Chapter 7 Bankruptcy: A Shot at a New Beginning . . .
For a long time, the word “bankruptcy” brought with it a slew of negative connotations. Disappointment, failure, ruin, guilt, shame, and defeat are just a few words that describe the emotional state of a person faced with overwhelming debt who is looking for protection from creditors. Having represented thousands of debtors in chapter 7 proceedings over 20 years, clients still say that they do not want to file bankruptcy because they “were raised to pay their debts” or “I pay my bills.” Ultimately, potential bankruptcy clients end up moving to a frank discussion about how they need to have credit to make it in today’s world. All these emotions and thoughts are completely legitimate, rational, and normal for someone faced with crushing debt.
The reality of bankruptcy is much different than what is perceived by the public. Not everyone faced with debt issues should file bankruptcy. Moreover, bankruptcy does bring with it some negative consequences (even if only temporary). However, for those people that are struggling with the decision to put food on the table or to pay a credit card bill, the positive consequences often outweigh the negative consequences of filing for chapter 7 bankruptcy protection.
A Bankruptcy History
The history of bankruptcy is a tale which shows that bankruptcy could be much worse for debtors that it is today. A debtor could be forced into servitude to pay off his debts, body dismembered as payment of debt, or be faced with debtor’s prison.
American history with bankruptcy has its start with the Constitution which gave Congress the power to enact a uniform bankruptcy law. Congress has made numerous changes to bankruptcy laws with the biggest and most recent changes coming with the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”). Don’t worry – BAPCPA does not require servitude, dismemberment or prison (although the latter may still be possible if you commit fraud).
Chapter 7 Mechanics
The first big question regarding how a chapter 7 operates is “how to file a chapter 7.” The overarching mechanics of a chapter 7 are straight forward but under the basic framework is a slew of nuances, twists and turns. The first step in a chapter 7 is qualifying. Essentially, the financial qualifications revolve around two budgets – an objective test and a subjective test.
The objective test or the Means Test is a formulaic approach to determine if a debtor has money to pay toward debt. It is composed of all income a debtor has received for the prior 6 months, some actual expenses and some IRS standard expenses. The Means Test is rigid and can be difficult to accurately reflect a debtor’s true ability to pay back debts.
The subject test is the actual, real-time budget for a debtor. A debtor discloses current income as their income stands at the filing of the case – as opposed to a 6-month look-back. The debtor lists actual expenses instead of the standard IRS numbers. Finally, the debtor projects certain expenses to fully reflect the true nature of the debtor’s financial situation.
Moving beyond the budget, an analysis of a debtor’s assets is the next step. Each state has its own laws which allow a debtor to protect (exempt) real and personal property which are called exemptions. Some states allow a debtor to choose between the state’s exemptions or the federal exemptions. If the debtor has a choice, the decision to use one set of exemptions over a different set of exemptions is determined by a thorough analysis of a debtor’s assets.
Next, a debtor must look back on certain events such as transfers of assets, payments of debts, and other actions the debtor took in different intervals of time – 90 days, 6 months, 1 year, 2 years, 6 years, 8 years and 10 years. Absent a major issue in this analysis, then the debtor may be able to file a chapter 7. This analysis may sound daunting at first, until you realize that many thousands of people file bankruptcy every year.
The filing of the bankruptcy case is a significant event. Immediately upon filing, the automatic stay is in place. The automatic stay stops almost all collection of debts, lawsuits, garnishments, and legal action against the debtor or the debtor’s assets; however, the automatic stay is more powerful than just stopping legal actions. It is the conduit that allows a debtor to go on the offensive against those that violate the automatic stay. For instance, if a creditor takes money from a debtor after the automatic stay is in place, the debtor can recover the money taken, attorney fees and potentially punitive damages against the creditor.
Upon the filing of a chapter 7 bankruptcy, the case moves in a legally defined timeline. First, a trustee is assigned to the case. The trustee’s job is to administer the case, recover money for the bankruptcy estate (if any), and distribute any proceeds to the creditors in a legally prescribed manner. The trustee will conduct a hearing (called the “meeting of creditors”) which the debtor will testify to the accuracy of the petition filed with the bankruptcy court. After the hearing, the trustee will perform the duty of collecting any assets or simply closing the case.
