Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, firstname.lastname@example.org
Filing for bankruptcy has been called “the last resort” when it comes to available strategies to handle a debt crisis. It is what people generally do when everything else (e.g., negotiation with creditors, credit counseling, loan refinancing, and voluntary surrender) will not work and/or the amount owed is so large (e.g., debt from uninsured medical bills) that it can’t possibly be repaid within a reasonable amount of time.
Bankruptcy is a constitutionally guaranteed right. It allows individuals and businesses to petition a federal court to officially proclaim that they are unable to pay their debts. A fundamental goal of the bankruptcy process is to provide debtors with a “fresh start” by providing relief from burdensome outstanding financial obligations. Filing for bankruptcy offers some “breathing room” for those facing hostile contact from creditors, foreclosure, repossession, etc. who need time to work out a reasonable repayment schedule.
While well over a million Americans per year have filed for bankruptcy for almost two decades, it is not a decision to make lightly. The after-effects will be felt for many years. First, bankruptcy can be a source of emotional distress. Then there are the legal expenses associated with a filing. Lawyers expect payment “up front” so they don’t get added to a client’s list of unsecured creditors. In addition, a bankruptcy filing is considered an extremely negative item in someone’s credit report and will remain there for 10 years, thus lowering their credit score. As a result, bankruptcy filers may find it difficult to obtain credit in the future or they are charged high “subprime” interest rates. In addition, notation of bankruptcy in someone’s credit file can affect decisions, not just about creditworthiness, but also employment, housing, and auto insurance.
Bankruptcy filers typically retain a lawyer to handle all the procedural details of their bankruptcy filing. Bankruptcies are filed in federal bankruptcy courts that are located within each of 90 judicial districts that are spread out across the U.S. Individual cases are administered by trustees, who are generally attorneys appointed by the bankruptcy court to manage the bankruptcy filing process. Debtors usually meet their trustee, at the trustee’s office, at a “meeting of creditors,” which is also known as a “341 meeting.” This title comes from a section of the Bankruptcy Code. The 341 meeting provides an opportunity for creditors, should they choose to attend, to question debtors about their outstanding debts and available assets.
There are two types of bankruptcy that are generally filed by individuals: Chapter 7, also known as “liquidation,” and Chapter 13, which is a court-ordered debt repayment plan. Chapter 7 is the process of converting a debtor’s non-exempt assets to cash and distributing the proceeds, if any, to creditors. Asset exemptions vary from state to state. In so-called “no asset cases,” there is little or no non-exempt property to distribute. If there are assets of value, they will be distributed among creditors who have filed a claim with the bankruptcy court. Debtors typically receive a discharge within a few months after their bankruptcy petition is filed. The discharge releases them from liability for dischargeable debts. Some debts are never discharged by the court, however, including federal and state income taxes, fines, alimony, and child support.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (PL 109-8 or BAPCPA) was signed into law in April, 2005. BAPCPA contained several significant changes, including a means test to determine eligibility to file for bankruptcy under Chapter 7. The means test is based on a bankruptcy filer’s current monthly income, family size, and the median income for their state of residence. Under the means test, those who earn less than the median income for a family of their size in their state will still be able to file under Chapter 7. Those who earn more and can afford to pay back at least $100 a month, after subtracting allowable expenses as determined by the IRS, will generally have to file under Chapter 13 and submit to a restrictive five-year repayment plan.
Every consumer bankruptcy case filed must first have a means test analysis performed, which has increased attorney’s fees for bankruptcy case work in recent years. Like a tax return, the means test requires a lawyer to work through the calculation step by step to determine if the Chapter 7 limitation applies. Despite all the required paperwork, the means test actually affects a small percentage of filers.
Unlike Chapter 7, Chapter 13 bankruptcies allow debtors to keep valuable assets such as equity in a home or car. They are a court approved plan to repay outstanding debt with future income, typically over a period of 3 to 5 years. Debtors, through their attorney, will propose a debt repayment plan, which is revised, if necessary, and eventually approved by the court. Then the hard part begins: living on a stringent budget for years until a discharge is received. During the time that a Chapter 13 bankruptcy is in effect, debtors are protected from creditor actions such as lawsuits and wage garnishment.
A similar type of debt repayment plan for individuals and households, called Chapter 12, is also available to family farmers and fishermen with regular income. These debtors continue to operate their businesses while debt repayment is made. Chapter 12 debt repayment plans disburse payments to creditors over time, but they are especially suited to the needs of agricultural producers due to their higher debt ceiling compared to Chapter 13. Farmers may also elect to file bankruptcy under other chapters of the Bankruptcy Code but are subject to all of the regulations pursuant to them (e.g., the credit counseling and financial education requirements for Chapters 7 and 13 described below).
The BAPCPA law requires that, as a condition to file either Chapter 7 or Chapter 13 bankruptcy, a debtor must have consumer credit counseling to explore alternative options, within 180 days prior to filing a petition. The counseling session must be with a qualified, non-profit agency approved by the U.S. Trustees office. A list of approved providers for credit counseling can be found at the Department of Justice Web site: http://www.usdoj.gov/ust/eo/bapcpa/ccde/cc_approved.htm. The BAPCPA law also contains a provision requiring filers to be current on post-petition domestic support obligations as a condition of plan confirmation.
Additionally, after filing for bankruptcy, debtors must complete an approved two-hour personal financial management course in order to obtain a discharge from a Chapter 7 or Chapter 13 bankruptcy. The course must cover basic financial topics such as budget development, money management, and the wise use of credit. Both the credit counseling and financial education services require filers to pay a fee set by the provider. A list of approved providers for the financial management course can be found at the Department of Justice Web site: http://www.usdoj.gov/ust/eo/bapcpa/ccde/de_approved.htm.
An important aspect of bankruptcy law is its effect on a filer’s assets. The BAPCPA law substantially increased protection of retirement plan assets from the claims of creditors for all filers. This includes employer-sponsored retirement plans and IRAs (Individual Retirement Accounts). These assets receive creditor protection in bankruptcy. Retirement accounts for employees and self-employed workers receive unlimited creditor protection while traditional and Roth IRAs are subject to a $1 million limit, excluding amounts attributable to rollovers from qualified retirement plans. Since IRA contribution rates have been low for decades and few people have accumulated anything near $1 million, the cap is virtually a non-issue. Good records are necessary, however, to document assets eligible for protection, especially if IRA accounts contain rollovers from employer retirement plans. It is absolutely essential to have a clear paper trail.
Bankruptcy experts recommend carefully time the filing of a bankruptcy petition. It is best to wait until the worst of a financial crisis is over. For example, after someone has returned to work after a period of unemployment or an injury or illness or someone who has started a consulting business, thereby earning additional income. The worst time to file is when a financial crisis is raging. First, it will be difficult to afford an attorney at that time and, second, additional debts are likely to be incurred until the situation stabilizes. Someone would then be unable to discharge those new debts for another eight years from the date that the previous bankruptcy was filed. This period was extended from six years under the BAPCPA law.