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Chapter 7 Discharges Debts, Provides a "Fresh Start"

Filed under Asset Protection Strategies. Fact checked on May 24, 2012.

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When you hear the word "bankruptcy," it probably means a Chapter 7 proceeding. In a Chapter 7 bankruptcy, your assets (other than your exempt assets) are gathered together and sold. Any unsecured debt that isn't paid off from the sale proceeds is discharged, giving the debtor a debt-free fresh start.

Traditionally, Chapter 7 has been the most common type of bankruptcy proceeding. It is available to an individual, a partnership, or a corporation or other business entity. Chapter 7 is one of the three major options for relief under the bankruptcy code. It differs from Chapter 13 and Chapter 11 plans in that it is a liquidation bankruptcy, while the other two are reorganization bankruptcies.

In Chapter 7 bankrutpcy, your non-exempt, unsecured assets will be sold and converted to cash, with the proceeds going to pay the costs of administering the case and to pay off your creditors. Most debts that can not paid off from the liquidation of all of your assets are discharged--that is, eliminated.

In addition, the bankruptcy filing causes an automatic stay of any collection efforts by creditors. This is welcome relief for beleaguered debtors. However, debtors should be aware that creditors, especially those with secured claims who are not being paid, can request that the automatic stay be lifted if foreclosure or repossession is an inevitability.

Warning

There will be a trustee appointed whose job it is to round up your assets and dispose of them for the benefit of your creditors. Depending upon where you live, you may well end up losing some of your property. 

Make sure that you consult the exemption rules for your state to understand what you have at stake. Also, you should have the advice of an attorney who is experienced with business bankruptcy and not a "bankruptcy mill" that churns out individual Chapter 7s and Chapter 13s.

Exempt or Secured Assets Are Not Sold

Your exempt assets are excluded from the assets that must be sold. The amount that you can "exempt" from sale depends upon your state of residence and whether that state allows you to take advantage of the federal bankruptcy exemptions, rather than your state's exemptions.

Because consensual liens that are secured by specific property, such as mortgages or car loans, cannot be discharged, you must either continue to pay these debts or surrender the property to the creditor. Usually, these consensual liens will encumber enough of the value of the property, so that the remaining value will fit within an asset exemption.

Example

A home may have mortgages and home equity loans that cover 90 percent of its value, and the remaining 10 percent may be protected by the homestead exemption. Thus, a sale of the asset would generate no proceeds for the other creditors. Accordingly, in typical cases, these assets are not sold, and in fact are retained by the debtor, who continues to pay off the liens.

With the exempt assets and encumbered assets removed from the pool, there are usually no assets available to the unsecured creditors who, in many cases, will be banks holding credit card accounts. The end result will be that these unsecured creditors will receive nothing, and the debts they are owed will be discharged.

Public Policy Bars Discharge of Certain Debts

Although most unsecured debt can be discharged, the law forbids the discharge of certain debts for public policy reasons. These include:

  • alimony and child support
  • most student loans
  • most federal, state and local taxes
  • debts incurred through fraud or false statements within one year (and possibly as much as four years) before the bankruptcy action
  • fines and penalties for violating the law
  • debts for purchases of more than $500 in luxury goods or services (or loans of more than $750 on an open-end credit plan) from a single creditor within 60 days of filing for bankruptcy
  • debts not listed on the bankruptcy petition.

Timing Your Bankruptcy Filing Is Critically Important

While bankruptcy is generous in providing a fresh start, the rules are strict and must be followed precisely, or you can end up with mountains of debt and no way to escape. Among the timing issues to be considered in a Chapter 7 filing:

  • Tax debts. If you have any tax debts, the timing for filing the petition is absolutely critical! While many tax debts are not dischargeable in bankruptcy, some are depending upon when the taxes were assessed and the petition was filed. If you have any tax debts, cross-examine any potential bankruptcy attorney regarding which debts are dischargeable and how much time must elapse before the petition is filed. There are hundreds of cases where the debtor is stuck with otherwise dischargeable debts because the attorney filed the petition one or two days to soon.
  • After-acquired assets and income. Certain income and assets acquired after a Chapter 7 filing may be included in your bankruptcy estate if you do not plan properly.
  • Recent asset transfers. Any recent transfers of assets will be examined, and may be undone, so you should proceed carefully.

Do You Qualify for Chapter 7 Bankruptcy

Not every individual who is in debt is eligible to file a Chapter 7 bankruptcy. To prevent abuse of the system (and the creditors,) there is a means test. The means test is designed to force those debtors who (1) have primarily consumer debt and (2) have the ability to pay some of their debts to do so. These individuals are denied the "clean slate" of Chapter 7 liquidation and forced into a five-year repayment plan under Chapter 13.

The means test is based on your "current monthly income" as defined in the Bankruptcy Code. This is your average monthly income received over the six calendar months immediately before you filed your bankruptcy petition. If you are filing a "joint petition" with your spouse, his or her income is included as well. Also, included are any regular contributions to your household expenses from other sources except social security income or certain crime-victim payments.

