Priority Rules in Bankruptcy
The 2 main objectives of bankruptcy are to give the debtor a fresh start and to distribute equally to unsecured creditors what is available of the debtor's property in a liquidation or to pay each creditor a pro rata share of their debt according to a payment plan under Chapter 11, 12, or 13. Secured creditors either get their collateral or the value of the collateral in cash. If the collateral is worth less than their claim, then the claim is bifurcated into a secured claim covered by the collateral and an unsecured claim for the remaining portion. The secured claim is paid in full while the unsecured claim receives a pro rata share of any payments to unsecured creditors.
However, there are some unsecured creditors that get a priority in payments over other unsecured creditors because Congress deemed these payments, most notably domestic support obligations (DSO), as being more important than the others. These are known as priority claims and are grouped into 10 categories with descending levels of priority by §507(a)(1) - (10) of the Bankruptcy Code. This priority of claims cannot be modified by state law nor can the states try to circumvent the priority order by creating a statutory lien that applies only under bankruptcy, since these liens can be avoided by the trustee under §545. Neither can the courts modify the order of the priorities, even if it would be more equitable. However, the courts do construe the priority provisions strictly, and the creditor must prove that its claim satisfies the requirements of a priority.
The claims of other unsecured creditors have the lowest priority. Each category of priority creditors must be paid in full before any creditor below that category gets paid. Hence, all priority claims must be paid in full before any nonpriority, unsecured creditors get paid. If there is not enough money left to pay a priority class in full, then all members of that class receive a pro rata share of what is left.
There are 2 exceptions to the pro rata distribution within a class. For domestic support obligations, individual claimants have priority over governmental units. If a Chapter 11 case is converted to a Chapter 7 liquidation, then the administrative expenses of the Chapter 7 case have priority over the superseded Chapter 11 expenses.
The priority rules apply to Chapter 7, 11, 12, and 13. In a liquidation under Chapter 7 or 11, the claims are paid in the order of their priority with whatever is available from the bankruptcy estate. However, where the debtor is required to make payments according to a payment plan submitted in the course of the bankruptcy under Chapter 11, 12, or 13, no payment plan can be confirmed unless it provides for full payment for all priority classes. These claims can be paid over the term of the bankruptcy, except for the 2nd and 3rd priorities under Chapter 11, which must be paid in full on the confirmation date of the plan.
Priority claims are grouped into the following categories, in descending priority:
Domestic support obligations are claims for support due to the spouse, former spouse, child, or child's representative, and at a lower priority within this class are any claims by a governmental unit that has rendered support assistance to the debtor's family obligations.
Administrative expenses required to administer the bankruptcy case itself. Originally, administrative expenses had the highest priority, but Congress elevated domestic support obligations above administrative expenses with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Nonetheless, regardless of Congress's intention, administrative expenses have a de facto priority over domestic support obligations, because such expenses are deducted before they are paid to DSO recipients. Since trustees are paid from the bankruptcy estate, the courts have allowed de facto top priority for administrative expenses because no trustee will administer a bankruptcy case without being compensated.
Claims in an involuntary bankruptcy petition under Chapter 7 or Chapter 11 that arose between the filing of the involuntary petition by the debtor's creditors to the order for relief issued by the court. These claims are given priority because otherwise creditors would not deal with the debtor, usually a business, when the business has not declared bankruptcy, but the court has not yet ruled in favor of the creditors seeking bankruptcy for the debtor.
Employee wages up to $13,650* for each worker, for the 180 days previous to either the bankruptcy filing or when the business ceased operations, whichever is earlier (180-day period).
Unpaid contributions to employee benefit plans during the 180-day period, but limited by what was already paid either by the employer under subsection (4) above plus what was paid on behalf of the employees by the bankruptcy estate for any employment benefit plan.
Any claims for grain from grain producers or fish from a fisherman for up to $6,725* each.
Consumer layaway deposits of up to $3,025* each.
Prepetition taxes and taxes due within 3 years of the bankruptcy filing. Outside of bankruptcy, taxes usually have a higher priority, which is why many times creditors file an involuntary bankruptcy petition against the debtor, so that they have a higher priority in bankruptcy than they would outside it. Note, however, that tax penalties do not have priority, and, therefore, are dischargeable. For instance, the Fifth Circuit, in U.S. v. Chesteen, No. 19-30195 (5th Cir. Feb. 20, 2020), ruled that the ACA shared responsibility payment is a tax penalty rather than a tax and is therefore dischargeable under bankruptcy.
Commitments by the debtor to a Federal depository institution to maintain the institution's capital.
Claims for death or personal injury from a motor vehicle or vessel that occurred while the debtor was legally intoxicated.
* Adjusted for inflation every 3 years on April 1. Figures are valid until the next adjustment in 2022. Source: Federal Register | Revision of Certain Dollar Amounts in the Bankruptcy Code
Super and De Facto Priorities
There are some claims that have priorities above the priority claims listed above that mostly apply to business debtors. Some higher priorities, called super priorities, are listed elsewhere in the Code. For instance, §507(b) gives a higher priority to a secured claimant for any lack of adequate protection given by the trustee or the court so that the debtor or trustee could use the creditor's property contingent on the promise by the trustee or the court that the creditor will not lose any value from its use. If the adequate protection turns out to inadequate, then the difference will be paid as a super priority claim.
Sometimes the debtor, usually as a business, needs to continue borrowing money even though it is in bankruptcy. However, no lender will lend the debtor money without some guarantee that it will receive payment. Hence, §364(c)(1) elevates any new loans to the debtor or the bankruptcy estate as a super priority claim.
There are also some specialized types of payments that are given a de facto priority by the courts, usually to make the law work, as in paying the trustee to administer the bankruptcy case, or to resolve conflicting goals of different laws.