The decision to file a personal or business bankruptcy is one of the most difficult decisions that an individual, family or business can make. People file bankruptcy for all sorts of reasons, from medical disasters to business failures to being victimized by scams to simple mishandling of credit cards and other debt. Whatever the reason, it hurts people when they realize that they have come to the point where they must ask the government for help in putting their financial lives back together.
But the bankruptcy laws, and particularly Chapter 7, are set up to help people in this sort of distress. Used appropriately, Chapter 7 can be a new beginning for a person, family or business. Chapter 7 allows for the “liquidation” of the debtor’s personal or corporate financial obligations. Liquidation means the sale of the debtor’s assets and the distribution of the proceeds to the creditors. Liquidation is available under Chapter 7 regardless of the amount of the debtor’s debts or even whether the debtor is solvent or insolvent.[1]
Most bankruptcies filed in United States are Chapter 7 personal liquidations. Although businesses can and do file Chapter 7, businesses are not allowed all the benefits of a Chapter 7 to which individuals and families are entitled.[2]
Limitations on Filing for Chapter 7
To qualify for relief under Chapter 7, the debtor may be an individual or married couple, a partnership, a corporation or other business entity.[3] Except under court order or by statute, there is no limit to the number of bankruptcies that a person or business can file under Chapter 7, though there are limitations on the eligibility to file a Chapter 7.
The first limitation is time. A petitioner cannot file a Chapter 7 until eight years from the date of filing a previous Chapter 7. A petitioner who previously received a Chapter 13 discharge must wait six years from the date of the Chapter 13 filing. However, this time limit does not apply if the Chapter 13 debtor repaid 100% of all unsecured debts under the previous filing, or at least 70% of those debts if the plan was proposed in good faith and the debtor made a “best effort” to repay them.[4]
Second, a debtor cannot file a Chapter 7 if a previous Chapter 7 was dismissed within the prior 180 days by the court for willful failure to appear in court or to follow a court order. The same is true if the debtor voluntarily dismissed the previous case after creditors who held liens on the debtor’s property sought relief from the bankruptcy court to recover the property.[5]
Third, debtors must take credit counseling courses, individually or in a group, within 180 days of filing a Chapter 7 liquidation action.[6] Any debt management plan developed with the credit counselor is filed with the court. If no appropriate, approved credit counseling agencies are available to the debtor, the court can waive the requirement.
Means Test
A personal Chapter 7 filing made up mostly of consumer debts will be subject to a “means test.”[7] To pass the means test, the filer must meet certain threshold financial qualifications based on income, expenses, residence and other facets of the filer’s debt to income ratio. The means test does not apply to a business bankruptcy. If a filer fails this means test, that person cannot file under Chapter 7, but may still file a Chapter 11 or 13 bankruptcy.
The first step in this test is determining if the filer’s income is below the state median household income.[8] This figure changes year-to-year and varies by state and household size. If the filer’s income is below that median figure, the filing is allowed. If his income is above the median figure, then the test moves to the next phase, which is a calculation of the debtor’s “disposable” income.[9] If the disposable income is above a certain limit, a Chapter 7 cannot be filed.
If the income is under that limit, there is still another step. The debtor fills out an income and expense form, which will determine whether the debtor earns enough to repay some outstanding bills after living expenses.[10] If there is money left over, the court can convert a Chapter 7 to a Chapter 13 with the debtor’s consent (a “conversion”) or can dismiss the case.
One more presumption is built into the means test: if a debtor’s income exceeds $12,850 per month (as of 2018), there is no Chapter 7 allowed absent a showing of special circumstances.[11]
We’ll now turn to what happens after the Chapter 7 petition is filed.
Filing a bankruptcy begins the creation of the bankruptcy estate.[12] With some exceptions, the estate becomes the temporary legal owner of the debtor’s property. This includes property in the debtor’s possession, debtor’s property in someone else’s possession, property the debtor has recently given away, proceeds from the debtor’s property (such as interest from bank deposits or rent generated by real estate), property to which the debtor is entitled, certain other future interests and the debtor’s share of marital property.
