Court Finds 401(k) Loan Not a “Necessary Expense″

The repayment of a 401(k) loan may be a real debt obligation, but it’s not a “necessary expense″ for bankruptcy purposes, according to a recent court decision.

Applying the “means test” from the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), the United States Court of Appeals for the 9th Circuit held (in an issue of first impression for the court) that the section 401(k) plan loan was not a “secured debt” or a “necessary expense” of the debtor.

Accordingly, the court upheld a bankruptcy court’s determination that the debtor’s Chapter 7 bankruptcy petition was “presumptively abusive” under the BAPCPA’s “means test.”

The Case

Scott Lee Egebjerg filed a voluntary Chapter 7 bankruptcy petition on December 31, 2006. At the time, Egebjerg, who had been employed by Ralph’s grocery store for 27 years and earned a gross income of $6,115.56 per month, was single with no assets other than an automobile he used for work and a timeshare. The 9th Circuit noted that he also had unsecured consumer debt of about $31,000.

Approximately two years before he filed for bankruptcy, Egebjerg had taken a loan from his 401(k) plan. The plan subsequently deducted $733.90 from his paycheck each month to repay this loan, which was scheduled to be fully repaid by September 2008. The court noted that, according to Egebjerg’s amended schedule of necessary expenses (in which he included the 401(k) repayment), he was left with a monthly disposable income of $15.31.

The Bankruptcy Court

The bankruptcy trustee objected to Egebjerg’s bankruptcy petition, arguing that he had improperly included the Section 401(k) loan repayment as a “necessary” expense.

The U.S. Bankruptcy Court for the Central District of California rejected that argument, concluding that the 401(k) loan was, in fact, a “secured debt” and one that could therefore be deducted from Egebjerg’s monthly income for purposes of the means test.

However, despite that finding, the 9th Circuit said that the bankruptcy court incorrectly applied the same “totality of the circumstances” test that the bankruptcy trustee had relied on, even though it ultimately dismissed Egebjerg’s Chapter 7 petition. The 9th Circuit noted that the lower court made its determination after concluding that the 401(k) plan loan would be repaid within a year and, after the loan was repaid, Egebjerg would have sufficient monthly income to meet his obligations. The bankruptcy court concluded that Egebjerg could therefore “pay a significant amount of his debts in a Chapter 13 proceeding and that, because of his ability to pay, it would be an abuse to permit the case to continue as a Chapter 7 proceeding.” Egebjerg appealed that decision.

The 9th Circuit’s Decision

Prior to enactment of the BAPCPA, there was a presumption in favor of granting bankruptcy relief to Chapter 7 debtors. However, according to the 9th Circuit, the BAPCPA “produced a sea change” with “an emphasis on repaying creditors as much as possible” and introduced a “means test’ to evaluate whether a debtor’s financial circumstances create a presumption against granting relief under Chapter 7. The court noted that that presumption can be rebutted if the debtor demonstrates “special circumstances.’

“Egebjerg’s obligation is essentially a debt to himself—he has borrowed his own money,’ Judge Michael Daly Hawkins said in writing for the court. “[S]hould he fail to repay himself, the administrator has no personal recourse against him. Instead, the plan will deem the outstanding loan balance to be a distribution of funds, thereby reducing the amount available to Egebjerg from his account in the future.” The court acknowledged that the resulting “deemed distribution will have tax consequences to Egebjerg, but it does not create a debtor-creditor relationship.”

The 9th Circuit also noted that “in BAPCPA, Congress expressly gave Chapter 13 debtors the ability to deduct 401(k) payments from their disposable income calculation, § 1322(f), but did not include any similar exemption for Chapter 7 debtors….In light of the amendments sprinkled throughout the Code [addressing 401(k) loans]—especially section 1322(f)— the lack of a 401(k) provision in section 707 is a glaring indication that Congress did not intend 401(k) loan repayments to be deducted in Chapter 7.”

The court noted that Egebjerg had claimed that “the replenishment of his 401(k) plan is necessary to his long-term ‘health and welfare,’ because he is approaching retirement and his 401(k) plan is his only significant asset.” However, the 9th Circuit said that IRS guidelines, “which Congress expressly incorporated into § 707(b)(2)(A)(ii), state specifically that “[c]ontributions to voluntary retirement plans are not a necessary expense.’’ The court then observed that, “[i]n short, Egebjerg’s monthly 401(k) repayments are the functional equivalent of voluntary contributions to a retirement plan.

“When it introduced the means test, Congress provided by reference to the IRS guidelines, specific guidance as to what qualifies as a necessary expense for the purposes of applying that test. For purposes of the new means test, voluntary retirement contributions are per se not a necessary expense and will remain so unless the IRS changes its guidelines,” the appeals court said.

The case is Egebjerg v. Anderson (In re Egebjerg), 9th Cir., No. 08-55301.