You must file Form B 22A, Chapter 7 Statement of Current Monthly Income and Means-Test Calculation, when you file your bankruptcy petition. This will establish whether you are exempt from the means test and, if not, whether you met the test. 

The form walks you through the calculation of your current monthly income and allowable expenses, but these are the four required steps. 

Are your debts primarily "consumer debts?" If the answer is "no" because your business is the primary reason you are facing bankruptcy, then you do not have to worry about the means test. You would check Box 1B on your Form 22A. You can skip over the next questions.

However, if you are facing bankruptcy because of personal credit card expenses, medical expenses or non-business judgments against you, continue to the next question. 

Is your "current monthly income" lower than the your state's median family income? If your income is lower than the median for your state, you've passed the means test and can skip the next questions.  If your income is higher, then continue to the next question. 

What is your monthly disposable income? You determine your monthly disposable income by subtracting living expense amounts that have been established by the IRS. 

National standards are used for food, clothing, and health care, whereas local standards are used for housing, utility, and transportation expenses. These national and local standards apply, regardless of whether your own expenses are more or less than the standard amounts, although certain additional adjustments are permitted. 

Multiply the result by 60 to determine the amount of disposable income projected to be available over the next five years. (These amounts are adjusted every three years. The last adjustment was April 1, 2013.)

  • Is your disposable income less than $7,025? If so, there is no presumption of abuse of the bankruptcy system and the "means test" will not bar you from proceeding with your Chapter 7 liquidation. If not, continue to the next question.
  • Is your disposable income more than $11,725? If so, you are considered to have the means to make some level of payment to existing creditors--you have flunked the means test and are likely to be required to proceed with a Chapter 13 reorganization. 
  • Is your disposable income is at least $7,025 but not more then $11,725? It's not clear whether you have passed or failed the means test--continue to the next question.

Is your disposable income less than 25 percent of your unsecured debt? To determine this, total up the amounts that you owe that are not secured by property. For example, credit card debt is unsecured debt; but a car loan generally is not. Then, multiply this total by 0.25. If the result is more than your disposable income, then there is a presumption of abuse. If it is less, there is no presumption of abuse and you can proceed with a Chapter 7 liquidation.

There are ways to appeal the presumption of abuse, but, in general, if you fail the means test you may well be better off considering other options. In The means test does allow special accommodations for active-duty military personnel, low-income veterans and those with serious medical conditions. It also does not apply to corporate or partnership bankruptcies.

In addition to the means test, an individual seeking to file Chapter 7 must complete a credit counseling course, unless he or she is incapacitated, disabled, or on active duty in a military zone.

Bankruptcy Estate May Include After-acquired Income, Preferential Transfers 

Filing a Chapter 7 bankruptcy creates a "bankruptcy estate" that is administered by a bankruptcy trustee. This estate technically becomes the temporary legal owner of all your property, including all legal or equitable interests you have in property as of filing of the petition, including property owned or held by another person if you have an interest in the property. The primary role of a Chapter 7 trustee is to liquidate your nonexempt assets in a way that brings in the most money for your unsecured creditors.

Certain After-acquired Income Belongs to Bankruptcy Estate

The filing date of the bankruptcy petition is line of demarcation. Everything you owned as of that date is no longer yours: it belongs to the bankruptcy estate. And, most property acquired after that date is yours. Thus, wages and other sources of income, including self-employment income, earned and received after the Chapter 7 bankruptcy action begins generally are excluded from the proceeding.

Think Ahead

Given this fact, a debtor who works on a contract basis (e.g., a building contractor) could postpone forming any lucrative contracts until after the proceeding commences. Similarly, where only one spouse works, planned employment for the other spouse should begin only after the action is filed. In these situations, it is better to wait until after the action is completed (not just filed), if at all possible, to avoid any allegation of fraud.

After-acquired assets can become part of the bankruptcy estate. Although nearly all assets earned and received after the proceeding begins are excluded from the bankruptcy, there are a few exceptions. These are:

  • property received through inheritance
  • property received as a result of a pre-bankruptcy divorce or legal separation settlement
  • life insurance or other death benefits
  • tax refunds related to pre-bankruptcy filing tax years

These assets are brought back into the bankruptcy action if they are received during the proceeding or within six months of the final discharge. 

Thus, if an inheritance were anticipated, the debtor should obtain a legal opinion establishing the inheritance, and then consider filing the action immediately so that the inheritance would be received after the six-month period. Similar timing issues revolve around divorce. There is generally little you can do about the timing of life insurance payments or death benefits.

Trustee Can Avoid Preferential Transfers

Once the petition is filed and the bankruptcy estate is created, the bankruptcy trustee will begin to "marshall" the estate's assets. The trustee has the power to undo ("avoid") a transfer of money or property that occurred before the bankruptcy was filed if these transfers are considered "preferential" transfers. These "preferential transfers" will be brought back into a Chapter 7 bankruptcy action and included in the assets available for liquidation.

Although the trustee's powers are far-reaching, they are not unlimited. In order to "avoid" the transfer, all the following conditions must be met.