The estate is administered by the trustee who pays the creditors (proportionately) from the non-exempt property of the estate.
Exemptions: What the Debtor Can Keep
Among the first questions that many debtors ask when thinking about going bankrupt are: “How much property can be protected from creditors? Can we keep the car? Can we keep the house? Furniture?”
Other bankruptcy chapters allow plans in which the filer can keep most or all property, but in a liquidation- theoretically, at least- “everything must go.” Still, the law does allow the debtor to keep some property as exempt from liquidation under federal bankruptcy law or under the laws of the debtor’s home state.[13] What kind of property and how much of it is exempt varies from state to state and is one of the few areas in which state law works with federal bankruptcy law.
All states provide for bankruptcy exemptions. Nineteen states[14] and the District of Columbia allow debtors to choose between their state systems of exemptions and the federal bankruptcy exemptions. The rest use only state law.
The most impactful exemption is the “homestead exemption”, which allows a debtor to keep one home (or more, in some cases) up to a certain value. Some states allow the debtor to keep her home regardless of its value.
Federal Exemptions
Federal exemptions are adjusted every three years on April 1st using the Consumer Price Index. Each exemption is doubled for married couples filing jointly. The following numbers are as of the 2016 adjustment.
The federal homestead exemption is $23,675 (doubled for married couples). This includes real property, co-ops, mobile homes and burial plots. Other exemptions include one motor vehicle (up to $3775); personal property (with some exceptions) up to a total of $12,625; some future income including lawsuits up to certain limits; some retirement accounts; public assistance, Social Security, alimony and child support, tools of debtor’s trade, insurance and some others.[15]
There is also the so-called “wild card” exemption, which exempts additional cash or property not covered by the exemption categories. The 2018 federal wild card exemption is $1,250, plus up to $11,850 of any unused portion of the homestead exemption.[16]
State Exemptions
Each state has its own set of exemptions for a liquidation case. Most of them exempt, at least, a home, a car, work tools, child support and cash necessary for some basic needs. These exemptions can also become important in debtor-creditor law.
One area in which states differ greatly is in the homestead exemption. For example, Florida, Iowa, Kansas, Oklahoma, South Dakota and Texas protect 100 percent of the equity in the home. Other states, such as New Jersey and Pennsylvania, do not have any homestead protection. Alabama[17] protects only up to $15,000; Arizona to $150,000[18]. In New York, the exemption amount varies by county.[19]
States also vary on the amount of cash on hand that can be exempted, but it usually is not very much.
The Role of the Trustee
When a chapter 7 petition is filed, the trustee (or the bankruptcy court in some states) appoints a trustee.[20] The trustee makes initial determinations about the case, including whether it should be dismissed or discharged without going through the rest of the bankruptcy process. Then the trustee sets a date for an initial hearing.
In most cases, there needs to be only this one hearing, but there are times when a bankruptcy may be contested, or the trustee may discover hidden assets or recover illegally transferred property or discover a fraud on the court. In such cases or in general, when things don’t go as planned, there may be more hearings or even a trial.
If the debtor has no assets, or all assets are subject to liens or exemptions, the trustee will declare a “no asset estate.” In this case, there will be no distribution to any creditors, and the case will wrap up quickly.[21]
If the debtor does have assets to distribute, then the trustee must notify the creditors that they have 90 days after the date of the first hearing to file a claim against the estate (180 days in the case of governmental entities).[22] To pay the creditors, the trustee sells or uses the estate assets. Property subject to liens can be sold if the value exceeds the lien amount. Otherwise, the property is kept by the estate or transferred to the lienholder. The trustee can also void fraudulent or illegal transfers, take over and run a business for a limited period[23] and perform other functions.
