§ 52.1 — Operating a Chapter 13 Debtor Engaged in Business

Revised: April 30, 2004

[1]

The Bankruptcy Code leaves much to be desired in its treatment of Chapter 13 debtors engaged in business. Section 1304 of the Code defines and confers special powers and responsibilities on a Chapter 13 debtor engaged in business:

(a) A debtor that is self-employed and incurs trade credit in the production of income from such employment is engaged in business.
(b) Unless the court orders otherwise, a debtor engaged in business may operate the business of the debtor . . . .1
[2]

The Bankruptcy Code does not define “self-employed.” Easy examples would be a sole proprietorship or an independent contractor who is not incorporated and is not doing business in any other form such as a partnership. Although there are no reported cases, an individual who works for any other entity may fail the “self-employed” requirement for a debtor engaged in business under § 1304(a). For example, an incorporated individual—a professional corporation or a limited liability corporation—would be employed but probably not self-employed, though this quickly becomes a technical distinction without practical meaning when the debtor is the only shareholder and controls the business of the other entity.

[3]

The consequence of not being self-employed is that the debtor is not engaged in business for purposes of § 1304(a). Statutory authority to operate the business of a Chapter 13 debtor extends only to a debtor engaged in business.

[4]

Similarly, not every self-employed debtor is also a debtor engaged in business. To be engaged in business, the debtor must also “incur[] trade credit in the production of income from such employment.”2 A self-employed debtor who does not incur trade credit is not engaged in business, and again, there is no provision of Chapter 13 that authorizes such a debtor to continue to operate the business.

[5]

There is no logic to allowing sole proprietors who incur trade credit to continue to operate their businesses in a Chapter 13 case while precluding a sole proprietor from continuing to operate the business when the debtor avoids incurring trade credit. Chapter 13 is an excellent vehicle for the rehabilitation of small business debtors without regard to the credit needs of the business. There is no doubt that many debtors operate businesses in Chapter 13 cases notwithstanding that one or another of the technicalities in § 1304 is not satisfied.

[6]

Prohibiting the debtor from operating a business because the debtor fails the test to be engaged in business would create quite a problem for further administration of the Chapter 13 case. The authority for a Chapter 13 debtor to operate the business of the debtor is “exclusive of the trustee” under § 1304(b) with the exception, “unless the court orders otherwise.” The court might “order[ ] otherwise” and empower someone else to operate the business of the debtor.3 But at least prior to confirmation, only the debtor has authority to possess property of a Chapter 13 estate.4 In a Chapter 13 case, the powers to use, sell, or lease property of the estate are exclusively the debtor’s.5 Even if a bankruptcy court were inclined to prohibit the debtor from operating the business, it is far from clear that the Code contemplates that anyone else could take possession and operate a business in a Chapter 13 case. In one reported decision, a bankruptcy court warned a Chapter 13 debtor engaged in business as a landlord that if the debtor did not comply with the court’s view of proper management, the court would put the trustee in charge of the debtor’s business.6

[7]

It has been said that a Chapter 13 debtor operates the business much like a Chapter 11 debtor-in-possession.7 Unfortunately, the Code is not constructed exactly that way. In a Chapter 11 case, 11 U.S.C. § 1107(a) grants a debtor-in-possession the powers and duties of a trustee. With some limitations, the debtor in a Chapter 12 case is empowered much the same as the debtor-in-possession in a Chapter 11 case.8 Because many powers and duties in Chapters 3 and 5 of the Bankruptcy Code are worded in terms of “the trustee,” this substitution gives a debtor-in-possession in a Chapter 11 case and the debtor in a Chapter 12 case broad powers.

[8]

There is no analogue to § 1107 or to § 1203 in Chapter 13.9 A Chapter 13 debtor engaged in business is authorized by § 1304(b) to “operate the business of the debtor” and to use the powers in §§ 363(c) and 364.10 The many powers of a trustee under other chapters are no more available to a Chapter 13 debtor engaged in business than to an ordinary Chapter 13 debtor.11

[9]

The Chapter 13 debtor engaged in business can transact business in the ordinary course without notice or a hearing and may use property of the estate for business purposes as provided in 11 U.S.C. § 363(c).12 A Chapter 13 debtor engaged in business can use § 364 of the Code to obtain credit.13 A Chapter 13 business debtor is subject to the ordinary rules with respect to the use of cash collateral: a debtor engaged in business that fails to provide adequate protection is prohibited from using cash collateral.14 The special powers of a business debtor under §§ 363(c) and 364 ordinarily may not be exercised by the Chapter 13 trustee15 but can be conditioned “as the court prescribes.”16 For example, if the debtor demonstrated poor fiscal control prior to bankruptcy, it might be appropriate for a creditor or the Chapter 13 trustee to ask the court to impose special banking or reporting requirements on the debtor’s continued operation of the business.

