Bankruptcy is a legal proceeding involving one or more debtors and their creditors. When an individual or business cannot pay their obligations, the debtor can file a petition in a federal bankruptcy court to get relief from certain debts, while providing creditors with partial repayments.
There are a number of different types of bankruptcy, each appropriate for particular situations.
The rules and procedures for a bankruptcy case are set out in the United States Bankruptcy Code and the Federal Rules of Procedure. The laws and rules are quite complex, and filing a petition in bankruptcy can be complicated. Because of this, it is a good idea for anyone considering filing for bankruptcy to bring in an attorney to advise them.
What Is Bankruptcy?
Most people understand that bankruptcy is a proceeding that assists a debtor who is overwhelmed by their debts or unable to meet their current debt repayment schedule. But getting a more complete overview of a bankruptcy case and reading up on bankruptcy basics are critical steps for anyone considering filing.
All bankruptcy cases must be filed in federal court, and the rules and procedures that must be followed are set out in the federal codes. State courts never hear bankruptcy cases, but state laws can impact some aspects of a bankruptcy filing, notably providing lists of exempt property.
The Federal Bankruptcy Code
The Bankruptcy Code sets out a number of different types of bankruptcy, each referenced by the chapter number in the Code where it is described. Simply, Chapter 7 bankruptcy is described in Chapter 7 of the Bankruptcy Code, while Chapter 13 bankruptcy is described in Chapter 13.
These are the two most common types of bankruptcy and they are very different.
In Chapter 7, a debtor's assets are sold, and a bankruptcy trustee uses the proceeds to partially pay creditors, while a Chapter 13 bankruptcy involves reorganizing the entire debt and paying it off over time.
What Are the Types of Bankruptcy?
The three most common types of bankruptcy are Chapter 7 (far and away the most popular and the easiest), Chapter 11 and Chapter 13.
Less common are Chapter 9, Chapter 12 and Chapter 15 bankruptcies.
But each of these is appropriate in specific circumstances described in the relevant chapters.
Chapter 7 Bankruptcy
When most people think of bankruptcy, they think of the procedure set out in Chapter 7 of the Bankruptcy Code. This is also known as "straight" or "foreclosure" bankruptcy. To be eligible to file Chapter 7, a debtor must meet a "means" income test and not exceed the maximum debt level limit.
In a Chapter 7 bankruptcy, the debtor is allowed to keep certain "exempt" assets. These are the types of property the law deems essential for a debtor to regain a place as a working member of society, like the homestead exemption for a primary residence. All other assets are sold by a bankruptcy trustee to pay creditors. Proceeds are divided equitably among the creditors by a bankruptcy trustee.
All of the debtor's unsecured debt, such as credit card or medical bills, that is not paid off in bankruptcy is forgiven or "discharged." Some types of debt cannot generally be discharged in bankruptcy. This includes federal student loans, back child support or alimony payments, tax bills, and personal injury judgments arising from damages from driving under the influence of alcohol.
Chapter 11 Bankruptcy
Chapter 11 is "reorganization" bankruptcy available to individuals or businesses. Although there is no debt-level limit and no required income level, Chapter 11 is the most complex and expensive form of bankruptcy and it is rarely used by individuals.
Filing Chapter 11 bankruptcy allows a business to remain open and operating while revamping its financial obligations. The debtor submits a reorganization plan, which can include downsizing and expense reduction plans, as well as some debt forgiveness. Creditors consider the plan and vote on it.
Chapter 13 Bankruptcy
A bankruptcy under Chapter 13 of the Bankruptcy Code is also a reorganization bankruptcy, but is available only to individuals, not businesses. There are debt limits – the individual must not have secured and unsecured debt of over $2,750,000 – and must have regular income.
Like with Chapter 11, the debtor presents a reorganization plan for restructuring debt, and some debt forgiveness is also possible.
The plan will provide regular (usually monthly or biweekly) payments to the bankruptcy trustee who distributes them to creditors according to the reorganization plan specifics, sometimes providing less than full payment.
Chapter 9 Bankruptcy
One of the less commonly used types of bankruptcy, Chapter 9 is available only to municipalities, like townships, cities, villages, counties or school districts that have financial issues. It is another type of reorganization bankruptcy that does not require the sale of assets.
