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5500 Preparer's Manual for 2012 Plan Years
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Debtor could not deduct 401(k) loan repayments under bankruptcy means test as necessary expense

A debtor's repayment of a 401(k) plan loan did not constitute a payment of secured debts or a necessary expense that could be deducted from the debtor's monthly income for purposes of applying the means test under Chapter 7 of the Bankruptcy Code, according to the U.S. Court of Appeals in San Francisco (CA-9), in Egjebjerg v. Anderson, a case of first impression.

401(k) loan failed to prevent bankruptcy

In an effort to avoid bankruptcy, an employee acquired a loan from his 401(k) plan, which was repaid through an automatic monthly deduction from his paycheck of $733.90. Two years later, the employee filed for bankruptcy under Chapter 7 of the Bankruptcy Code, claiming monthly disposable income of $15.31. The employee's calculation of his monthly income reflected his inclusion of the 401(k) loan repayment as a necessary expense.

The bankruptcy trustee objected to the Chapter 7 petition, maintaining that the loan repayments were not a necessary expense and that the debtor's filing was presumptively abusive under the Chapter 7 means test. The U.S. Bankruptcy Court in California initially found that the loan was a secured debt that could be deducted from the debtor's income for purposes of the means test. However, upon examining the totality of the circumstances of the case, the court dismissed the Chapter 7 petition, reasoning that because the loan would be repaid at the time the court's order was issued, the debtor would have sufficient funds to pay a significant amount of his debts in a Chapter 13 proceeding. Allowing the Chapter 7 petition to proceed under such circumstances would be an abuse of the process, the court stressed.

Loan repayment is not a secured debt

A debtor is permitted under the Chapter 7 means test to deduct average monthly payments made on account of "secured debts." However, the Ninth Circuit, in accord with the majority of jurisdictions, held that a debtor's obligation to repay a loan from a retirement account is not a debt under the Bankruptcy Code that may be deducted from income under the means test.

Noting that an employee's obligation under a 401(k) loan is to himself, the court stressed that the plan administrator has no right to personal recovery against the debtor in the event of default. The plan is not empowered to sue the debtor for payments, but may only offset the funds against future benefits. In addition, the court emphasized, the deemed distribution that results from a loan default, will subject the debtor only to tax penalties, and does not provide the plan with repayment rights or other legal recourse.

The court acknowledged that debtors in Chapter 13 proceedings are expressly authorized to deduct 401(k) loan repayments in the calculation of disposable income. However, the court cautioned, bankruptcy law does not provide a comparable right for Chapter 7 debtors.

Loan repayment is not a necessary expense

Under the means test, debtors may deduct actual monthly expenses that qualify as "other necessary expenses." The debtor maintained that the monthly 401(k) loan repayments were a necessary expense. According to the debtor, the replenishment of his 401(k) account was necessary to his long-term health and welfare because the account would be his only significant asset in retirement.

In rejecting the debtor's claim, the court noted that the Internal Revenue Manual and the Bankruptcy Code expressly state that contributions to voluntary retirement plans are not a necessary expense. Finding 401(k) loan repayments to be the functional equivalent of voluntary contributions to a retirement plan, the court concluded that the contributions could not be deducted from income as a necessary expense.

Rejecting contrary conclusions, based on application of the totality of circumstances test under prior law, the court explained that, under the currently applicable means test, voluntary retirement contributions are per se not a necessary expense. Therefore, allowing the debtor to deduct the 401(k) loan repayments from his disposable income for purposes of the means test would justify a presumption of abuse of Chapter 7 relief.

The presumption of abuse under Chapter 7 may be rebutted if "special circumstances," such as a serious medical condition or a call or order to active military duty, justify additional expenses or an adjustment of current monthly income, for which there is no reasonable alternative. However, a debtor's obligation to repay a loan, the court stated, would not (absent life altering circumstances beyond the general financial problems incident to bankruptcy) constitute a special circumstance sufficient to rebut the presumption of abuse.

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