Pass-Through Taxes: The Ninth Circuit BAP Holds There Is No Per Se Bar on Deducting Owner Taxes from Subchapter V Projected Disposable Income

Three Key Takeaways

• Subchapter V requires a cramdown plan to be “fair and equitable,” which under section 1191(c)(2) of the Bankruptcy Code means the debtor must commit all projected disposable income (or its value) for three to five years. Disposable income under section 1191(d) is income not reasonably necessary for the continuation, preservation, or operation of the debtor’s business.
• In In re A CAB, Series L.L.C., the Ninth Circuit Bankruptcy Appellate Panel held there is no per se rule prohibiting a subchapter V debtor from deducting pass-through income taxes paid by (or distributed to) its owner. Whether the deduction is reasonably necessary is a factual question left to the bankruptcy court’s discretion.
• For single-member LLCs and other pass-through entities, the decision confirms that distributions to cover owner-level taxes on business income can be treated as ordinary and necessary business expenses when supported by the record. Creditors challenging such deductions must show clear error in the court’s factual findings.

One of the signature features of subchapter V is the streamlined path to confirmation of a nonconsensual plan. A plan that does not obtain the consent of every impaired class can still be confirmed if, among other things, it is “fair and equitable.” Pursuant to section 1191(c)(2) of the Bankruptcy Code, in order to be “fair and equitable,” the plan must provide that all of the debtor’s “projected disposable income” over a three-to-five-year period will be applied to plan payments, or that the value of the property distributed under the plan is not less than the projected disposable income.

Section 1191(d) defines disposable income as income received by the debtor that is “not reasonably necessary to be expended … for the payment of expenditures necessary for the continuation, preservation, or operation of the business of the debtor.” One question that regularly arises for pass-through entities is whether taxes imposed on an owner as a result of the business’s income may be considered a “necessary” expenditure, and, as a result, an expense that can reduce “projected disposable income” (thus, deducting the tax amounts from creditor recoveries).

In In re A CAB, Series L.L.C., 2026 WL 2239918 (9th Cir. BAP Aug. 4, 2026), the Ninth Circuit Bankruptcy Appellate Panel clarified that there is no per se prohibition against such a deduction, and, in this case, affirmed the bankruptcy court and allowed the deduction.

The Facts in A CAB

A CAB (the “Debtor”) operated a taxi service in Las Vegas, Nevada. Its sole member was a family trust, and the manager of the Debtor controlled the trust. For tax purposes the Debtor is treated as a sole proprietorship, which means that the Debtor’s income passes through to the owner and is taxed on the owner’s individual tax return.

The Debtor filed bankruptcy primarily due to judgments entered in favor of a group of drivers (the “Murray Creditors”) in the amount of approximately $870,000, plus a substantial attorneys’ fee award. After judgment was entered, the creditors aggressively sought collection of the judgment, including attempts to appoint a receiver and to recover alleged fraudulent transfers. The Debtor filed chapter 11 bankruptcy in December 2022 pursuant to subchapter V of the Bankruptcy Code.

The debtor filed an amended plan that proposed to pay the Murray Creditors’ allowed claims in full, with post-petition interest at the Nevada judgment rate, over five years. Funding sources consisted of projected disposable income (reduced by deductions for pass-through income taxes), an expected Employee Retention Tax Credit, and a balloon payment at the end of the term if needed, in addition to payments from the principal/owner if actual income was insufficient to make the payments.

The Murray Creditors objected to confirmation, arguing that the plan improperly deducted pass-through income taxes from the calculation of projected disposable income under section 1191(d) of the Bankruptcy Code, noting that these were obligations for which the debtor had no legal liability. The Murray Creditors believed (rightly) that the deduction would shrink the Debtor’s cash flow and, as a result, a larger share of their recovery would be deferred to the balloon payment. At the same time, the owner of the Debtor would retain more cash that can be used to pay personal taxes, shifting risk away from the owner and onto the creditors, despite projections that all creditors would ultimately be paid in full.

The bankruptcy court overruled the objections, found the tax expenditures reasonably necessary for the continuation and operation of the business, and confirmed the plan. The Murray Creditors appealed to the Bankruptcy Appellate Panel (the “BAP”).

The BAP’s Analysis

The Panel began its analysis with the plain language of the Bankruptcy Code. Section 1191(d) does not limit deductible expenditures to those for which the debtor itself is legally liable. Rather, section 1191(d) is concerned only with whether the expenditure is reasonably necessary for the continuation, preservation, or operation of the business.

Ultimately, the BAP held that nothing in the Bankruptcy Code prohibits a bankruptcy court from concluding that distributions to an owner sufficient to cover taxes on the income generated by the business are reasonably necessary. Without those distributions the owner would owe tax on income he never received, creating a hardship that could impair his ability (and willingness) to continue managing the enterprise. Further, many businesses that file bankruptcy under subchapter V are taxed as sole proprietorships or disregarded entities. Requiring these businesses to devote “gross” or “pre-tax” income to creditors while leaving the owner to pay the resulting tax bill out of personal funds would be contrary to the purpose of subchapter V.

The BAP’s analysis also tracks and cites Judge Paul W. Bonapfel’s A Guide to the Small Business Reorganization Act of 2019. As Judge Bonapfel observed, without the distributions the owner “will owe a tax on the business income but will receive no money to pay it. When the generation of income by a business gives rise to taxation, it seems appropriate to determine disposable income on an after-tax basis, regardless of the tax status of the business.”

Because the Bankruptcy Code imposes no per se bar, there was likewise no basis to force the debtor to calculate the deduction at the lower corporate rate. Based on the record, the BAP found no clear error. In fact, the owner testified that he relied on distributions from the company to pay the taxes and that requiring him to pay them personally would create an “incredible hardship.” Despite an opportunity to cross-examine the owner, the creditors presented no evidence to the contrary. The plan committed the company to full payment of the judgments with interest, preserved avoidance actions, and required additional contributions from the owner if the Debtor’s cash flow was insufficient to make such payments. Under those circumstances the bankruptcy court’s determination that the tax expenditures were reasonably necessary was supported by the evidence and was not illogical or implausible.

What Parties Should Take from the Decision

For subchapter V debtors organized as pass-through entities, A CAB provides some clarity. Distributions to cover owner-level taxes on business income can be treated as necessary operating expenses when the record supports that conclusion. Debtors should document the tax liability, the owner’s reliance on distributions, and the connection between the owner’s continued involvement and the success of the reorganization (and, in turn, the debtor itself). If, as in A CAB, a plan proposes full payment of all creditors (with interest), the argument is especially solid.

Despite the holding, bankruptcy courts retain discretion and the determination is ultimately based on the facts of each case. Indeed, a court may limit the deduction, require election of corporate tax status, or disallow it entirely if the facts do not support reasonableness. Rather, A CAB simply confirms that a categorical ban is inconsistent with the statute and with the purposes of subchapter V.

Whether you are a small business debtor preparing a subchapter V plan or a creditor evaluating projected disposable income, the attorneys at FactorLaw can help you analyze how pass-through tax treatment affects confirmation prospects and the amount available for distribution.

By: Sean P. Williams