Instead, the parties work out a plan to resolve the debt over time. Filing also protects the municipality from collection actions with an automatic stay.
Chapter 12 Bankruptcy
This is another of the "specialty" bankruptcies that individuals and most businesses cannot use. Chapter 12 bankruptcy is specifically for farms and fisheries.
Individually owned farms and fisheries or those owned by corporations can file for Chapter 12, a reorganization bankruptcy. Working with a bankruptcy trustee, the debtor can put together a feasible payment plan for their debts over three to five years.
Chapter 15 Bankruptcy
Chapter 15 bankruptcy is actually a set of rules and procedures that allow a U.S. Bankruptcy Court to cooperate with a foreign bankruptcy court when insolvent debtors, their assets or their creditors are located in both the United States and in another country.
It is based on the model law enacted by many countries. Essentially Chapter 15 permits a representative in a bankruptcy case that is filed in another country to directly access the U.S. Bankruptcy Court.
Who Qualifies for Bankruptcy Filing?
Eligibility for filing bankruptcy is different under different chapters of the code. Chapter 7 has the most filings annually and is, by far, the most common kind of bankruptcy for individuals.
To file under foreclosure bankruptcy, an individual must meet certain income guidelines to establish that they truly cannot meet their debts. They must also take a credit counseling course. There are similar requirements for individuals filing under Chapter 13.
Means Test for Bankruptcy Proceedings
The Bankruptcy Code provides a means test for individual debtors filing for Chapter 7 bankruptcy, found in Bankruptcy Form 122A; those for Chapter 13 are found in Form 122C. The test compares the debtor's income to the mean income in the state.
It requires individuals who want to file bankruptcy to demonstrate that they do not have the means to repay their debts. The requirement is intended to curtail abuse of the Bankruptcy Code. The means test factors in income, assets, expenses and unsecured debt information.
Credit Counseling Requirement
There is also a requirement that any individual filer must, before filing, take and complete a credit counseling course that has been pre-approved by the bankruptcy court. After filing, they must take a debtor education course.
Level of Debt Requirement
The only eligibility requirement for an individual filing for Chapter 13 bankruptcy involves the level of their debt. All individuals, including those who are self-employed or operating unincorporated businesses, are eligible for Chapter 13 relief if they don't owe more than $2,750,000 in both secured and unsecured debt.
How Do You File for Bankruptcy?
The procedure for filing for bankruptcy differs depending on the type of bankruptcy case. but all require some of the same, general steps, including:
Determine the appropriate type of bankruptcy
As described above, there are six distinct types of bankruptcy, including several types available to individuals. It is critical to understand the differences and to select the one appropriate for the situation.
Collect relevant documents
Anyone filing for bankruptcy will need income and asset lists, as well as lists of debts and creditors, including their contact information. Using those documents, determine eligibility for Chapter 7 or Chapter 13, including the means test.
Discuss the matter with a bankruptcy attorney
Most individuals and businesses that file for bankruptcy should consider bringing in an experienced bankruptcy attorney to assist them. The Bankruptcy Code is complex, and the court holds those filing without an attorney to the same standards as attorneys in terms of knowing and following the rules and procedures.
For Chapter 7 filings, talk to the attorney about exempt property laws in the relevant state and learn what debts cannot be discharged.
Gather the requisite forms
Bankruptcy forms are available free of charge from the court's website or from a bankruptcy attorney. Those without an attorney can download and print their forms from the internet.
Complete credit counseling
Attending credit counseling is a prerequisite to filing a petition in bankruptcy for an individual. Be sure that the credit counseling is approved by the Bankruptcy Court before signing up. The course will provide a completion form to be submitted to the court when filing.
Submit the bankruptcy petition
All types of bankruptcy cases start with a petition. Fill it out and submit it together with other requisite forms and the appropriate fees.
What Happens After You File for Bankruptcy?
The minute a bankruptcy petition is approved for filing, an automatic stay is imposed. This prevents creditor collection action from occurring, including wage garnishment and foreclosures, although it cannot eliminate those actions already in place.