  1. There must have been a transfer.
  2. The transfer must have been for the benefit of the creditor.
  3. The transfer must have been made to satisfy a pre-existing debt.
  4. The debtor must have been insolvent at the time of the transfer.
  5. The transfer must have taken place within 90 days prior to the bankruptcy filing (or within one year if the creditor is an "insider" under bankruptcy law.)
  6. The creditor received more as a result of the transfer than would have been received under the bankruptcy distribution of assets.
Example

As a business owner, it is possible that you could be on the receiving end of the transfer, rather than in the role of the bankruptcy debtor. If you receive payment for goods and services from a company that files for bankruptcy the next week, then you may have the U.S. Trustee knocking on your door to recover the payment you received. "Intent to defraud" is not necessary for a transfer to be "preferential." It doesn't matter if you acted in good faith or not.

If you find yourself in this position, there are actions you can take to prevent the trustee from nullifying the transfer and requiring you to stand in line with all the other creditors. 

Look to see if all the requirements for a preferential transfer are met. If they are (which is likely,) then, you may be able to assert one or more of the following defenses: "course of business," "new value," "contemporaneous exchange," and "purchase money security interest."

The rules for claiming these defenses can be complex, so it is advisable to consult an attorney who is experienced in business law--ideally in creditor's rights law.

When possible, then, transfers to insiders should be planned and carried out more than a year before the action is filed. In theory, however, bankruptcy courts can go back in time (in some cases as much as four years) and undo transfers proved to be fraudulent.

Warning

However tempting it may seem to transfer your assets to avoid having them distributed in bankruptcy, it can be a very costly strategy. 

If the transfer is found to be "fraudulent," then you may expose yourself to a number of painful consequences, ranging from denial of a bankruptcy discharge to jail time in extreme cases. 

Of course, not all transfers are fraudulent, but if you are contemplating asset transfers and are tettering on the edge of insolvency, work with an attorney to ensure the best course of action.

Discharging Personal Liability in Chapter 7

In a Chapter 7 filing, the debtor's personal liability for dischargeable debts is erased. However, liens that are not subject to elimination (i.e., most consensual and statutory liens) survive the discharge. This is why a homeowner must continue to pay the mortgages on his home, or face foreclosure, even after a Chapter 7 action is completed.

The distinction between dischargeable debt and the surviving lien on property can be important when the debtor surrenders the property, and the amount of the liens exceeds the value of the property.

Example

John Smith owns a home with a value of $100,000 that is subject to mortgage liens totaling $150,000. Because these liens cannot be eliminated, or (generally) even bifurcated, if Smith intends to keep his home, he will have to pay the $150,000 in mortgages.

Once his Chapter 7 discharge is final, Smith will have no personal liability for the mortgages. The liens will, nevertheless, still attach to the home. Thus, if Smith wants to retain the home, he will still have to pay the mortgages. If he has defaulted on the mortgages, and he wants to reinstate them by paying the arrearage over time, he may have to file in Chapter 13.

Alternatively, Smith can surrender the home. If he does so, he will not be liable for the $50,000 mortgage deficiency, as he has no personal liability for the mortgages after the discharge.

Some states provide a somewhat similar provision. In some states, a debtor has no personal liability for a deficiency judgment that results from a foreclosure of a purchase-money mortgage. 

Note that this state provision is very narrow in scope because:

  1. It only applies in some states.
  2. It only applies on purchase-money (first) mortgages. It usually does not apply to second mortgages, or refinancings, which are far more likely to cause a deficiency.
  3. For the provision to apply, the debtor must lose his or her home in foreclosure.

Nevertheless, debtors who face the loss of their home through foreclosure of a first mortgage should be aware that, in some states, it may be possible to eliminate any deficiency judgment, without resorting to bankruptcy. Debtors in this situation should consult an attorney on the best way to proceed in the particular state in question.

What Are the After-Effects of Bankruptcy

When concluded, a bankruptcy filing remains on the debtor's credit report for 10 years. However, the damage to the debtor's credit rating may be mitigated by other factors.

For example, most debtors are unaware that FHA, the federal agency that insures millions of mortgages, has one of the most liberal polices concerning bankruptcy and me mortgages. Generally, the FHA only precludes debtors from obtaining a new FHA mortgage for two years from the discharge date of a Chapter 7 bankruptcy, provided the debtor has an otherwise acceptable credit standing during the two-year period. Because a home is typically the largest purchase individuals make, debtors should realize that financing for a new home may still be available shortly after the bankruptcy action is completed.

It is important to list all debts in a bankruptcy filing, as debts not listed cannot be discharged. However, some debtors retain a credit card with a very low (or no) balance, but a large credit line, by purposely omitting the debt from the filing, to ensure they will have future credit available. On the other hand, many banks periodically check customer's credit reports. If this is done, the card will likely be canceled anyway. Such an action could also jeopardize the bankruptcy discharge, for it smacks of fraud.

Any recent shuffling of debt from the card retained to the listed cards is likely to be attacked as fraudulent. This is especially true if it happened in the year leading to the bankruptcy. However, if planned well in advance, and before any financial difficulties arise, an extra card held in reserve will be effective. This card can be used only infrequently, and then only for small purchases, to keep it active. (See our discussion of timing and related issues involving transfers.)

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