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Tax Newsletter

Chapter 7 and 11 Bankruptcy of Employers and Employee Benefits

Generally, a business that is facing serious financial difficulties might seek to file for bankruptcy under either Chapter 7 or Chapter 11 of the U.S. Bankruptcy Code. Chapter 7 bankruptcy is more severe, as it involves a liquidation of all of the company’s assets and the business ceases to exist. On the other hand, Chapter 11 bankruptcy enables the business to continue to operate by allowing it to develop a plan of repayment. When an employer files for bankruptcy, one important consideration is to determine what becomes of benefits earned by the employer’s employees up until that point.

Chapter 7 vs. Chapter 11 Bankruptcy

When an employer declares bankruptcy, they must file under either Chapter 7 (liquidation) or Chapter 11 (reorganization). In general, under Chapter 7, the business is required to turn over all of its non-exempt assets to a bankruptcy trustee. The trustee then liquidates, or sells the assets and distributes the sale proceeds to the business’ creditors. The creditors are ranked and paid off in order of their priority, but only to the extent that assets are available. The business then ceases to exist.

In contrast, under Chapter 11, the business typically continues to operate under the protection of the bankruptcy court. The business debts are reorganized, the company establishes a plan of repayment, and the creditors are paid off in a specified period of time according to the terms of the plan.

Significance of the Bankruptcy Chapter Under Which the Employer Files

There is a significant difference between employer bankruptcy under Chapter 7 and Chapter 11 for the purposes of determining what will become of the employees’ benefits. For example, if an employer files for Chapter 7 liquidation, it is likely that their employees’ health plans and pensions will also dissolve, or terminate. However, Chapter 11 reorganization may not affect employee health plans or pensions, which may continue throughout the bankruptcy process.

Employee Benefits Governed by ERISA

The Employee Retirement Income Security Act (ERISA) was enacted by Congress in 1974 and is the nation’s primary pension law. ERISA governs several forms of employee benefits including:

  • Retirement plans, such as profit sharing and 401(k)s
  • Welfare plans, such as health, disability and life insurance plans
  • Health coverage continuation and accessibility programs such as COBRA and HIPAA

Administered by the U.S. Department of Labor’s Employee Benefits Security Administration (EBSA), ERISA provides rights and protections for health and pension plan participants and beneficiaries in the arena of private employment.

Retirement Plans in Employer Bankruptcy

When an employer files for bankruptcy, employees face significant concerns over what will happen to their retirement benefits. In general, retirement plans that are ERISA qualified will be protected under the laws of all states, and will not be included as an asset in the bankrupt business estate. This is because ERISA specifically requires pension benefits to be both adequately funded by the employer and kept separate from all other business assets. As such, the retirement funds are likely to be held in trust or invested in an insurance contract and will thus remain secure from the creditors’ reach.

Further, traditional “defined benefit plans” (promised set monthly benefits on retirement), are insured by the federal government and protected by the Pension Benefit Guaranty Corporation (PBGC). The PBGC assumes the responsibility to fund the plan should the employer become financially unable to do so. However, “defined contribution plans” (contributions are made and invested so the ultimate pay out fluctuates) are not federally insured.

The pension plan at least owes the employees all of their accrued benefits up until the point of their employer’s bankruptcy. However, that does not mean that the benefits will actually be paid out before the employee reaches the age of retirement (usually age 65). The time of the pay out will depend on the type of plan and its terms. Since taking a distribution of pension plan benefits before retirement may have adverse tax consequences, it is prudent to consult with a tax advisor before accepting such a distribution.

Health Plans in Employer Bankruptcy

In the case of health plans, the distinction between Chapter 7 and Chapter 11 are significant. Typically, when employees lose their jobs under other circumstances, they might retain the right to continue their health coverage under The Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA). COBRA applies to most public and private employers, except for “small employers” employing less than 20 employees on a typical business day, certain government units and church plans. The right to retain coverage under COBRA applies where the employees are terminated, change jobs or reduce their hours, thereby making them ineligible for their employer’s health plan.

COBRA may also be available when the employer files under Chapter 11 and reorganizes. In this scenario, if the employer discontinues some or most of its health plans, the employees might be able to obtain coverage under a different employer-offered plan. However, in a Chapter 7 liquidation, the employer will necessarily be discontinuing 100% of its health plans and thus, COBRA is not available to those employees. In this scenario, the employees will have to seek outside coverage or convert the employer’s group health plan to an individual policy.

Special rules apply to individuals receiving health benefits as a retiree of a company that has declared bankruptcy, or individuals receiving health benefits as the result of a collective bargaining agreement.

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