The debtor’s responsibilities during the pendency of the case include attending the meeting of creditors, cooperating with the trustee, and completing a required debtor education class. A debtor’s goals with filing a bankruptcy vary; however, one main theme is keeping assets of the debtor. A debtor can claim certain assets as exempt, and if the exemption is allowed, the assets remain with the debtor. For assets that are secured by a loan (e.g. a home or vehicle), the debtor often has a choice on how to handle the debt associated with the asset. Generally, a debtor can keep an asset by simply maintaining the payments; however, a debtor may choose to reaffirm certain debts.
To understand what it means to reaffirm a debt, it is important to understand what a discharge of a debt means. Discharging a debt removes the personal responsibility to pay the debt. In other words, a debtor cannot be sued personally for a discharged debt. If a debt is reaffirmed, the personal liability remains on the debt and the debtor could be sued personally for the debt. The benefits of reaffirming a debt include maintaining the business relationship with the lender; thus, allowing the lender to potentially report positively to the debtor’s credit report.
Generally, after a few months and if no objection or other issue arises in the case, a bankruptcy judge will issue a discharge. The debtor will receive a discharge of the debt included in the chapter 7, and the case is done. The debtor can begin the process of rebuilding credit.
The second big question regarding how a chapter 7 operates is: “how can I rebuild after going through a chapter 7”? The simple answer is that you can often rebuild your credit rapidly after a discharge of your debts in a chapter 7. It is entirely possible to obtain a credit score of 720 in 12 to 24 months after a discharge of your debts – but you must work at rebuilding your credit. Additionally, federal law provides for legal remedies when a creditor or credit bureau fails to accurately report the discharge of a debt. Rebuilding your credit and the federal laws which afford consumer protection is a subject for a future consumer bankruptcy installment.
Bankruptcy in the Real-World
Filing bankruptcy can be a new beginning and a fresh start for those that want to improve their life. A look at the famous people who have filed bankruptcy either personally or for their business only goes to show that it can be a new beginning:
- Dave Ramsey
- Donald Trump
- Walt Disney
- Larry King
- Willie Nelson
- Burt Reynolds
- Mickey Rooney
- Toni Braxton
- MC Hammer
- George Jones
- Jerry Lewis
- Milton Hershey
- P.T. Barnum
- Merle Haggard
- Zsa Zsa Gabor
- Redd Foxx
- LaToya Jackson
- Kim Basinger
- Dorothy Hamill
- Johnny Unitas
- Lawrence Taylor
- Terrell Owens
- Henry Ford
- Mark Twain
- Vince Neil
- Mike Tyson
- Warren Sapp
- Cyndi Lauper
Financial distress can happen to anyone as debt does not discriminate. While most businesses and people who file for bankruptcy are not famous, typical and very normal life situations can lead someone to need or want to file for bankruptcy protection to solve their financial problems. Hearing that a famous person has filed bankruptcy is one thing; however, the best way to understand how bankruptcy can bring positive change to people’s lives is to see it work in real-world scenarios.
Case Study One
- John and Sally (filing a joint case in bankruptcy is allowed)
- Family of 4
- Own a home with a mortgage and 2 vehicles with vehicle payment
- $15,000 credit card debt
- $100,000 medical debt
- $20,000 student loans
John and Sally were both employed when they had their second child. Soon after the birth of the child, they were informed that the child had a medical condition that required a year of surgeries and rehabilitation to remedy. John and Sally made the decision to have John quit his job to focus on the recovery of their child due to the fact that he was a nurse, Sally’s income was higher, and her health insurance was better than John’s insurance. While their child made it through the surgeries and rehabilitation, Sally’s employer changed its health insurance plan to a less robust plan which resulted in skyrocketing medical debt. The couple was faced with doing everything they could for their child which meant incurring a large amount of medical debt or not providing the necessary health care to their child. The choice was simple, and they provided the help to their child.
During the consultation, it became clear that John and Sally certainly did not ever plan on filing bankruptcy. They both had good paying jobs and other than a bit of student loan debt, did not carry much unsecured debt. Then, by no fault of their own, they were slapped with suffocating medical debt. John and Sally easily passed the budget requirements for qualifying for a chapter 7. An analysis of their assets resulted in them being able to exempt the home, two cars and all their personal belongings; therefore, there would be no non-exempt assets. They were able to file a chapter 7 bankruptcy, discharge the credit card and medical debt, keep their home, cars, and other assets, and begin rebuilding their credit immediately.
