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What is bankruptcy and how does it work in the U.S.?

Bankruptcy is a legal process that can help you reset your finances if you’re struggling financially. Each year, an estimated 530,000 families turn to bankruptcy as a last resort.

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Bankruptcy is a legal process that can help you reset your finances if you’re struggling financially. Each year, an estimated 530,000 families turn to bankruptcy as a last resort, yet many people across the country don’t know much about the process. In this article, we explain what bankruptcy is and common circumstances that may lead you to consider it as a path out of financial distress. 

What is bankruptcy? 

In the United States, bankruptcy is a legal process intended to assist individuals and businesses struggling financially by providing a way to partially or fully eliminate a portion of their debt. In addition to assisting those who are struggling financially, bankruptcy also helps creditors by providing a way to obtain repayment for outstanding debt. 

While bankruptcy can help to relieve your debts and ease financial burdens, it also has a long-lasting effect on your credit history. If you choose to file for bankruptcy, it will remain on your credit report for a minimum of 7 years. Bankruptcy not only negatively impacts your credit score by reducing it by as much as 220 points, but it also affects your eligibility for loans, credit cards and other services that rely on a good credit rating. 

The basics of bankruptcy 

If you are thinking about filing for bankruptcy, you will need to meet certain eligibility requirements. For example, you will have to provide proof that you are unable to repay the debts you have accumulated.  You will also be required to attend a credit counseling course under the guidance of a government-approved credit counselor who will help you review your finances, explain options that you might consider instead of bankruptcy and create a budget. 

After you have attended credit counseling, if you decide that you would like to proceed with filing for bankruptcy, you will need to determine the type of bankruptcy you will file, gather all of the necessary documentation and appear before a judge. While you can file for bankruptcy on your own, consider working with an attorney specializing in bankruptcy law for help navigating the process. 

Types of bankruptcy

The three most common types of bankruptcy are Chapter 7, Chapter 11, and Chapter 13. 

What is Chapter 7 Bankruptcy? 

Chapter 7 bankruptcy, known as “liquidation” and commonly referred to as “straight bankruptcy”, is the most common form of bankruptcy in the United States.  It is intended for individuals and businesses that have little or no assets. 

Under this type of bankruptcy, you can eliminate your unsecured debts including credit cards and medical bills; however, certain financial obligations are excluded, including student loans, tax debt and child support. You will also be permitted to retain “exempt property” (property that Bankruptcy Code deems necessary). If, however, you have assets that are not protected by this exemption, a court-appointed trustee can sell these assets. The funds secured from the sale of these assets will then be distributed to your creditors in a process known as “liquidation.”

Examples of “exempt” property usually include clothing, your primary residence, household products, clothing, personal vehicles that are valued up to a certain amount, and tools for your livelihood. Examples of Property typically not considered exempt under Chapter 7 Bankruptcy Code includes second homes, stocks, bonds and valuable collections or heirlooms such as artwork. If you do not have any valuable assets and you only own property that is exempt, you will not be required to repay your unsecured debt; rather, that debt will be discharged, or “wiped clean,'' so to speak. 

What is Chapter 11 Bankruptcy? 

Typically, businesses file for Chapter 11 bankruptcy; however, certain individuals may opt to file this type of bankruptcy.  Often referred to as “reorganization” bankruptcy, this type of bankruptcy allows you to restructure your debts and repay those debts over a specified period of time. 

During this type of bankruptcy process, the debtor reorganizes their debts and files a schedule of current assets and liabilities as well as a disclosure statement with details on financial standing. The organization plan illustrates how the debtor intends on repaying creditors and priority is given to creditors according to the form of debt. Creditors reserve the right to vote on the reorganization proposed by the debtor, which must be approved by the court before it can proceed. 

Creditors of those who file for Chapter 11 bankruptcy do not always receive full repayment—sometimes they may not ever be repaid. Secured creditors like financial institutions are usually given first priority. Unsecured creditors such as utility providers receive second priority while stockholders are usually the last to be repaid. 

Businesses that file for Chapter 11 bankruptcy are required to continue their operations; but, they are not permitted to make certain types of financial decisions unless those decisions are approved by the court. Furthermore, creditors cannot take legal action against debtors in an attempt to recover the money they are owed during this process of bankruptcy. 

What is Chapter 13 Bankruptcy?

Also known as a “wage earner’s plan,” Chapter 13 bankruptcy is intended for those who are not eligible for Chapter 7 bankruptcy because they earn too much money. Under Chapter 13 of the Bankruptcy Code, individuals and businesses that have access to consistent income can develop a debt repayment plan. Typically, this plan involves making payments in installments over the course of either a three- or five-year period. In return for repaying their debts, those who file for Chapter 13 bankruptcy do not have to liquidate any of their assets. 

In this scenario, the debtor’s income and debt balances are used to determine the type of payments that will be made. If any remaining debts still exist after the completion of a Chapter 13 repayment plan, those debts can be discharged. 

Bankruptcy Requirements

In order to file for bankruptcy, you will have to meet specific eligibility requirements, which vary based on the type.