For example, if a debtor files for bankruptcy the day before the bank forecloses on their home, the stay prevents a sale in foreclosure. If the filing occurs the day after foreclosure, the stay has no effect.
Subsequent Bankruptcy Process Steps
Subsequent steps depend on the type of bankruptcy filed. In a Chapter 7 filing, the case is assigned to a bankruptcy trustee who gathers and sells nonexempt assets and distributes the proceeds to creditors.
Ultimately, the court will discharge any remaining debts, with certain exceptions. That is, some types of debts cannot be discharged in bankruptcy, including most federal student loans, federal taxes and family support payments.
In a Chapter 13 filing, the debtor must propose a repayment plan and work with creditors to get it accepted. Debts are discharged when the debtor completes the repayment plan.
Advantages of Declaring Bankruptcy
Like every other aspect of life, filing for bankruptcy has some advantages and some disadvantages. It is important to discuss these with an attorney and carefully weigh the options before filing.
Generally, advantages of bankruptcy include:
- Fresh start. Bankruptcy gives an overwhelmed debtor a fresh start, turning the page on the financial difficulties and allowing a debtor to emerge from default.
- Relief. Bankruptcy immediately provides relief from harassing calls, letters and other actions by creditors. The automatic stay puts the brake on all collection activity.
- Communication. After a debtor's petition is accepted, the court-appointed bankruptcy trustee – a neutral third party – takes over communications between the debtor and their creditors. This U.S. trustee works to find the best solution for all parties, both debtor and creditor.
- Unsecured debts. Bankruptcy can clear unsecured debts like credit card balances and medical bills even if there are not sufficient assets to cover these bills.
- Assets. Depending on the relevant state exemption laws, a debtor may be able to retain protected assets in a Chapter 7 filing, assets that will not be sold to pay creditors. In a Chapter 13 bankruptcy, generally assets are not sold, and the debtor keeps everything while they adhere to the agreed-upon repayment schedule. This could prevent a foreclosure action or a vehicle repossession action.
- Lien. A bankruptcy case enables a debtor to avoid the consequences of a legal judgment or lien against them.
Disadvantages of Declaring Bankruptcy
There are some downsides to filing bankruptcy, as well.
The most common disadvantages of bankruptcy include:
- Secured assets. In a Chapter 7 bankruptcy, all secured assets are seized and sold to pay protected creditors, including a mortgaged residence and a liened vehicle. In a Chapter 7 bankruptcy, all other nonexempt assets are sold to pay other creditors.
- Co-signors. If there are family or friend co-signors on debts reported in bankruptcy, they may be legally mandated to pay those debts.
- Credit. Filing for bankruptcy has a very negative effect on the debtor's credit score. Bankruptcy stays on a credit score for up to 10 years. Bankruptcy on a credit report can prevent the debtor from getting credit and will certainly increase the cost of credit.
- Public information. Bankruptcies are public information, so a bankruptcy on a credit record can prevent an individual from getting a new job.
- Owed debts. Certain debts are not eligible for discharge. This means that the debtor will emerge from bankruptcy with those debts still due and owing. These include most federal student loans, past-due family support payments, and most taxes owed.
- Price. Filing for bankruptcy is not free. Those debtors who do not qualify for legal aid will pay several thousand dollars to file. Attorneys are also expensive.
Consequences of Bankruptcy
Although bankruptcy can give a debtor a new start, the negative consequences cannot be ignored. Anyone considering bankruptcy will do well to consider them and discuss them with an attorney.
The first and most obvious negative consequence of bankruptcy is the fact that a debtor will emerge from bankruptcy with less property than they owed when they filed the petition.
It is entirely possible that a creditor will have to sell real estate, vehicles, family heirlooms, jewelry, art collections, and anything else of value that isn't exempt, termed nonexempt property. Any debt that involves a co-signor will also impact that co-signor, who may be a parent, sibling or friend.
Impact on Credit Score
Another well-known consequence of bankruptcy is the impact it will have on the debtor's credit score.
For obvious reasons, bankruptcies tend to make the debtor less reliable in the eyes of a potential lender, and a bank or financial institution will likely charge more for credit to someone coming out of bankruptcy, if they will lend them money at all. And the negative impact from the bankruptcy can remain on the credit report for up to a decade.
