Even the most responsible person or well-run business can sometimes suffer financial setbacks that lead to mounting debts. When those debts become unsustainable there are several options under federal and state law that can help debtors regain control of their financial future. One of those options is filing for bankruptcy, which is a legal method for eliminating or reorganizing debts.
Bankruptcy has long-lasting implications for a debtor’s credit and should not be undertaken lightly. Furthermore, there are many different types of bankruptcies as well as non-bankruptcy alternatives (such as debt negotiation) that a skilled bankruptcy attorney can assist with.
Not all debts are treated equally. Depending on the type of debt and the type of bankruptcy, some can be discharged and some cannot. Before considering filing for bankruptcy you should find out whether your home, retirement assets like 401(k) and IRA plans, or life insurance policies will be affected.
Additionally, the debtor may not be the only person or entity affected. Loan co-signers (which may include family members) should also be considered.
Types of Bankruptcy
There are six major types of bankruptcies, called chapters, but for most individuals and businesses, only three are relevant:
In this type of bankruptcy the debtor’s assets are almost entirely liquidated (sold off to repay their debts) and their remaining debts are almost entirely discharged. For that reason, Chapter 7 is sometimes called a “fresh start” bankruptcy. Certain debts and assets are exempt from Chapter 7, however.
Businesses primarily rely on this type of bankruptcy because it allows them to continue to operate while they and their debtors develop a court-approved plan to repay outstanding debts. In some cases, the court will appoint a trustee to take control of the business and its property during the process, but not all.
Also called a reorganization, this type of bankruptcy is for individuals with regular income who do not wish to liquidate all their assets. The court creates a repayment plan that gives them more time to repay their debts, typically three to five years. (Chapter 12 is similar to Chapter 13 but has specific provisions for family farmers and family fishermen.)
The various types of bankruptcies all have a similar goal: to create an orderly framework for creditors and debtors to come to an arrangement that gives creditors the opportunity to receive some or all of their loan payments back and debtors the opportunity to regain control of debts that have spiraled out of control or to get a completely fresh start.
To file for Chapter 7 bankruptcy, an individual must pass a means test proving their income is below average. The exact amount varies and changes over time, but in Pennsylvania, a family of four can generally not have a household income above $104,000.
There is a debt ceiling for Chapter 13 bankruptcy. The debtor cannot have more than $1.4 million in secured debts and $400,000 in unsecured debts.
As mentioned previously, certain assets may be exempt from bankruptcy and cannot be collected by creditors. Debtors can choose whether to opt for the current federal or state exemptions. For most people, the federal exemptions are more generous and a better option.
- $25,150 in home equity (the value of the property minus the outstanding mortgage and any liens)
- $4,000 in equity in a vehicle
- $625 per item of household goods (up to a total of $13,400)
- $2,525 in items necessary for the debtor’s employment (tools, computers, etc.)
- $1,700 in jewelry
- $1,325 in wildcard property (any property of the debtor’s choosing), plus up to $12,575 of any unused exemption in the debtor’s home
Additionally, under federal exemption, certain benefits are also protected:
- Social security payments
- Unemployment compensation
- Veterans’ benefits
- Public assistance payments
- Retirement accounts
- Government benefits
- Current wages
- Property of a business partnership
- $300 in wildcard property
If a debt is secured, meaning the debtor has offered collateral that the creditor is entitled to collect if the debtor defaults on the loan, the creditor may be able to take the property, such as a home, from the debtor and sell it to recover their losses. In some cases, the debtor can pay the creditor what the property is worth rather than relinquish the collateral.
At the conclusion of a bankruptcy case, the court will notify all creditors of any debts that have been discharged. That notification is an official court order that prevents creditors from attempting to collect those debts.
The type of debts that can be discharged are numerous and often include:
- Medical bills
- Credit card balances
- Some back taxes
- Payday and signature loans
Just like some assets are exempt from creditors, some debts cannot be discharged in a liquidation bankruptcy. Examples include:
- Child support payments
- Property settlements
- Criminal restitution
- Certain taxes
- Debts resulting from fraud
- Some student loans (especially those owed to a government lender)
- Debts for personal injury judgements resulting from a DUI
- Certain taxes
180 Day Rule
If a debtor files for bankruptcy and receives certain payments within 180 days of that filing, their creditors may be entitled to some or all of that income. For example, if a debtor receives an inheritance, a property settlement, or life insurance benefits (and those assets are otherwise not exempt) within 180 days of the filing, the creditor can attempt to claim those assets to repay the debt.
One of the major protections that filing for bankruptcy affords a debtor is called an automatic stay, which is a court order that prevents creditors from taking certain adverse actions, such as:
- Foreclosing on a home or other real estate
- Harassing the debtor
- Garnishing wages
- Repossessing cars or other property
- Levying a bank account to collect funds from it
The length of the automatic stay will be determined by the bankruptcy court, but can last as long as five years in cases.
There are other protections under the law for individuals who have filed for bankruptcy. For example, utility companies cannot refuse or cut off service to someone simply because they have filed for bankruptcy.
The three primary credit reporting agencies track the creditworthiness of individuals using a variety of metrics, one of which is previous bankruptcies. A bankruptcy will remain on the individual’s credit report (and negatively affect their FICO score) for ten years.
However, because filing for bankruptcy lowers the burden placed on debtors and/or gives them more time to repay their debts, some individuals end up better able to rebuild their credit during that ten year period.