Student Loans Not Dischargeable, Even If Made to Family

When an individual files for bankruptcy, they are released from personal liability for certain specified types of debts. However, for public policy reasons, Congress has determined that certain debts can’t be discharged by filing for bankruptcy.[1] One of the most well-known non-dischargeable liabilities is student loan debt.[2] The recent U.S. Bankruptcy Court case, In re Mallet,[3] held that a loan from an individual’s grandmother-in-law, which was used to pay off the individual’s student debt, also was not dischargeable in bankruptcy.

Facts

Christine Melissa Mallett (“Christine”) took out loans between 2000 and 2007 to attend several different universities. After graduating in 2007, Christine consolidated her various loans into two loans, being a federal consolidated loan serviced by Navient and a private consolidated loan serviced by ACS. After paying on her consolidated loans for two years, Frances Mallett (her then-husband’s grandmother) offered to loan Christine the money to pay off her private student loans. On April 29, 2009, Christine and Mrs. Mallett entered into a written loan agreement, under which Mrs. Mallett loaned Christine over $70,000, and Christine agreed to repay that amount over twenty-five years at 4 percent interest. Christine then used the loan proceeds to pay off her private student loans with ACS

Christine paid on the loan for the next eight years and claimed the interest she paid on the loan as a deduction on her tax returns. After filing for divorce from her husband in 2017, Christine stopped paying on the loan. After Mrs. Mallet passed away, her son Victor Mallet took assignment of the loan. He then sued Christine for breach of the loan agreement in state court. On December 5, 2018, the state court entered a $61,407 final judgment in Victor Mallet’s favor.

Three months later, Christine filed for bankruptcy and included the debt owed to Mrs. Mallet on the required bankruptcy schedules. Victor, who took assignment of the loan and held the $61,407 final judgment, sued to have the debt determined to be non-dischargeable under Bankruptcy Code Section 523(a)(8), which provides that certain student loans cannot be discharged in a bankruptcy proceeding.

Law

As previously stated, Congress has specified that certain liabilities are non-dischargeable in a bankruptcy proceeding, and student loans are one such liability.[4] Student loans are broken down into four categories by Bankruptcy Code Section 523(a)(8). The first two categories are educational loans which are made, insured, or guaranteed by a governmental unit or are made under a program partially or fully funded by a governmental unit or nonprofit institution.[5] The third category is an obligation to repay funds received as an educational benefit, scholarship, or stipend.[6] The fourth category is any other educational loan that is a “qualified education loan” under Internal Revenue Code Section 221(d)(1).[7] Thus, if a loan meets the definition of “qualified education loan” under Internal Revenue Code Section 221(d)(1) for tax purposes, then it is non-dischargeable under Bankruptcy Code Section 523(a)(8)(B).

Internal Revenue Code Section 221(d)(1) defines “qualified education loan” as any indebtedness incurred by the taxpayer solely to pay qualified higher education expenses, so long as the expenses were incurred on behalf of the taxpayer, the taxpayer’s spouse, or a dependent of the taxpayer, were paid or incurred timely, and were related to education furnished while the recipient was an eligible student.[8] Importantly, the flush language of Section 221(d)(1) also specifically includes indebtedness used to refinance debt which previously qualified as a qualified education loan in the definition. Section 221(a) provides a tax deduction for the interest paid on qualified education loans.

Analysis

The main question before the court was whether the loan from Mrs. Mallet met the requirements for a qualified education loan under Internal Revenue Code Section 221(d)(1). Since the loan was not from a governmental unit or nonprofit institution, nor was it an obligation to repay some educational benefit, scholarship, or stipend, the loan could only potentially fall under the fourth category of educational loans.

The court noted the flush language of Section 221(d)(1), and thus concluded that the loan from Mrs. Mallet would be non-dischargeable under Section 523(a)(8)(B) if Christine’s original private student loans were “qualified education loans.” Victor bore the burden of proving that the original loans were non-dischargeable. Christine argued that he failed to meet this burden because he did not prove that the original loan “was used solely to pay higher education expenses.” Citing two 2020 bankruptcy cases, In re Quintanilla[9] and In re Conti[10], the court stated that “courts should look to the initial purpose of the loan—rather than how the loan proceeds were used—to determine whether a loan is a qualified education loan.” The court continued by considering that focusing on the initial purpose of the loan is consistent with the plain language of Section 221(d)(1), and to do otherwise would result in the absurd scenario where borrowers would be rewarded for misusing their student loans. Thus, Christine’s original argument did not persuade the court.

Christine next argued that Victor failed to prove the initial purpose of the loan was to pay education expenses because he failed to introduce her original loan application, her promissory note, or any other evidence regarding the original loans. The court concluded that she had a point, to an extent. While Victor did not admit evidence relating to the original loan documents, as was present in both the Quintanilla and Conti cases, he did admit copies of Christine’s tax returns for 2009 through 2016 at trial. The returns showed that Christine claimed a tax deduction each year for the interest paid to Mrs. Mallet on the loan. The court concluded that Christine could not have claimed these deductions unless the loan met the definition of a “qualified education loan” under Section 221(d). The court further concluded that Christine’s statements on her tax returns, which were made under penalty of perjury, were therefore an evidentiary admission that the loan from Mrs. Mallet was a “qualified education loan,” equivalent to her sitting on the stand and testifying under oath to the same. This evidentiary admission could be controverted or explained away, but Christine failed to do so. Thus, the court ruled that Victor met his burden of proving that the loan from Mrs. Mallet was non-dischargeable under Bankruptcy Code Section 523(a)(8)(B) and entered a separate final judgment declaring that the debt owed to Victor Mallet was non-dischargeable.

Takeaway

There are a couple key points to this case. First, arguing that student loans are dischargeable because they were not actually used to pay education expenses is a losing argument. Second, Christine’s tax treatment of the loan was the determining factor in the case. As is the case of many intra-family contracts, the terms of the loan likely were not drafted carefully to lay out the circumstances surrounding the transaction, and even if it did, it might not have been sufficient to meet Victor’s burden of proof. Fortunately for Victor, Christine treated the loan as a legitimate qualified education loan on her tax returns and was therefore held to that treatment for bankruptcy purposes. It would seem that if Christine had forgone deducting the interest on the loan, she would have likely won (barring Victor admitting further evidence relating to the original loan documents). Christine choosing not to deduct the interest, in the off chance that she filed for bankruptcy at some point in the future, would almost certainly not have been effective tax planning, however such might not be the case for all taxpayers. The tax consequences of a transaction should always be considered, but they aren’t always the most important factor. After all, allowing the tax tail to wag the dog can often result in unintended consequences.

 

[1] Bankruptcy Code Section 523 & 727.

[2] Bankruptcy Code Section 523(a)(8).

[3] In re Mallett, No. 8:19-AP-00249-MGW, 2021 WL 1113793, at *1 (Bankr. M.D. Fla. Mar. 23, 2021).

[4] Bankruptcy Code Section 523(a)(8).

[5] Bankruptcy Code Section 523(a)(8)(A)(i).

[6] Bankruptcy Code Section 523(a)(8)(A)(ii).

[7] Bankruptcy Code Section 523(a)(8)(B).

[8] “Qualified higher education expenses” are defined as the “cost of attendance” (also a defined term) at an “eligible institution” (another defined term).

[9] In re Quintanilla, 2020 WL 7333590 at *5 (citing Conti v. Arrowood Indem. Co., 612 B.R. 877, 881 (E.D. Mich. 2020)).

[10] Conti v. Arrowood Indem. Co., 982 F.3d 445, 449 (6th Cir. 2020).