Classes of Claims
There are six descending classes of claims[24]. Each claim in a higher class must be paid in full before any claim in a lower class is paid. Each is only paid if the creditor files a proof of claim with the trustee.[25]
Claims can be either secured or unsecured. A secured claim is collateralized by property, usually in the form of a lien or a mortgage to secure payment. Examples of secured property include mortgaged houses and financed cars. Unsecured debts include personal loans, credit cards, utility bills and the like.[26]
The first class of claims is secured creditors. The second class is “priorities” claims[27] under the law. These include domestic support obligations, administrative expenses of the bankruptcy case, certain unsecured claims including salaries owed to employees and certain money deposits.
The next classes, in descending order, are: most classes of unsecured claims; late-filed unsecured claims; penalty claims (fines, punitive damages); and interest. Anything left over after all claims are paid goes back to the debtor.[28]
The creditors can also make their own agreements for distributing the assets. The debtor has nothing to do with these negotiations.
Discharge
People file Chapter 7 bankruptcies fundamentally to obtain discharges of debts. A discharge takes place at the end of the Chapter 7 process, after all assets are liquidated and all debts that can be paid from the estate are paid (in order of priority and proportionately among debts of equal priority). Following the discharge, debtors are no longer liable for the debts that were discharged, and creditors cannot seek to collect them.[29]
Except for cases that are dismissed or converted to another form of bankruptcy, 99 percent of filed individual Chapter 7 cases lead to discharges.[30] In most of these cases, the discharge is awarded 60-90 days after the initial meeting of creditors.
However, there are debts that cannot be discharged in bankruptcy.[31] These include debts for alimony and child support, certain taxes, debts for certain educational benefit payments or loans made or guaranteed by the government, debts for willful and malicious injury by the debtor to another entity or to the property of another entity, debts for death or personal injury caused by the debtor’s drunk or drugged driving and debts from certain criminal restitution orders.
Reaffirmation
If a debtor agrees to pay a debt that would be discharged in bankruptcy despite the discharge, the debt is re-instituted and enforceable.[32] Reaffirmed debts may include real estate loans and car loans that the debtor reaffirms to avoid foreclosure or repossession. A debtor may even reaffirm a credit card debt to be able to keep the credit card. A written reaffirmation agreement must be filed with the court before the discharge to effectuate this agreement between the debtor and creditor.[33]
If the debtor defaults on a reaffirmation agreement, secured or unsecured, the creditor regains the legal rights to the debt. If the debtor defaults on an agreement to reaffirm a secured debt, the creditor regains rights in the property and can sue or seize that property as if the bankruptcy never happened. If the debt is unsecured, the creditor can take collection action.
Misbehavior
A bankruptcy court can deny a discharge if the debtor failed to keep or produce adequate books or financial records; failed to explain satisfactorily any loss of assets; committed a bankruptcy crime such as perjury; failed to obey a lawful order of the bankruptcy court; fraudulently transferred, concealed, or destroyed property that would have become property of the estate or failed to complete an approved instructional course concerning financial management.[34] In addition, a court can revoke a discharge after it is granted under circumstances such as fraud, failing an audit, and failure to follow a court order.[35]
Chapter 7 for Businesses
Filing a business Chapter 7 terminates the existence of a company. Because of this, corporate Chapter 7s are relatively rare; most corporate bankruptcies are filed as Chapter 11 reorganizations.
In a business Chapter 7, the trustee takes over the business, liquidates assets and pays creditors just like in an individual liquidation. The same rules apply. A business Chapter 7 is a process of full disclosure of company assets and debts, which gives creditors an “inside view” of the company so they can determine whether people involved with the company might be taking the assets. It also provides a recognizable process for paying creditors in accordance with the processes described earlier in this module.
Small companies can be incorporated, but may still only be owned by one or two people. In these cases, the individual owners may be liable for corporate debts. If a creditor thinks that the business or the bankruptcy is some kind a fraud or sham, the creditor can institute an adversarial proceeding to “pierce the corporate veil” and potentially go after individual assets of the owners. Businesses do not need or get discharges since they cease to exist at the end of the Chapter 7 proceeding.
