Bankruptcy Basics

Bankruptcy comes in six different forms, which are given the names of the chapters of the US Bankruptcy Code that describe them. 

The only chapters that consumers are interested in are the first two- Chapter 7 and Chapter 13, which govern consumer debts, but for the sake of completeness, we’ve included a description of the rest.

Chapter 7 Liquidation

Chapter 7, entitled “Liquidation,” is a procedure in which the trustee takes over the assets of the debtor’s estate, reduces them to cash, and “liquidates” them by distributing them to creditors (subject to the debtor’s right to retain certain exempt property).  Chapter 7 is really for those who have no non-exempt assets to distribute, in which case there is no liquidation.   These cases are called “no-asset cases.” An unsecured creditor will only receive a payment   if the case is an asset case.  At the conclusion of a successful Chapter 7 case (which normally takes about 3 months), the debtor receives a discharge that releases him or her from personal liability for dischargeable debts.

If Chapter 7 sounds easy, that’s because it is.  Unfortunately, not everyone qualifies to file under Chapter 7.  To determine whether you qualify for a complete discharge, you need to take what is known as a “Means Test.”  If you pass this test, you are eligible for 7 relief.

SEE IF YOU QUALIFY: CLICK HERE to see whether you can pass the means test to qualify for a Chapter 7 discharge.

Chapter 9 Adjustment of Debts

Chapter 9 is called Adjustment of Debts of a Municipality.  It’s not unlike a reorganization under Chapter 11, but only municipalities such as cities and towns, as well as villages, counties, taxing districts, municipal utilities, and school districts can file under Chapter 9.

Chapter 11 Reorganization

Chapter 11 entitled Reorganization, is usually filed by businesses that want to continue operating and repay creditors through a court-approved plan of reorganization. The chapter 11 debtor files a plan of reorganization with a disclosure statement containing information adequate to enable creditors to evaluate the plan. The court will either approve or disapprove the plan.  If approved, the debtor can reduce its debts by repaying a portion of its obligations and discharging others. The debtor can also terminate burdensome contracts and leases, recover assets, and rescale its operations in order to return to profitability. Under chapter 11, the debtor normally goes through a period of consolidation and emerges with a reduced debt load and a reorganized business.

Chapter 12 Adjustment of Debts

Chapter 12 is entitled Adjustment of Debts of a Family Farmer or Fisherman with Regular Annual Income.  As the name implies, it provides debt relief to family farmers and fishermen.

Chapter 13 Adjustment

Chapter 13 is designed for an individual debtor who has a regular source of income and is able to pay all of his or her debts if given enough time.  Chapter 13 enables the debtor to keep a valuable asset, such as a house.  A debtor will propose a “plan” to repay creditors over time – usually three to five years. Chapter 13 is also used by consumer debtors who do not qualify for chapter 7 relief under the means test.

At a confirmation hearing, the court either approves or disapproves the debtor’s repayment plan. Chapter 13 is very different from chapter 7 since the chapter 13 debtor usually remains in possession of the property of the estate and makes payments to creditors, through the trustee, based on the debtor’s anticipated income over the life of the plan. Unlike chapter 7, the debtor does not receive an immediate discharge of debts. The debtor must complete the payments required under the plan before the discharge is received. The debtor is protected from lawsuits, garnishments, and other creditor actions while the plan is in effect. The discharge is also somewhat broader (i.e., more debts are eliminated) under chapter 13 than the discharge under chapter 7.

Chapter 15 Ancillary and Other Cross-Border Cases

The purpose of Chapter 15, entitled Ancillary and Other Cross-Border Cases, is to provide an effective mechanism for dealing with cases of cross-border insolvency.

Do You Qualify For Chapter 7 Bankruptcy?

Chapter 7 bankruptcy offers a clean slate, because it wipes out all of your dischargeable debts (credit cards, medical bills, etc.).  To be eligible for Chapter 7 discharge, you must essentially have no assets, very little income, and no ability to pay off your debts.

The Means Test

To determine whether you qualify, the bankruptcy courts employ a formula called a “means test,” which is designed to weed out those who have sufficient income to pay their debts via a Chapter 13 bankruptcy.    The means test compares your income and assets to your expenses, so you may qualify even if you make a significant income.

The first step in the means test is determining whether your income is more or less than the median income in your state.  If your current monthly income is less than the median income for a household of your size in your state, you automatically pass the means test.  Median income levels vary by state and household size, and each county and metropolitan region has different allowed amounts for categories of expenses: basic necessities, housing, and transportation.

If you earn more than the median, you must figure out whether you would have enough left over to repay some of your debt after subtracting  certain essential expenses (mortgage, rent, taxes, child support, etc.). The means test looks to the average amount of income you earned over the six calendar months before filing bankruptcy, and subtracts those expenses to arrive at your monthly “disposable income.” The higher your disposable income, the more likely you won’t qualify for Chapter 7.  Click Here to download a copy of Form 22a (The Means Test).

If you don’t pass the means test, you are limited to using Chapter 13 bankruptcy, which requires you to make monthly payments over a three- to five-year period according to a strict budget monitored by the court. Most people who file for bankruptcy prefer Chapter 7, which requires no repayment. However, Chapter 13 bankruptcy is still the best way to handle specific types of problems, like curing a default on a mortgage.

 Exceptions to the Means Test

There are three situations when you don’t have to pass the means test in order to qualify for Chapter 7 bankruptcy.

Non Consumer Debts:  If more than 50% of your debts are non-consumer (business) debts, you are excused from the means test requirement.

Disabled Veterans: If you are a veteran with a disability rating of at least 30%, and your debts were incurred primarily while you were on active duty, you don’t have to pass the means test.

Military Reservists and the National Guard:  If you are in the military reserve or National Guard for the period they are on active duty and for 540 days thereafter, as long as they were on active duty or performing homeland defense activities for at least 90 days. Once the exclusion period ends, if the time has not passed for objections to the means test qualification in your bankruptcy case, you will have to take and pass the means test.