A Primer on Individual Bankruptcy
This blog was guest written by Kenneth J. DeGraw, CPA, CFP®, CrFA®, Partner, WithumSmith+Brown, PC. Ken is the person I turn to when a client has questions about bankruptcy.
Filing under Chapter 7 of the federal Bankruptcy Code is the most common, personal bankruptcy. In a Chapter 7, the individual will generally walk away with no pre-filing liabilities (with some exceptions) but also no assets (with some exceptions). Note that, Chapter 7 does not specifically discharge secured liabilities, such as an auto loan or home mortgage, as the creditor can generally look to their collateral. In circumstances where the value of the collateral is less than the secured obligation, there may be an opportunity to address the shortfall in the Chapter 7 process.
The Chapter 7 process requires a liquidation of the debtor’s assets under the supervision of a court-appointed trustee, and the distribution of the proceeds to creditors based on a statutory priority. In order to file under Chapter 7, the individual debtor must pass a means test, which is designed to prevent high income earners from taking advantage of Chapter 7. The means test evaluates income and expenses and the amount, if any, of the excess income. If there is sufficient excess income only a Chapter 13 can be filed (see next paragraph). Upon filing of the bankruptcy petition, by operation of law, there is an immediate stop to most collection actions and lawsuits. At the end of the process, the individual debtor receives a discharge and is able to attain a fresh start.
Since not all debt can be discharged, a careful examination of debtor obligations is critical.
A Chapter 13 petition is filed in instances where the debtor is unable to qualify for a Chapter 7, such as failing the means test or where they want to freeze a foreclosure proceeding with a secured creditor while retaining the asset, protect co-debtors on consumer obligations from collection actions while the plan is in place, get the ability to discharge obligations that cannot be discharged under Chapter 7 or where they have a regular source of income and wish to remain in control of their assets. Under Chapter 13 the debtor enters into a plan to make creditor payments usually over a five-year period. Using Chapter 13 is subject to limitations on the amount of the secured and unsecured debt.
Individuals can occasionally file under Chapter 11, but it is not usual and not covered here.
Assets that can be retained are qualified pension assets and IRAs, a residence or homestead, and certain personal property. The exemption amounts vary by state. In addition, there is a Federal set of exemptions. The election as to which exemption (Federal or State) you will choose is made when you file. To determine what can be retained especially where there are pensions or IRAs you best should consult with an attorney familiar with the bankruptcy laws.
Debts that cannot be discharged are secured debts, college loans, child support payments and certain taxes and penalties. These, too, must be discussed with an attorney before filing.
Tax issues always ensue when debt is cancelled. In general, cancellation of debt under a bankruptcy proceeding does not result in taxable income, as it might if the same debts were cancelled without the bankruptcy filing. For people with business assets it can become more complicated.
Taxes that are not more than three years old and are penalties, regardless of when assessed, cannot be discharged.
Assets transferred by a debtor prior to filing a petition or because of the intended filing might have to be repaid to the appointed trustee for distribution to creditors. The time limits vary based on circumstances.
The above is a brief primer of the issues involved with an individual filing for bankruptcy. Two helpful websites with a wealth of information are www.abiworld.org and www.njb.uscourts.gov. People considering a bankruptcy should consult with an attorney to determine how it will affect them and the ramifications of such filing.
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