How to Find a Bankruptcy Lawyer
Anyone filing for bankruptcy should consider hiring an experienced attorney to assist them. The bankruptcy court recommends this.
An attorney can assist a debtor in many ways:
- Advise a debtor on whether to file a bankruptcy petition.
- Advise a debtor under which chapter to file.
- Advise a debtor on whether debts can be discharged.
- Advise a debtor on whether or not they will be able to keep a home, car or other property after filing.
- Advise a debtor of the tax consequences of filing.
- Advise a debtor on whether to continue to pay creditors.
- Explain bankruptcy law and procedures.
- Help a debtor complete and file the proper forms.
- Assist a debtor with most aspects of a bankruptcy case.
Knowledge of Laws is Required
Although the bankruptcy courts permit individuals to appear on their own, the court makes a point to advise them that it will hold them to the same standard as an attorney in terms of required familiarity with the federal Bankruptcy Code, the Federal Rules of Procedure and all local rules.
That means that a debtor must understand all relevant laws and follow all mandatory procedures or risk financial sanction or even dismissal of their petition.
Anyone seeking an attorney can contact their local or state bar association. While the rules of bar associations vary by state, most, if not all, are happy to provide lists of experienced attorneys to those seeking counsel. Someone who cannot afford an attorney can contact local Legal Services.
There are several alternatives to bankruptcy for those with debts they cannot manage. It is worth considering these options before filing a bankruptcy petition. Although these solutions may also negatively impact a credit report, they will be less impactful than a bankruptcy case.
Some debtors find relief by negotiating with their creditors to set up a repayment plan they can maintain. If this seems difficult, consider getting help from a credit counselor who will communicate with creditors on the debtor's behalf.
Creditors know that they are not likely to get 100 percent of their money back if the debtor files for bankruptcy and so they may work with the debtor to prevent that rather than risk receiving little or nothing.
Payment Restructuring or Debt Consolidation
Consider proposing lower payments or paying over a longer period of time. This can be accomplished through loan modification, permanently altering the terms of the original loan.
Alternatively, some debtors are able to negotiate debt settlements where the creditor agrees to accept a reduced payment as full payment. This may also have negative credit repercussions, however.
Some debtors have the resources to take out a debt consolidation loan. This allows the debtor to pay off their high-interest debts into one larger, lower-interest loan. Of course, the debtor will have to keep current on these payments to avoid future insolvency proceedings.
Forms and Resources for Filing Bankruptcy
It's a good idea to learn as much as possible about bankruptcy laws and procedures before filing. Fortunately, all of the forms are available online from the United States Courts website, as are many resources. For example, it is possible to access online the United States Bankruptcy Code (Title 11, United States Code) as well as the Federal Rules of Bankruptcy Procedure.
What about local rules of practice and procedure adopted by each bankruptcy court? These are available on each local court's website.
For those who prefer not to research online, these materials can also be found in their local law library. The local rules of practice and procedure adopted by each bankruptcy court are also available in person at the local bankruptcy court clerk’s office.
What is the difference between bankruptcy and liquidation?
Comparing bankruptcy and liquidation is not like comparing apples and oranges. Liquidation happens when a debtor's assets are sold to pay creditors. This can be an element of a bankruptcy case, but it isn't always.
Bankruptcy is the legal process of resolving financial issues between a debtor and their creditors. When an individual or business cannot pay their obligations, the debtor can file a petition in a federal bankruptcy court to get relief from some debts, while providing creditors some repayment.
There are a number of different kinds of bankruptcy, each one slightly different than the others. In a Chapter 7 bankruptcy, also called foreclosure bankruptcy, all of the debtor's assets that are not exempt are sold to pay creditors. This is liquidation. In a Chapter 13 bankruptcy, however, the debtor's assets are not liquidated. Rather, the debtor and creditors work out a repayment plan
When did the bankruptcy law change?
Bankruptcy law today is seen as a way to assist an individual or business to clear their debts and make a new financial start while obtaining partial repayment for creditors. But it wasn't always that way.
In colonial days, bankruptcy was seen as a criminal offense, as was the case in English common law. Insolvent debtors who were unable to pay their debts had their property seized and turned over to their creditors, and were imprisoned.
