What is Chapter 7 Bankruptcy?

A Chapter 7 Bankruptcy is also known as “liquidation” Bankruptcy, and does not involve a repayment plan. Rather, the general principle of Chapter 7 is that the property of the debtor is sold and then distributed to their creditors. Some of this property will be exempt, meaning the property is allowed to be kept by the individual filing, and not allowed to be sold to satisfy creditor claims. Other property may be subject to a security interest (being held as collateral), and may be repossessed by the lender who made the loan. All the remaining property will be sold and monies distributed to unsecured creditors. Any amount of the unsecured debt that is remaining will be discharged, eliminating the personal liability on the debt.

Chapter 7 Bankruptcy is most often the preferred type of filing because it results in a more immediate discharge than Chapter 13 Bankruptcy. However, Chapter 7 Bankruptcy is not available for every debtor. Additionally, Chapter 7 can result in exemption and discharge issues. Continue reading or click to jump to the details of the following issues: (1) eligibility for Chapter 7; (2) exemptions; and (3) which debts are dischargeable.

Eligibility for Chapter 7

The Bankruptcy code allows a petition to be dismissed if there is a finding that Chapter 7 filing would be an “abuse” of Chapter 7. Since 2005, “abuse” has been presumed if the consumer is unable to pass the “means test.” The “means tests” is a formula for establishing whether or not someone would have sufficient income to make payments under a rehabilitation Chapter 13 plan rather than a liquidating Chapter 7 plan. The purpose of the test was to curtail alleged abuse by debtors who chose to file under Chapter 7 when they could have paid a greater amount to unsecured creditors under a Chapter 13 plan. The “means test” is really divided into two separate steps: (1) the median family income test; and (2) the means test.

Step 1 -- The Median Family Income Test

The first step to determining whether or not you are eligible for Chapter 7 is to determine whether or not your “current monthly income” is greater than or less than the “median family income” for your area. If it is less, then the “means test” will be inapplicable to you, and your case will likely be able to be filed under Chapter 7. “Current monthly income” is the average monthly income from all sources that the consumer receives during the six month period preceding the filing of the petition. The “median family income” is reported by the Bureau of the Census for the most recent year. Here are the figures for Texas residents as of October 1, 2008 as reported by the U.S. Trustee. * (add $6,900 for each person over family of 4)

• Example 1: Freddy Filer is single and was recently laid off from his job where he earned pre-tax income of $4,000 per month. If Freddy files immediately, his currently monthly income will exceed the median family income and he will be subject to the means test ($24,000 in income last six months divided by 6 equals $4,000 per month). This equals $48,000 on an annualized basis exceeding the $37,120 for a one earner household). Compare to if Freddy tries to find work and cannot for the next two months. In this case, Freddy will not be subject to the means test and a presumption of abuse cannot apply when filing under Chapter 7 ($16,000 income for last six months divided by 6 equals $2666 per month. This equals $32,000 on an annualized basis which is less than the $37,120 for a one earner household).

Step 2 – The Means Test

Once it is established that the “current monthly income” is greater than the “median family income”, the consumer must pass the “means test” in order to prevent the presumption of abuse. (Remember, if abuse is found then it is unlikely to be able to file under Chapter 7). The basic idea of the test is to take the debtor’s “current monthly income” and deduct expenses to see if the consumer would have enough money left over to fund a Chapter 13 rehabilitation plan. While this seems simple, it is also somewhat illogical as the consumer is only allowed to use pre-set numbers for their living expenses, and not their actual living expenses. Additionally, some of these expense amounts are fixed nationwide, while others take into considerations local differences in cost of living. Finally, a limited group of additional expenses are allowed if the consumer debtor qualifies. Overall, the “means test” is complicated, making it very difficult for you to individually determine whether or not you pass the test. The bulleted list below is meant to give a better understanding regarding this area, but contact the Law Offices of William Collins for a free initial consultation and to see how the “means test” relates to your specific situation.

