The terms "insolvent" and "bankrupt" are used informally to mean an uncomfortable lack of assets and monetary resources. In legal terms, however, these words mean something more specific than simply being broke. Insolvency -- a tax code term -- relates to the ability to qualify for certain income tax benefits, and bankruptcy -- a legal process -- resolves debts with the court's oversight.
There are two different types of insolvency related to business: cash flow and balance sheet. When a business experiences cash flow insolvency, it does not have the monetary assets to pay its bills or debts as they become due. Balance sheet insolvency means that a business's total debts outweigh its total assets. A business may be cash flow insolvent but still has significant non-cash assets such as real estate, equipment and inventory. As such, a business with long-term debt, like a mortgage, may be balance-sheet insolvent, but still capable of paying its monthly bills from cash-flow revenues. It is not unusual for businesses to operate successfully for an extended period of time in a state of balance sheet insolvency.
A person is insolvent when his total debts exceed the value of his total assets, but some insolvent individuals may be able to meet their monthly financial obligations even though their mortgage, student loans, credit card or medical debt exceed the value of their assets. However, individual insolvency usually means that a person cannot pay his bills on time. Under federal tax rules, canceled debts are considered taxable income, unless the taxpayer can demonstrate insolvency. Debt may be canceled by negotiation or asset repossession, and by virtue of a mortgage revaluation program. A taxpayer who can demonstrate insolvency by using the Internal Revenue Service insolvency worksheet may be able to exclude cancelled debt from his taxable income.
The term bankrupt is used colloquially to refer to the state of being in a bankruptcy proceeding, but as a legal term, bankrupt refers to the person who is the subject of a bankruptcy court action filed under the United States Bankruptcy Code. The bankruptcy court may extinguish some or all of the bankrupt's debts, or may restructure those debts, depending on the type of bankruptcy action filed and the bankrupt's assets and obligations.
Differences and Considerations
To receive the protection of the bankruptcy court in resolving debts, the person or business filing for bankruptcy must demonstrate insolvency. However, merely being insolvent does not make a person bankrupt. Some insolvent individuals and businesses avoid filing for bankruptcy by finding ways to pay their bills such as selling assets, taking on additional employment or renegotiating debt. Filing for bankruptcy brings negative consequences including lowering the bankrupt's credit score. Investors are warned away from investing in businesses involved in bankruptcy proceedings.
- Internal Revenue Service: Publication 4681 Cancelled Debts
- Duhaime: Bankrupt Definition
- Oregon Laws: Definition Bankruptcy
- Debt.org: Insolvency
- Tax Girl: IRS Releases New Insolvency Pub
- MyFICO.com: How Does Bankruptcy Effect FICO Score?
- U.S. Securities and Exchange Commission: Investing in a Bankrupt Company -- A High Risk Venture