If you owe sales commissions to an independent contractor when you file bankruptcy, it may be a priority debt. Here’s what determines this.
Our last blog post was about conditions in which wages, commissions, or benefits owed to an employee are “priority” debt.
But what if your debt was not to an employee but an independent contractor? Especially in today’s “gig economy,” small businesses (and large ones, too) often have independent contractors instead of employees.
Why “Priority” Matters
As discussed last week, whether a debt qualifies as a priority debt can make a huge difference.
This most often matters in a Chapter 13 “adjustment of debts” case. You have to pay all priority debts in full during the 3-to-5-year court-approved payment plan. In huge contrast, usually you only pay the non-priority “general unsecured” debts to the extent you can afford to pay. The common result is that you pay priority debts 100%, while those that don’t qualify as priority little or nothing.
The distinction between priority and general unsecured also matters in an “asset” Chapter 7 case. That’s the relatively uncommon situation in which a debtor needs to surrender an unprotected asset to the Chapter 7 trustee. In that situation the trustee liquidates the asset and pays priority debts in full before paying any general unsecured debts. The result: priority debts often get paid in full or in part, while there’s nothing for any general unsecured debts.
The distinction between priority and general unsecured does not directly matter in a simple, “no-asset” Chapter 7 “straight bankruptcy” case. That’s the common situation when everything you own is “exempt”—protected from the Chapter 7 trustee. Many Chapter 7 cases are “no-asset” ones. (However, note that most priority debts can’t be discharged in a Chapter 7 bankruptcy. So while such debts won’t receive anything from the trustee, you’ll likely still have to pay the debt afterwards yourself.)
The Basic Amount/Timing Rule
Whether you owe an employee or an independent contractor, some of the conditions to make the debt priority are the same.
First is the maximum dollar amount. The maximum amount of a debt that would qualify as priority is $13,650. See the discussion in our last blog post about this amount. (Also see the original statute’s $10,000 amount in Section 507(a)(4) of the U.S. Bankruptcy Code, the cost-of-living provision in Section 104 of the Bankruptcy Code, and the current $13,650 amount since April 1, 2019 in this notice in the Federal Register.)
The second condition is the timing. The debt owed must be
earned within 180 days before the date of the filing of the [bankruptcy] petition or the date of the cessation of the debtor’s business, whichever occurs first
Section 507(a)(4) of the Bankruptcy Code.
So, any amount owed to an employee/contractor beyond $13,650 would be a general unsecured debt, not a priority one. Same with any amounts earned outside the specified 180-day period.
The Special Independent Contractor Rule
Beyond the above amount/timing conditions, there’s another significant condition especially for independent contractors. The debt is a priority debt ONLY if
during the 12 months preceding that date [of bankruptcy filing or cessation of business], at least 75 percent of the amount that the individual or corporation earned by acting as an independent contractor in the sale of goods or services was earned from the debtor.
Section 507(a)(4)(B) of the Bankruptcy Code.
So if your independent contractor earned less than 75% of its overall income during that one-year period from you, then none of what you owe it is priority.
Presumably the purpose of this condition is so that it applies only to independent contractors who are more like employees. It includes only those independent contractors who work mostly for you. It is not meant to apply to debts owed to suppliers of goods and services that serve many customers. Those are more like conventional payables, which are general unsecured debts, not entitled to priority.