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March 2004 Synopsis of Bankruptcy Cases
Prepared for the DBCA Bankruptcy Subcommittee

Open-Ended Order Permitting Payment to Any Vendor Without Analysis is Invalid
In re Kmart Corporation, 2004 WL 343520 (7th Cir. 2004):
The Seventh Circuit examined the issue of whether Bankruptcy Courts have the discretionary authority to authorize full payment to certain unsecured creditors for pre-petition debt. In Kmart, the Debtors moved the Bankruptcy Court to permit full payment of certain pre-petition claims that the Debtors deemed “critical” for a successful reorganization. The theory behind this request was that these “critical” vendors would be unwilling to do business with delinquent Debtors, thus resulting in injury to all vendors if business were to shut down. Without factual or legal analysis, the Bankruptcy Court entered an Order granting the Debtors’ request. The District Court reversed and the Seventh Circuit affirmed, holding that that Section 105 of the Bankruptcy Code does not authorize full payment of any unsecured debt, unless all unsecured debt in that particular class are paid in full. The Seventh Circuit hinted at the possibility of using Section 363(b)(1) as a means to permit payments to certain unsecured creditors however the record must clearly reflect the prospect of benefit to the other disfavored creditors.

Failure to Timely File Income Tax Obligations Are Not Per Se Disqualified under Section 523
In re Payne, 2004 WL 404482 (Bankr.N.D.Ill.): Judge Schmetterer held that an untimely filed income tax return was not per se disqualified under Section 523 of the Bankruptcy Code. In Payne, the Debtor neglected to file his income tax returns for tax years 1983 through 1990. This resulted in the IRS to investigate and determine the Debtor’s tax liability. Sometime in 1990 the Treasury made assessments to the Debtor’s tax liabilities. In 1992, the Debtor prepared (with the assistance of an accounting firm) and mailed his 1040 income tax returns for all of the delinquent tax years without payment. In 1997 the Debtor filed for relief under Chapter 7 of the Bankruptcy Code, listing the IRS as a creditor for unpaid income taxes for tax years 1983 through 1991. The IRS did not file a claim nor did it file an adversary complaint. After discharge the IRS continued to pursue the Debtor, prompting the Debtor to file an adversary complaint for violating the discharge injunction. The issue at trial was whether the late-filed return qualified as an “honest and reasonable attempt to satisfy the requirements of the tax law.” The Bankruptcy Court found for the Debtor, stating that Congress could have conditioned the discharge of tax debt on whether a return was filed prior to assessment but instead, chose not to.

Refund on Joint Federal Income Tax Return Presumed to be a Joint Asset
In re Barrow, 2004 WL 383378 (Bankr.W.D.N.Y.): The Bankruptcy Court for the Western District of New York examined the issue of whether a non-Debtor spouse was entitled to a joint income tax refund. In Barrow, the Debtor filed for relief under Chapter 7 of the Bankruptcy Code. Amongst his outstanding debts were liabilities to the IRS resulting from non-joint income taxes returns. Shortly after petitioning for relief, the Debtor filed a joint income tax return along with his non-Debtor spouse. Because of the automatic stay, the IRS held the current income refund until the Bankruptcy Court provided proper guidance to the IRS. The non-Debtor claimed the refund due to an IRS exception providing relief to innocent spouses. The Trustee objected, claiming that he was entitled to a portion of the refund. The Bankruptcy Court acknowledged a rift amongst other courts. The majority view allocates a joint tax refund between spouses in proportion to their tax withholdings. A second approach divides refunds in proportion to the income that each spouse generated. Other courts have ruled that each spouse owned the refund equally. The Bankruptcy Court sided with the latter view, reasoning that total tax liability are not necessarily linked to income. Rather, a refund may be attributable to a number of factors, such as a tax credit or credits for education, etc. In the absence of evidence for separate ownership, such as present conduct or a history of financial managements, the refund should be presumed equal.

Qualification for a Chapter 13 Plan Constitutes Abuse For Dismissal of Chapter 7 Bankruptcy
In re Behlke, 2004 WL 314905 (6th Cir. 2004): The Sixth Circuit addressed the issue of whether contributions to a Debtors’ retirement plan, which were excluded from the Debtors’ disposable income, constituted “substantial abuse” for dismissal purposes. In Behlke, the Debtors had accumulated over $100,000.00 in credit card debt. The Debtors also listed in their Schedule I a voluntary contribution of $460.00 to an employer-sponsored 401K plan. The Debtors also listed monthly income of $4,923.00 and monthly expenses of $4,749.00. The Trustee determined that the Debtors were not “needy” and subsequently filed a motion to dismiss under Section 707(b) of the Bankruptcy Code. The Bankruptcy Court noted that the 401K contributions should be included in their disposable income and because of those contributions; the Debtors had the ability to pay out of future income and subsequently dismissed the Debtors’ Chapter 7 Bankruptcy. The Sixth Circuit affirmed noting that a finding of “dishonestly” was not necessary to conclude substantial abuse under the Code.

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