• First, determine the “current monthly income” which is the average monthly income from all sources that the consumer receives during the six month period preceding the filing of the petition.

• Second, subtract the following monthly expenses:
  
  • National standards have been established for: (1) food; (2) housekeeping supplies; (3) apparel and services; (4) personal care products and services; and (5) miscellaneous. The amount varies by the size of the family. The information can be found at the U.S. Trustee Program website.
  • Local standards for: (1) Housing; and (2) Transportation. These figures are determined on a local level and are broken down by county. The consumer is allowed to either claim the local standard amount, or the amount they actually pay, whichever amount is less. The information can be found at the U.S. Trustee Program website.
  • Actual expenses for: (1) reasonably necessary health insurance; (2) disability insurance; and (3) health savings account expenses.

• Third, subtract the additional expenses that are allowed under specific circumstances (not always available):
  • Other necessary expenses that are either for: (1) the health and welfare of the taxpayer and/or their family; or (2) the production of income.
  • An increase of up to 5 % of the amount used for food and clothing if the debtor can show that they are reasonable and necessary.
  • An increase in the housing and utility allowance if they are the actual costs and if they are reasonable and necessary.
  • Expenses for the care of debtor’s elderly, chronically ill, or disabled family member.
  • Regular contributions that are made to tax-exempt charities (this amount is limited to up to 15% of gross income).
  • The amount that the debtor would pay in a Chapter 13 case including the expenses administering a Chapter 13 plan (up to 10% of plan payments) and expenses on payments of secured debts due over the 60 month post petition period.

• Fourth, take the amount left over and multiply by 60 months. If this amount is over $10,950 then the presumption of abuse applies. If it is less than $6595, then the presumption of abuse does not apply. If the amount is in between $6595 and $10950 the presumption of abuse will arise if the debtor can pay more than 25% of his non-priority unsecured debt over a 5 year plan
  • Example 1: Planner Paul is considering Chapter 7 and conducts the “means test” to see if he is eligible. After the test, he finds out that his monthly excess is $135. This means that over 60 months he would be able to pay back $8100. Because this amount is between $6595 and $10,950 he must check to see if this amount is enough to pay back 25% of his non-priority unsecured debt (typically credit card debt). If his credit card debts is $25,000 then Paul would fail the means test and presumption of abuse would apply ($8150 divided by $25,000 is greater than 25%). If the credit card debt is $35,000 then the presumption of abuse would not apply, enabling Paul to file under Chapter 7 ($8150 divided by $35,000 is less than 25%).

Exemptions available under Chapter 7

Exemption laws provide protection for debtors because they permit the debtor to retain certain property for themselves and their family despite the fact that their creditors will not be paid. Exemption laws go to the heart of the policy behind Bankruptcy of allowing the person filing to obtain a true “fresh start.” This makes sense because a person would not be able to start over if creditors were taking property that the filer used to provide income to pay creditors and/or provide for their family.

In Texas, the debtor is allowed to choose between the exemptions provided for under Texas law or the exemptions under the U.S. Bankruptcy Code. The major difference between the two is: (1) Texas allows for an unlimited homestead exemption; (2) Texas allows you to choose which property you want to bundle into your personal property exemptions vs. the strict categories in the federal exemptions. Contact the Law Offices of William Collins for a free initial consultation to see your options in exemption planning.

Texas Exemptions

• Unlimited amount of equity in the debtor’s homestead (cannot exceed 1 acre in city, town, or village OR 100 acres elsewhere –200 acres for family)

• $30,000 ($60,000 for families) in personal property. Includes:
  • One automobile per driver in the family
  • 2 firearms
  • Home furnishings
  • Family heirlooms

• Insurance benefits

• Pension benefits

Federal Exemptions

• $20,200 of equity in the debtor's primary residence.

• $10,755 of household goods, furnishings and appliances, provided that no single item is valued at over $525.