[10]

Though rarely used in Chapter 13, the reference to § 364 in § 1304(b) offers a vehicle for financing the business after the petition. Especially in a jurisdiction that delays confirmation until after the claims bar date,17 the business debtor may need interim financing—for example, a crop loan to put in next year’s crop. This can be accomplished by motion practice under § 364 just as in a Chapter 11 case.

[11]

The debtor engaged in business who regularly incurs trade credit may have difficulties during the preconfirmation period because suppliers and employees are likely to demand cash and may condition further dealings on payment of prepetition debts. The immediate or accelerated payment of prepetition debts is problematic in Chapter 13 cases.18

[12]

If the debtor must maintain a prepetition source of supplies or services, the debtor may have to file a motion for permission to pay essential prepetition obligations. In some districts, it is routine in Chapter 11 cases for debtors to seek “first day” orders to pay, for example, prepetition wages to essential employees.19 Although there are no reported Chapter 13 cases dealing with the subject, it is reasonable that bankruptcy courts would permit Chapter 13 debtors engaged in business to pay critical prepetition debts during the preconfirmation period upon proper application.

[13]

Whether a Chapter 13 debtor is “engaged in business” has other important consequences. For example, at confirmation, a debtor engaged in business is entitled to deduct the expenditures necessary for the “continuation, preservation, and operation” of the business to calculate the “disposable income” that must be paid to creditors to satisfy the test in § 1325(b)(1).20 In one reported decision, a Chapter 13 debtor claimed to be engaged in business and deducted business expenses to arrive at the disposable income that must be paid to creditors; however, on closer inspection, the alleged business had never produced any income, the debtor was not engaged in business for purposes of § 1304, and the debtor was not entitled to deduct business expenses in the § 1325(b) calculation.21

[14]

In at least one district, representing a Chapter 13 debtor engaged in business can command enhanced attorney’s fees for debtor’s counsel. As explained in In re Dorsett,22 under fee guidelines for the Eastern District of California, counsel in a business Chapter 13 case may be entitled to a higher fee. Ironically, in Dorsett the bankruptcy court found that the debtors were “self-employed in a for-profit enterprise” and thus were engaged in business, but this business did not have the “potential level of complexity to warrant the increased Guideline Fees for legal services.”23 The court explained: “The Debtor’s business has no employees (other than themselves) and it does not appear to maintain any significant inventory or equipment . . . . It is run out of the Debtors’ home. . . . [T]his court concludes that the ‘business’ Guideline Fee is not necessary or reasonable in this case.”24


 

1  11 U.S.C. § 1304(a), (b).

 

2  11 U.S.C. § 1304(a) (emphasis added).

 

3  See 11 U.S.C. § 1304(b).

 

4  See 11 U.S.C. § 1306(b), discussed in § 44.1 [ Debtor Has Exclusive Control of Estate Property ] § 45.1  Debtor Has Exclusive Possession and Control of Estate Property.

 

5  See 11 U.S.C. § 1303, discussed in § 44.1 [ Debtor Has Exclusive Control of Estate Property ] § 45.1  Debtor Has Exclusive Possession and Control of Estate Property.

 

6  William v. Clark (In re Clark), 91 B.R. 324 (Bankr. E.D. Pa. 1988) (Chapter 13 debtor engaged in business as a landlord was ordered to make payments to the Chapter 13 trustee to fund repairs of apartments. Trustee was directed to make repairs and given limited authority under § 1304(b) to operate debtor’s business. If the debtor does not comply with prior orders requiring repairs, court will replace the debtor with the Chapter 13 trustee and give the trustee total charge of the debtor’s business.).

 

7  First Nat’l Bank v. Pittman, 8 B.R. 299 (D. Colo. 1981).

 

8  See 11 U.S.C. § 1203.

 

9  The closest thing, 11 U.S.C. § 1303, contains a limited grant of power to the Chapter 13 debtor to use, sell or lease estate property under some parts of § 363. See § 44.1 [ Debtor Has Exclusive Control of Estate Property ] § 45.1  Debtor Has Exclusive Possession and Control of Estate Property.

 

10  See below in this section.

 

11  See §§ 52.1 [ Turnover of Property ] § 50.1  Turnover of Property, 53.1 [ Strong-Arm Powers, Statutory Liens, Preferences and Fraudulent Conveyances ] § 50.3  Strong-Arm Powers, Statutory Liens, Preferences and Fraudulent Conveyances and 53.2 [ Postpetition Transfers ] § 50.7  Postpetition Transfers.

 

12  11 U.S.C. § 1304(b).

 

13  11 U.S.C. § 1304(b).