Chapter 7 Eligibility Requirements

In order to qualify for Chapter 7 bankruptcy, your income and debt must meet certain requirements. To determine the amount of debt you owe compared to your income, the government imposes a means test based on the deduction of certain monthly expenses from the average income made in the six months prior to filing for bankruptcy. The means test is meant to determine your disposable income, the amount of income left over after monthly expenses are accounted for. 

A high amount of disposable income suggests that you have access to funds that can be used to repay your debts; therefore, the higher your disposable income is, the less likely it is that you will be considered eligible for Chapter 7 bankruptcy in many cases.

Only those who are filing for Chapter 7 bankruptcy with debts that are considered “consumer” in nature (rent, household products, clothing, utility bills, food, etc.) are typically required to take a means test. Those whose debts are primarily “business” in nature (credit card bills, medical bills, commercial leases, etc.) are usually not required to take a means test. 

A means test will also usually determine if the debtor's income is higher than or lower than the median income of the state in which he or she resides. Median income levels vary based on state and household sizes. 

If the debtor’s income is higher than the median income in his or her state, the government will assess if he or she has enough earnings after accounting for monthly expenses that can be used to repay outstanding debts. If a debtor’s income is below the median income in his or her state, he or she will usually automatically be considered eligible for Chapter 7 bankruptcy. If the debtor’s disposable income exceeds a specific amount, he or she will typically not pass the means test and will be ineligible for Chapter 7 bankruptcy. 

Chapter 11 Eligibility Requirements

Both individuals and businesses can file for Chapter 11 bankruptcy; however, this type of bankruptcy is filed primarily by businesses that have amassed a large amount of debt. With this type of bankruptcy, the debtor or the debtor’s creditors must file an involuntary petition with the United States Bankruptcy Court. 

Once the petition is filed, an automatic stay for all collection activities becomes effective, which means that creditors cannot continue to pursue collection activities for any unpaid debts. This stay gives the debtor a chance to create a reorganization plan as well as an opportunity to negotiate repayment terms with creditors.

Once the petition is received, the court will review the bankruptcy case. If the court determines that the reorganization plan is reasonable, has been created in good faith and complies with the law, the plan – and therefore the Chapter 11 bankruptcy case – may be more likely to be confirmed. However, if the court determines that the reorganization plan is not reasonable, has not been created in good faith, or is not in compliance with the law, the case is more likely to be denied. 

If a Chapter 11 bankruptcy is approved, any debts that were in place prior to the confirmation date and were not addressed directly in the reorganization plan will be removed. The filer then begins repaying creditors as per the arrangements that were made in the reorganization plan. 

Chapter 13 Requirements

If you failed the means test for Chapter 7 bankruptcy, your disposable income may have been considered too high, leaving Chapter 13 as one of the primary remaining options. 

To determine your eligibility for this type of bankruptcy, you will need to demonstrate that you will have income remaining after certain expenses and necessary payments towards secured debts (a mortgage or an auto loan, for example) have been deducted from your earnings. You must also establish a repayment plan that indicates your intention to repay certain types of debts in full. If you fail to meet these qualifications, you may not be permitted to proceed with Chapter 13 bankruptcy. 

In addition to the above qualifications, if your secured and unsecured debts are too high, you will not be eligible for Chapter 13 bankruptcy. You cannot typically file for this type of bankruptcy in the name of a business; instead, you will have to file for Chapter 11 bankruptcy. There is, however, a notable exception to this role: sole proprietors. If a sole proprietor files as an individual and includes both their business and personal debts in their filing, he or she may be eligible for Chapter 13. 

Should you file for bankruptcy? 

The decision to file for bankruptcy is not one that should be taken lightly. Filing affects your credit score and can remain on your credit report for seven to 10 years and bring your credit score by as much as 220 points. After weighing the options that consecutive missed payments and late payments can have on a credit score, some people may still opt to file for bankruptcy. 

If you are not sure if you should file for bankruptcy, consult an attorney to determine whether or not bankruptcy is the right choice for you. 

Recovering from bankruptcy

Even if bankruptcy is the right option, recovering your credit score will take time. There are things that you can do in order to manage and improve your credit score.  

Assess your credit score

Check your credit score periodically, especially after filing for bankruptcy in order to determine if and when the debts included in your bankruptcy will be discharged. If you filed for Chapter 7 bankruptcy, for example, debts included in your case should show a balance of $0 on your credit report and should no longer be delinquent. If you find that something hasn’t been properly reported, contact one of the credit bureaus.

Begin building your credit

While it may be difficult to qualify for credit cards and loans after you have filed for bankruptcy, you can still work on rebuilding your credit. You can apply for secured credit cards and store credit cards, for example, which will help to increase your credit score. Additionally, continue to make on-time payments for any debts that you have that were not discharged – utility bills, car payments, mortgage, rent, or student loans. 

Be conscious of spending 

After you have filed for bankruptcy, the last thing you want to do is get back into debt. Therefore, it’s important to manage your finances well and be conscious of your spending habits. Establish a budget and stick to it to make it easier to manage your finances and stay on track to remain or become debt-free.

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