North Carolina Business Litigation Report

Fourth Circuit Carves Up Children (For Bankruptcy Purposes Only)

Maybe you've got a friend who is a bankruptcy lawyer.  Maybe not.  But if you do, you should think about forwarding to them this post about the Fourth Circuit's decision from last Tuesday in Johnson v. Zimmer.  It's a decision of first impression in all of the Circuit Courts about how to determine the size of a Chapter 13 Debtor's "household", which is relevant to determining her "disposable income" for purposes of a Chapter 13 Plan.

Let's start with why those terms are important.  A Chapter 13 Debtor is obligated to make payments to his creditors based on her "projected disposable income."  The Bankruptcy Code defines "disposable income" as "current monthly income received by the Debtor" reduced by "amounts reasonably necessary to be expended for the Debtor's maintenance and support, for qualifying charitable contributions, and for business expenditures."

The "amounts reasonably necessary to be expended" are determined, in part, by the size of the Debtor's "household."  Congress didn't bother to define what "household" means, so that was the main challenge for the Fourth Circuit.

How The Dictionaries Define "Household"

Well that's easy, you would think.  Look up "household" in the dictionary.  Because we give undefined words their ordinary meaning. But that doesn't really work because the common definitions for "household" are different and could yield different results.

Black's Law Dictionary says that a "household" is "1. A family living together.  2. A group of people who dwell under the same roof."  Webster's Third New International Dictionary says that the term means "a social unit comprised of those living together in the same dwelling place."

How The Bankruptcy Courts Have Dealt With This Issue

The bankruptcy courts have adopted three different approaches to define a "household."  Those are:

  • The "heads-on-beds" approach, which follows the Census Bureau’s broad definition of a household as "all the people who occupy a housing unit," without regard to relationship, financial contributions,or financial dependency;
  • the "income tax dependent" method derived from the Internal Revenue Manual’s definition that examines which individuals either are or could be "included on the debtor’s tax return as dependents";
  • The "economic unit" approach that "assesses the number of individuals in the household who act as a single economic unit by including those who are financially dependent on the debtor, those who financially support the debtor, and those whose income and expenses are inter-mingled with the debtor’s."

The reason that Johnson's case was so difficult was that she was divorced and remarried.  Her new husband had three kids from his prior marriage and she had two.  The children from the first marriages spent about half a year with the Debtor and her new husband and the rest of their time with their other parent.

So the Debtor said her household consisted of her husband and all the kids, or seven.  Zimmer, a creditor, said that the count of 7 resulted in an overcalculation of the Debtor's expenses and that counting the household as smaller would free up income to pay under her Chapter 13 Plan to her unsecured debts.

The Fourth Circuit Applies The Economic Unit Approach, With Fractions

The Bankruptcy Judge, J. Rich Leonard, agreed partly and applied a variation of the economic unit approach.  He "fractionated" the kids based on the number of days that they were in the Debtor's house, and calculated that she had 2.59 children in her house full-time.  He rounded that up to three, and declared the household to be one of five.

A divided Fourth Circuit affirmed.

Why The Fourth Circuit Rejected The "Heads-on-Beds" And The "Income Tax Dependent Approaches

It rejected the "heads-on-beds" approach as being inconsistent with the purpose and objectives of the Bankruptcy Code.  It held that:

The calculation of a debtor’s monthly income and expenses is aimed at ensuring that debtors pay the amount they can reasonably afford to pay to creditors. It makes little sense to allow debtors to broadly define their "households" so as to include individuals who have no actual financial impact on the debtor’s expenses. The over-inclusion of individuals in a debtor’s household size would lead to an artificially high calculation
of the debtor’s "amounts reasonably necessary to be expended" each month, and thus to an incorrect determination of the debtor’s disposable income and ability to pay creditors.

Op. 21.

The Fourth Circuit majority also said that requiring a person to be a federal tax dependent before being counted in a household also carried problems.  It posited that minor children might live with an estranged debtor, but there might be a divorce agreement saying that the debtor would not claim the child as a dependent on his tax return.  Or the debtor would not be able to claim as a member of his "household": "step-children, a cohabitating fiancee, live-in elderly parents, and the like."  Op. at 26.  Put another way, this approach poses the risk of underskewing a Debtor's disposable income.

Judges Agee and King concluded that the application of the economic unit approach satisfied the language of the Bankruptcy Code, and avoided the problems presented by the heads-on-bed and income tax dependent methods.

There's A Dissent

Judge Wilkinson took them to task in his dissent, in a graceful and courtly way.  He called the majority opinion "a grievous . . . assault upon the statutory text."  Op. 33.  He said that while it might be "laudable" to recognize that there were a growing number of Debtors with "blended families" like Johnson's, but that "in our legal system, we leave the updating of statutes to Congress."  Op. 36.  And even if Congress did not amend the Code, he said that courts can still take economic realities into account "without slicing a debtor's dependents into bits and pieces."  Op. 37. He would have reversed the Bankruptcy Court.

It remains to be seen what the other Circuit Courts will do if they are confronted with this issue, so if there's a split it seems likely that the Supreme Court will address this issue.

Let me disclaim that I am not a bankruptcy lawyer, so if I have dumbed down this Chapter 13 issue too much, to the point where I thought I understood it, but got it wrong, I apologize and invite comment.

Don't forget to forward this post to a bankruptcy lawyer.  It will give him or her something to talk about at the next bankruptcy lawyer cocktail party.

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Mack Sperling
Brooks Pierce, LLP
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