Case Study Two
- 26-year-old, single, no kids
- Rents an apartment in the city, close to his work
- $25,000 credit card debt
- $85,000 student loan debt
- $45,000 car loan
Sam graduated college 4 years ago. He took out the necessary loans to put himself through college and after he graduated, found a job in his given field. At first, he lived outside of the city, so he needed a reliable vehicle. His student loans were in deferment and he was able to afford the car. He started to enjoy life and socialize now that he had a stable source of income. He decided to move into the city to be closer to his work and closer to his preferred social scene. After a few months, his girlfriend moved in and started to share the living expenses. The help with the living expenses could not have come at a better time as his student loans came out of deferment. Unfortunately, the relationship with his girlfriend went south and they broke up. She moved out leaving him with the full rent, car payment, student loan payment and credit card payments. He quickly defaulted on his monthly debt obligations and sought a way out.
Sam’s case required a heavy dose of pre-bankruptcy planning as he was over the median income for a household of one and, at first, was not qualifying for a chapter 7. His job paid him a base salary plus commissions. The commissions fluctuated dramatically from month-to-month; therefore, his median income changed dramatically from month-to-month as well. Beyond qualifying issues, the conversations with Sam included serious discussions of what reality would be like post-bankruptcy. He wanted to stay in the city, so it was obvious that he did not need a vehicle. He would never be below the median income; however, he eventually passed the means test and filed a chapter 7. He was able to let the vehicle go in the bankruptcy meaning he discharged that particular debt but had to turn the vehicle over to the lender. He received a discharge of the credit card and vehicle debt; thus, allowing him to remain in the city, in the apartment he loved and begin repaying his student loan debt.
Case Study Three
- 44-year-old, single, 1 child
- Owns a home with a mortgage, car with car payment
- Owns a salon
- $18,000 personal credit card debt
- $8,000 business credit card debt
- $55,000 contract for deed payment for the salon
- $25,000 tax debt from 5 years previous
- $4,500 dental debt
- $9,000 attorney fee debt from her recent divorce
Kathy always had a dream to own her a salon. After 18 years working for someone else, she decided to open her own salon. She purchased a salon from someone who was getting out of the business, was able to keep 5 additional stylists employed and had success in building her business. The initial success was tempered a bit by a divorce and some bad tax advice which resulted in a tax debt. She made it through the divorce but not without incurring a large attorney fee debt, and despite the tax debt, Kathy’s salon flourished.
Kathy was able to continue to pursue her dream of owning her own salon and provide for her son. However, world events out of her control forced her to close the salon for an extended period. She tried to do everything right by keeping the house, car, and salon payments current. She helped her employees avoid financial collapse by taking out a PPP loan to keep her employees on the payroll. However, the shutdown was longer than she could handle and fell back on credit cards to keep things afloat. Eventually, her salon re-opened, but Kathy was strapped with the burden of excessive debt.
The analysis into Kathy’s financial situation and determining if bankruptcy is a viable solution was multi-layered with multiple “what if” options. She had goals that went beyond just discharging her debt. In addition to wanting to keep her home and vehicle, she wanted to keep her business. Since the business was operating and making money, it made financial sense to pursue that goal.
While the bankruptcy filing did not prevent her from retaining the business; however, she had some non-exempt assets associated with the business valued at $5,000. She was able to negotiate with the trustee to buy back the assets from the bankruptcy estate. Finally, the discharge of the debt allowed Kathy to come away from the bankruptcy with a fresh start. The personal credit card, dental and attorney fee debt was all discharged. Most importantly, the $25,000 of tax debt met the requirements for discharging taxes, and Kathy was able to get through the bankruptcy with her business and a manageable amount of financial obligations.
Case Study Thoughts
In each of these case studies, the debtor initially faced daunting financial distress but found freedom from the shackles of the debt through solid bankruptcy planning and ultimately the discharge of debt. The debtors did not let life circumstances interfere from finding a viable solution and moving forward with their lives. The decision to file bankruptcy is hard – but the results from making that hard decision allowed these debtors to achieve their goals.
Beyond a Chapter 7
A chapter 7 bankruptcy is not always the best solution. In fact, there are many specific situations that call for a different solution. What if you are behind on your mortgage payments? What if you need help paying back taxes owed to the IRS? What if you have assets that you must keep but you still need help with your debt? What if you can make partial debt payments but cannot afford the whole debt? Well, these questions may have an answer in a chapter 13 bankruptcy. More on chapter 13 bankruptcies later.