 

14  See In re Goode, 235 B.R. 584, 589 (Bankr. E.D. Tex. 1999) (Debtor engaged in various businesses failed to provide adequate protection and is prohibited from using cash collateral. Bank had security interest in a $23,142 cash receivable. Debtor was a sole proprietor in the construction business, in a trucking business and supplying livestock for rodeos. “Under the provisions of 11 U.S.C. § 1304(b), a Chapter 13 debtor engaged in business may exercise the powers of a trustee under § 363(c) of the Bankruptcy Code to seek authorization to utilize the cash collateral of a creditor. . . . [A] debtor is required to segregate and account for any cash collateral in his possession and is further prohibited from using such cash collateral in any manner, unless all secured creditors having an interest in such cash consent to such use or the court authorizes such use over the creditor’s objection, after notice and a hearing. . . . [T]his Debtor concedes that no traditional forms of adequate protection can be provided to CNB for the use of the cash collateral.”). Compare In re Czyzk, 297 B.R. 406, 410 (Bankr. D.N.J. 2003) (Chapter 13 debtor engaged in business is not sanctioned for using cash collateral without court permission because bank took no action to protect its rights for two months and then froze business account with more money than the bank’s right of setoff. “Although the debtor’s use of his account postpetition may have been the unauthorized use of Wachovia’s cash collateral, the court will not impose any obligation on the debtor to return the funds or comply with any other equitable remedy . . . . [T]he bank was aware of the debtor’s bankruptcy but took no action to protect its rights for two months. . . . [W]here a bank allows a debtor to use cash collateral funds in his or her checking account postpetition, the bank loses its right to enforce section 363(c)(2). . . . Wachovia has not sought any remedy for the use of the cash collateral nor presented any evidence that it has been harmed by debtor’s actions. . . . [T]he debtor is not liable for violating section 362(c)(2).”).

 

15  Walls v. Appalachian Tire Prods., Inc., 17 B.R. 701 (Bankr. S.D. W. Va. 1982). See Spricer v. Woodhouse, 17 B.R. 275 (Bankr. S.D. Ohio 1982); In re Ballard, 4 B.R. 271 (Bankr. E.D. Va. 1980).

 

16  11 U.S.C. § 1304(b).

 

17  See § 216.1 [ Timing of Hearing on Confirmation ] § 115.1  Timing of Hearing on Confirmation before BAPCPA.

 

18  See, e.g., In re Grear, 163 B.R. 524, 527 (Bankr. S.D. Ill. 1994) (In the context of an unfair discrimination challenge to the debtor’s plan, the court observes that the disposable income test may preclude a Chapter 13 debtor engaged in business from separately classifying trade creditors with claims incurred in the month preceding bankruptcy for full payment outside the plan in the ordinary course of business. “[T]he debtor proposed to pay [trade creditors with claims incurred in the month preceding bankruptcy] ‘outside the plan in the ordinary course of the debtor’s business.’ Since, under the disposable income requirement of § 1325(b)(1)(B), all the debtor’s disposable income must be applied to make payments under the plan, the debtor may not pay these creditors’ claims during the period of this plan without violating the disposable income requirement of § 1325(b)(1)(B).”). See § 204.2 [ Order of Payments to Creditors ] § 113.7  Order of Payments to Creditors before BAPCPA.

 

19  See, e.g., In re Chateaugay Corp., 80 B.R. 279 (S.D.N.Y. 1987) (Rigid application of priorities in § 507 would defeat the flexibility needed in reorganization cases to deal with pressing prepetition liabilities.); In re Eagle-Picher, Indus., 124 B.R. 1021 (Bankr. S.D. Ohio 1991) (There is no per se rule prohibiting payment of certain prepetition claims.); In re Gulf Air, Inc., 112 B.R. 152 (Bankr. W.D. La. 1989) (Chapter 11 debtor is authorized to pay prepetition employee wage and benefit claims.). But see Official Comm. of Equity Sec. Holders v. Mabey, 832 F.2d 299 (4th Cir. 1987) (questioning pre-plan payment of unsecured creditors in Chapter 11 cases). See generally Jordan Tabb, Emergency Preferential Orders in Bankruptcy Reorganizations, 64 Am. Bankr. L.J. 75 (1990).

 

20  See § 167.1 [ Debtor Engaged in Business ] § 91.6  Debtor Engaged in Business.

 

21  In re Schnabel, 153 B.R. 809, 819 (Bankr. N.D. Ill. 1993) (A Chapter 13 debtor engaged in business is entitled to deduct reasonably necessary business expenses in arriving at disposable income for purposes of § 1325(b). Section 1304 defines “debtor engaged in business” as a debtor “that is self-employed and incurs trade credit in the production of income from such employment.” Here the debtor is not entitled to deduct alleged business expenses because the debtor testified that the business has never produced income and is not anticipated to produce any business income during the life of the plan. The debtor is not engaged in business, and the alleged business expenses must be included in the debtor’s disposable income. “The Court finds that the Debtor’s venture is a hobby more than a business and will not allow a hobby to be used as a basis for withholding payments from creditors.”).

 

22  297 B.R. 620 (Bankr. E.D. Cal. 2003).

 

23  297 B.R. at 625.

 

24  297 B.R. at 625–26.