This continued into the 1800s. The first congressional bill on insolvency, the Bankruptcy Act of 1800, incorporated the English common law. It only provided for involuntary proceedings and only for merchants, and it was repealed after only three years.
The Bankruptcy Act of 1938 made the bankruptcy option more attractive to debtors and permitted them to access the system voluntarily. Since then, the law has been amended many times to create the current U.S. Bankruptcy Code.
2005 bankruptcy Law Overhaul
A recent overhaul of the bankruptcy laws occurred in 2005, when Congress imposed new restrictions on those filing for Chapter 7 bankruptcy. They enacted the means test to prevent high-income filers from getting out of paying all their debts by sending them into Chapter 13 instead.
That law also imposed the pre-filing credit counseling requirement for all individual bankruptcy filers.
What is the purpose of bankruptcy?
Bankruptcy provides an organized, court-supervised resolution of an insolvency situation. The purpose of this legal proceeding is two-fold: It allows a debtor to get out from under unmanageable debt and to try to provide creditors with full or partial repayments.
Because insolvency doesn't look the same in every situation, the Bankruptcy Code offers a variety of bankruptcy types, including "foreclosure" bankruptcy in Chapter 7, and "reorganization" bankruptcy in Chapters 11 and 13.
Other situations are also addressed, including farm/fisheries bankruptcies in Chapter 9, municipality insolvency in Chapter 12, and international bankruptcy cases in Chapter 15 where debtors, creditors, assets or debts are found in both the United States and a foreign country.
What is the law that governs bankruptcy cases?
The federal U.S. Bankruptcy Code is the central law that governs bankruptcy cases. Procedures and rules are set out in the Federal Rules of Bankruptcy Procedure, but each federal bankruptcy court can impose their own local rules that must be followed in their proceedings.
In addition, state laws can also impact bankruptcy cases. Generally bankruptcy is a federal matter handled exclusively in federal courts. But states can and do enact their own laws on exempt property. What is exempt property?
The law recognizes that those filing for bankruptcy will require certain essential assets to function in society and earn a living. Bankruptcy exemptions are lists of protected property that a debtor need not turn over to be sold for creditors.
States May Have Their Own Exemptions
While the federal law contains exemptions, states are also permitted to, and do, make their own exemption laws for their residents. Most states require that the person filing a petition in bankruptcy use the state-enacted exemptions.
Others offer a debtor a choice between the state and federal exemptions, but it is never permissible to mix and match federal and state exemptions.
How much debt do you have to have before declaring bankruptcy?
The question of how much debt an individual should have before filing bankruptcy is more a practical consideration than a legal requirement. Generally, there is no minimum debt to file bankruptcy, so the amount does not matter in terms of eligibility. There are upper debt limits, such as $2,750,000 aggregate debt for Chapter 13, but no minimum requirements.
However, practically, an individual should consider well the amount of their debt as they are weighing the pros and cons of filing a petition. Bankruptcy has serious negative consequences that impact an individual's ability to borrow money in the future.
Impact on Credit Record
A discharge in bankruptcy stays on a credit record for up to 10 years. In addition, there is a social stigma attached to bankruptcy that might prevent an individual from getting a particular job or being permitted to rent an apartment.
Bankruptcy is not a casual filing. A filer is entitled to discharge debts only in Chapter 7 bankruptcy every eight years. That means that if an individual discharges a few thousand dollars of debt today, they will not have this option available to them again for many years even if they are overwhelmed with debt.
Teo Spengler earned a J.D. from U.C. Berkeley's Boalt Hall. As an Assistant Attorney General in Juneau, she practiced before the Alaska Supreme Court and the U.S. Supreme Court before opening a plaintiff's personal injury practice in San Francisco. She holds both an M.A. and an M.F.A in creative writing and enjoys writing legal blogs and articles. Her work has appeared in numerous online publications including USA Today, Legal Zoom, eHow Business, Livestrong, SF Gate, Go Banking Rates, Arizona Central, Houston Chronicle, Navy Federal Credit Union, Pearson, Quicken.com, TurboTax.com, and numerous attorney websites. Spengler splits her time between the French Basque Country and Northern California.