In our next module, we’ll look at re-organization under Chapter 11 of the Bankruptcy Code, which is the primary way businesses in severe trouble take advantage of bankruptcy rules to keep afloat and re-organize.
[1] “Chapter 7 – Bankruptcy Basics,” United States Courts,http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics (last visited Aug. 31, 2018).
[2] Id.
[3] 11 U.S.C. §§ 101(41), 109(b).
[4] Carron Armstrong, “If I Filed Bankruptcy Before, How Soon Can I File Again?,” The Balance, (Sept. 28, 2017), https://www.thebalance.com/if-i-filed-bankruptcy-before-how-soon-can-i-file-again-316173.
[5] 11 U.S.C. §§ 109(g), 362(d) and (e).
[6] 11 U.S.C. §§ 109, 111.
[7] Bankruptcy Form 122A-2, “Chapter 7 Means Test Calculation.”
[8] Found on the website of the US Census Bureau: https://www.census.gov.
[9] Bankruptcy Form 122C-2, “Calculation of Your Disposable Income.”
[10]Bankruptcy Form 122A-1, “Chapter 7 Statement of Your Current Monthly Income.”
[11] “Chapter 7 – Bankruptcy Basics,” United States Courts, http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics (last visited Aug. 31, 2018).
[12] 11 U.S.C. § 541.
[13] 11 U.S.C. § 522(b). The list of exempt property is filed in “Schedule C”.
[14] Kathleen Michon, “Federal Bankruptcy Exemptions,” The Bankruptcy Site, https://www.thebankruptcysite.org/exemptions/federal.html (last visited Aug. 31, 2018). These states are: Alaska, Arkansas, Connecticut, Hawaii, Kentucky, Massachusetts, Michigan, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Texas, Vermont, Washington, Wisconsin.
[15] Id.
[16] Carron Armstrong, “Federal Bankruptcy Exemptions,” The Balance, (July 31, 2017), https://www.thebalance.com/federal-bankruptcy-exemptions-316163.
[17] Ala. Code §§6-10-2, 27-14-29.
[18] Ariz. Rev.Stat. § 33-1101A.
[19] “Homestead Exemptions by State and Territory,” Asset Protection Planners, https://www.assetprotectionplanners.com/planning/homestead-exemptions-by-state/ (last visited Aug. 31, 2018).
[20] 11 U.S.C. §§ 701, 704.
[21] “Chapter 7 – Bankruptcy Basics,” United States Courts, http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics (last visited Aug. 31, 2018).
[22] Id.
[23] 11 U.S.C. § 721.
[24] 11 U.S.C. § 726.
[25] 11 U.S.C. § 501.
[26] “Secured vs. Unsecured Debt in Chapter 7 Bankruptcy,” The Bankruptcy Site, https://www.thebankruptcysite.org/resources/bankruptcy/debt-relief/secured-vs-unsecured-debt-chapter-7-bankruptcy (Aug. 31, 2018).
[27] Under 11 U.S.C. § 507.
[28] Edward G. Lawson, “Unsecured Claims,” Law Offices of Edward G. Lawson, http://www.edlawsonlaw.com/unsecured-claims/ (last visited Aug. 31, 2018).
[29] “Chapter 7 – Bankruptcy Basics,” United States Courts,http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics (last visited Aug. 31, 2018).
[30] Id.
[31] 11 U.S.C. § 523(a).
[32] 11 U.S.C. § 524(c); 11 U.S.C. § 524(k) (disclosures).
[33] Cara O’Neill, “Reaffirming Secured Debt in Chapter 7 Bankruptcy,” NOLO, https://www.nolo.com/legal-encyclopedia/reaffirming-secured-debt-chapter-7-bankruptcy.html.
[34] 11 U.S.C. § 727; Fed. R. Bankr. P. 4005.
[35] 11 U.S.C. § 727(d).