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If a person falls hopelessly behind in his or her debt payments, one option is to declare bankruptcy, a legal proceeding conducted in a federal bankruptcy court that may allow the debtor to be relieved of some or all of his or her debts. Filing bankruptcy is not a panacea, however. Although it is often said that bankruptcy gives a person a fresh start, it can negatively affect his or her credit rating and make it hard to obtain credit in the future.
Consumers, like businesses, have options in terms of which type of bankruptcy to pursue. These options are set forth in separate chapters of the Bankruptcy Code, and they are commonly referred to by their chapter numbers. Chapter 7 bankruptcies, for instance, the most common form chosen by consumers, are called liquidation bankruptcies. Chapter 7 is employed by individual debtors who want to liquidate their assets and be relieved of their debts.
The Chapter 7 proceedings begin when the debtor files a petition with the bankruptcy court. The filing of the petition triggers the automatic stay, which is bankruptcy terminology for the termination of all debt-collection activity. All collection actions against the debtor or his or her property must then cease. In a Chapter 7 bankruptcy, the court appoints a trustee who oversees the case and liquidates the debtor’s assets in order to pay off the debts. In many cases, however, the debtor’s assets are exempt or already subject to valid liens, so there will be no assets to liquidate. (Bankruptcy law provides for certain assets, such as a personal residence, auto, some household goods, tools of one’s trade, and the like, to be exempt – up to certain dollar amounts – from being sold to satisfy debts.)
If there are assets to sell, the trustee will collect the sale proceeds in a fund from which the debts will be paid to the extent possible. When all of the proceeds are distributed, any remaining unpaid debts are discharged, meaning that they no longer exist and the debtor has no further obligation to pay them. Some debts, however, are non-dischargeable, such as taxes, domestic support obligations, damages resulting from the debtor’s willful or malicious acts, debts incurred by giving false financial information, and some debts incurred just prior to filing for bankruptcy.
A debtor may choose Chapter 13 if he or she has a stable income, believes the financial crisis is temporary, and wants to repay at least some debt. However, the debtor must have less than $290,525 in unsecured debt and $871,550 in secured debt (these amounts are automatically adjusted upward every three years) in order to be eligible for Chapter 13. A Chapter 13 proceeding is often called a wage-earner plan.
A Chapter 13 proceeding is initiated by filing a petition. As in Chapter 7 cases, the filing of the petition stops the creditors from trying to collect on their debts. The debtor then has time to file a plan that sets forth the details of how he or she intends to pay off the creditors in the next three (or, with the court’s permission, five) years. Creditors have the opportunity to ask questions about and object to the plan. If the court approves the plan, the creditors can take no action outside the plan’s scope to collect their debts. The debtor must also disclose his or her most recent year’s federal tax returns, and obtain credit counseling.
Once the plan is completed, the debtor is entitled to a discharge, which releases him or her from all debts provided for or disallowed under the plan. Creditors have no further rights with regard to discharged obligations.
Chapter 13 has certain advantages over Chapter 7 in consumer bankruptcies. For instance, there is not an eight-year waiting period before the consumer can file for bankruptcy again after filing for Chapter 13 relief. In addition, a Chapter 13 bankruptcy allows the debtor to discharge a few more types of debts than Chapter 7 does. Under Chapter 7, the court may order that all of the consumer’s assets be sold, whereas in Chapter 13 the debtor may be able to retain his or her assets.
The petitioner’s choice of Chapter 7 or 13 is not necessarily permanent, and once proceedings have begun, a case may be converted to a different chapter. Once converted, however, the case may not be converted back again. The most common conversions are those that start in Chapter 13 with the best of intentions but break down and eventually are converted to Chapter 7 “straight liquidation” cases. However, with the advent of means testing in 2005 it will be far more difficult to convert to straight liquidation.
Most consumer bankruptcy cases are initiated voluntarily, but they can also arise involuntarily when creditors band together and attempt to force the debtor into bankruptcy. A minimum number of creditors and amount of debt are required for an involuntary bankruptcy. Creditors face stiff financial penalties, however, if they initiate an involuntary bankruptcy for invalid reasons and the court sides with the debtor.
Bankruptcy can be an expensive process and has serious long-term effects. There are alternatives to bankruptcy, such as working informally with creditors to develop a plan for repayment, working with a private credit counselor, or seeking the assistance of a nonprofit credit-counseling agency. A lawyer experienced in bankruptcy law can help a consumer decide which option is best.
Worksheet: If You Are Considering Bankruptcy
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