• The debtor's interest of up to $3,225. In one motor vehicle

• Jewelry of a value up to $1,350

• Tools of the trade or business of debtor having a value of up to $2,025

• Cash value of life insurance up to $10,775

• Professionally prescribed health aids - unlimited

• Social security benefits, disability benefits, most pension benefits, and child support or alimony - no dollar limits

• Personal injury claims having a value of up to $20,200

• The catch-all: any other assets up to $1,075.00 in value plus up to another $10,125 of value if the homestead exemption was not fully utilized.

Exemption Planning

Exemption laws can vary greatly by state. In the past, this caused potential Bankruptcy filers to pack up and relocate to states with favorable Bankruptcy laws such as Texas and Florida. In 2005, Congress sought to decrease this type of activity by passing a series of rules limiting how debtors can use a given states exemptions. The following list touches on the main areas that a potential filer should be aware of, especially if they have recently moved to Texas.

• The debtor can use the exemption laws of the state for which he has been domiciled in the previous two years. If the debtor has not been in one state for the required two year period, then the debtor must use exemption law of the state where he was domiciled in the 180 days immediately preceding the 2 year period.

• The homestead exemption is limited to $125,000 if the filer has acquired the homestead within 1215 days before filing of the petition (does not apply to the extent that the equity in current home is the result of proceeds from the sale of a previous home acquired before the 1215 day period).

• The value of the state homestead exemption is reduced by any addition to the value of the exemption which is caused by a sale of nonexempt property made by the debtor with the intent to hinder, delay, or defraud creditors during the 10 years prior to the bankruptcy filing.

Discharge under Chapter 7

A Bankruptcy discharge is a forgiveness on the filer’s debts which is mandated by the U.S. Bankruptcy Code. The forgiveness of the debt applies to personal liability and does not affect the creditor’s ability to take back collateral. This Bankruptcy discharge is mandatory despite the fact that creditors may not have agreed to it. This makes the discharge Bankruptcy discharge a key benefit compared to other forms of debt relief such as credit industry sponsored programs. However, it is important to note that the Bankruptcy discharge is not universal in nature. Specifically, exceptions for the discharge apply to the following situations: (1) Denial of the general discharge because of certain conduct; and (2) types of debts that are excluded from a Chapter 7 discharge.

Denial of the Discharge

A denial of the discharge will result of the debtor has engaged in any type of specified conduct which would make a discharge an abuse of the Bankruptcy system. Below is a list of the common types of activities that would result in a general denial of the Chapter 7 discharge. It is important that you be very careful before you file for Bankruptcy. Please seek the advice of a Bankruptcy Attorney to avoid any activity that may endanger your ability to get a discharge.

• The debtor cannot receive a discharge under their current Chapter 7 plan if they have previously filed and received a discharge within the past 8 years under either a Chapter 7 or Chapter 11. If the previous filing was a Chapter 13 then this time period is 6 years (with limited exceptions)

• If the debtor engages in conduct in anticipation of the Chapter 7 case such as the fraudulent transfer of property, concealment of or damage to property, concealment of records, destroying or falsifying records, or inability to comply with the court orders.

• The debtor cannot receive a discharge if they fail to take required course on financial management.

Types of Debt Excluded from Chapter 7 Discharge

Some specific types of debts are excluded from discharge. Most of these types of debts are based on the public policy that that certain debts should not be discharged, or preventing the debtor from benefiting from wrongful conduct. Below is a list of the common types of debts that are excluded from a Chapter 7 discharge.

• Domestic support obligations which includes debts established by court order, divorce decree, or property settlement agreement. These debts can be owed to a spouse, ex-spouse, child, person responsible for a child, or government unit.

• Debts which arose from the willful or malicious injury to another AND liabilities that occurred due to driving under the influence of alcohol or drugs.

• Debts which were incurred as a result of fraudulent behavior by the debtor.

• Priority taxes AND government fines, penalties and forfeitures

• Student loans