane Davis

Feb. 7 --The U.S. Court of Appeals for the Eighth Circuit Jan. 31 held that a bankruptcy court correctly concluded that a Chapter 13 plan is unfairly discriminatory because it proposes to pay tax creditors in full as a special class (Copeland v. Fink (In re Copeland), 2014 BL 27501, 8th Cir., No. 12-4018, 1/31/14).

Affirming the judgment of the Bankruptcy Appellate Panel for the Eighth Circuit, Judge Lavenski R. Smith concluded that the debtors' plan lacked good faith. Applying the four-part test of unfair discrimination in In re Lesser, 939 F.2d 669 (8th Cir. 1991), the court found that the debtors' plan was discriminatory.

According to the court, the debtors proposed to pay off as much nondischargeable debt as possible while leaving other creditors with nothing at the close of bankruptcy. “The Copelands clearly are prioritizing payment to creditors who will be paid in full regardless of the plan implemented in bankruptcy, at the expense of creditors with no other recourse. In short, they propose to 'protect' those creditors least in need of protection, at the expense of the most vulnerable,” the court said. 

Chapter 13 Filing

Debtors Shawn and Lauren MK Copeland filed for Chapter 13 protection using a disposable income plan to last for 60 months. Debtors pay their disposable income into a plan, supervised by the bankruptcy court, for use in the repayment of creditors for the designated period. The fund created by the debtors' payments is called the Disposable Income Pot (DIP).

At the time of filing, the debtors' state and federal taxes were in arrears. The debtors' back taxes are unsecured, nonpriority claims in the bankruptcy case. 

Debtors' Proposed Plan

The debtors' first proposed plan treated their delinquent tax debt as a “Special Class to be paid 100 percent” from the DIP. The plan also provided that their attorney would receive payment for tax return preparation from the DIP. If approved, the plan would have paid their nondischargeable tax debts virtually in full and left nothing for their remaining unsecured creditors with dischargeable debts.

The bankruptcy trustee estimated, based on claims filed, that the debtors' proposed plan would provide a distribution of approximately 97 percent to the tax creditors, and nothing for the remaining unsecured, nonpriority creditors. Thus, the bankruptcy court rejected the plan. 

Amended Plan

Subsequently, the debtors amended their plan to remove the special classification provisions. The trustee estimated that under this plan, there would be a distribution of approximately 78 percent to all unsecured, nonpriority creditors.

The debtors objected to their own plan because it did not provide for prioritized payment of the tax debts.

The bankruptcy court overruled their objections, but did not enter a confirmation order. Later, the debtors amended their plan and renewed their objection to the absence of preferential treatment for the tax creditors.

The bankruptcy court overruled the objection and confirmed the plan. The BAP affirmed (24 BBLR 1555, 11/29/12). 

Debtors' Plan Not Discriminatory?

The debtors appealed, arguing that the bankruptcy court has authority to confirm a Chapter 13 that proposes to pay tax creditors in full as a special class, and Bankruptcy Code Section 1325(a)(3) does not prohibit payment of tax return preparation fees from the DIP.

According to the debtors, their plan is not discriminatory because it meets all four prongs of the Leser test. They emphasize the nondischargeable nature of the tax debts, and contend that the nondischargeability of the tax debt indicates a strong public policy in favor of full tax collection. According to the debtors, this satisfies the “reasonable basis” requirement.

The debtors also argued that too stringent application of the nondiscrimination requirement means that debtors will find it difficult, if not impossible, to appeal the bankruptcy court's discrimination determination. They also contended that their good faith was demonstrated by their intention to pay all tax debt and not merely those that are nondischargeable. According to the debtors, the government is an involuntary creditor “akin to the child support recipients in Leser,” and it must continue to provide services to the debtors regardless of whether it is paid. 

Leser Test for Unfair Discrimination

Section 1322(b)(1) permits a Chapter 13 plan to “designate a class or classes of unsecured claims, as provided in section 1122 [of the Bankruptcy Code],” but the plan “may not discriminate unfairly against any class so designated,” the court said. Some differential or discriminatory treatment is clearly permitted by Section 1322(b)(1), otherwise “the power to classify and the 'discriminates unfairly' restriction would be superfluous,” the court said, citing Leser.

Under the four-part test of Leser, the court considered:

“(1) whether the discrimination has a reasonable basis; (2) whether the debtor can carry out a plan without the discrimination; (3) whether the discrimination is proposed in good faith; and (4) whether the degree of discrimination is directly related to the basis or rationale for the discrimination.”

Nondischargeability alone does not justify special classification, the court said, citing In re Groves, 39 F.3d 212 (8th Cir. 1994). The court also found the debtors' reliance on Leser misplaced. According to the court, while Leser held that the nondischargeability of child-support arrearages reflects a strong public policy in favor of full payment, that public policy does not apply with full force to the debtors. The debtors' tax delinquency makes their debts nondischargeable. If they had filed their pre-petition tax returns on time, the tax debts would largely be dischargeable, the court noted. Child support payments are by nature nondischargeable, but tax debt becomes nondischargeable only after the debtor fails to file timely returns, the court said.

The court rejected the debtors' argument that the court apply the second “no discrimination” prong with caution to avoid the rule being “simplified to the 'Debtor always loses.'” According to the court, the debtor must formulate a plan that pays the nondischargeable debts pro rata with other unsecured creditors during the life of the plan and as a continuing obligation thereafter. “Such a plan may interfere with the 'fresh start' that bankruptcy provides, but it is hardly remarkable that a nondischargeable debt may remain after a debtor has emerged from bankruptcy; that is precisely what 'nondischargeable' means,” the court said. 

Plan Lacks Good Faith

The court also found that the debtors' plan lacked good faith. According to the court, the debtors clearly are “prioritizing payment to creditors who will be paid in full regardless of the plan implemented in bankruptcy, at the expense of creditors with no other recourse.” They propose to “protect” creditors least in need of protection at the expense of the most vulnerable, the court said.

The court also rejected the debtors' argument that their post-petition tax preparation fees should be treated as pre-confirmation legal fees or trustee administration fees because the bankruptcy could not have proceeded without filing those returns. This is a self-created problem, the court noted. If they had filed their pre-petition tax returns on time, they would have paid their tax preparer directly at that time, the court said.

Judges Roger L. Wollman and Jane Kelly joined the opinion.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com

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