Bankruptcy
Bankruptcy in the United States is a legal process designed to help individuals, businesses and certain other legal entities eliminate or repay their debts under the protection of the federal bankruptcy court. It provides a fresh financial start for those who are unable to meet their debt obligations. However, bankruptcy comes with serious consequences, such as a significant negative impact on your credit score and financial reputation.
There are different types of bankruptcy in the U.S., each catering to specific situations and types of debt. Here’s is an overview about how bankruptcy works, the types available, and the long-term consequences. The information is just general, and it is advisable to seek professional help to make sure you make the optimal decisions for your specific situation. Also, remember that rules pertaining to bankruptcy in the U.S. are subject to change.
Bankruptcy can provide relief for those overwhelmed by debt, offering a way to wipe the slate clean and start fresh. However, it comes with serious consequences, including damage to your credit report and credit score. Also, certain types of debt can not be removed by bankruptcy.
It’s important to weigh the pros and cons of bankruptcy and consider alternatives before making a decision. Consulting with a bankruptcy attorney or financial advisor can help determine whether bankruptcy is the right option for your specific situation.
Legal Framework
The U.S. Bankcruptcy Code, formally Title 11 of the United States Code, is the source of bankruptcy law in the United States Code. The United States Code is the official codification of the general and permanent federal statutes of the United States. It contains 53 titles, which are organized into numbered sections, and Title 11 is the title which deals with bankcruptcy.
Title 11 of the United States Code is subdivided into nine chapters.
- Chapter 1: General Provisions
- Chapter 3: Case Administration
- Chapter 5: Creditors, the Debtor and the Estate
- Chapter 7: Liquidation
- Chapter 9: Adjustment of Debts of a Municipality
- Chapter 11: Reorganization
- Chapter 12: Adjustment of Debts of a Family Farmer or Fisherman with Regular Annual Income
- Chapter 13: Adjustment of Debts of an Individual with Regular Income
- Chapter 15: Ancillary and Other Cross-Border Cases
They are not numbered 1-9, because Title 11 used to have more chapters, and when chapters are repealed, the numbering does not change.
It is also good to know that some laws that can become relevant in bankcruptcy cases are found in other parts of the U.S. Code. Laws regarding bankcruptcy crimes are for instance found in Title 18 (Crimes) while Title 26 (Internal Revenue Code) is relevant for the tax implications of bankrupcty.
The Three Most Common Types of Bankruptcy in the U.S.
The most common types of bankruptcy for individuals and businesses are filed under Chapter 7, Chapter 13, and Chapter 11 of the U.S. Bankruptcy Code. Each type of bankruptcy has different eligibility requirements and outcomes.
Chapter 7 Bankruptcy (Liquidation)
Chapter 7 bankruptcy is designed for individuals or businesses that do not have the means to repay their debts. It is often referred to as liquidation bankruptcy because a court-appointed trustee may sell (liquidate) the debtor’s non-exempt assets to pay creditors. Once the assets are sold, most remaining unsecured debts are discharged, meaning they no longer need to be repaid.
- Who Can File: Individuals, partnerships, corporations, and other business entities.
- Eligibility: To qualify for Chapter 7, you must pass the means test, which compares your income to the median income in your state. If your income is below the median, you can file for Chapter 7. If your income exceeds the threshold, you may be required to file under Chapter 13 instead.
- Process: After filing, a trustee is appointed to oversee the sale of non-exempt assets. Many assets, like your primary residence, retirement accounts, and personal items, are often exempt from liquidation.
- Timeframe: Chapter 7 cases typically take 3-6 months to complete.
- Discharge: Most unsecured debts, such as credit card debt, medical bills, and personal loans, are discharged at the end of the process. However, certain debts like student loans, tax debts, alimony, and child support typically cannot be discharged.
Chapter 13 Bankruptcy (Reorganization Bankruptcy – Wage Earner’s Plan)
Chapter 13 bankruptcy, also known as a reorganization bankruptcy, is for individuals who have regular income and want to keep their property while repaying their debts over time. Instead of liquidating assets, Chapter 13 allows debtors to create a repayment plan to pay off their debts over a period of 3-5 years. Once the repayment plan period is completed, any remaining unsecured debts may be discharged, provided that the deptor carried out the plan correctly.
- Who Can File: Only individuals (including those who are self-employed) can file for Chapter 13. Businesses, organizations, etcetra can not file for Chapter 13 bankrupcty.
- Eligibility: You must have a regular source of income and your unsecured and secured debts must fall below specific limits. As of 2024, unsecured debt must be less than $419,275 and secured debt less than $1,257,850.
- Process: Debtors propose a repayment plan, usually over 3 to 5 years, based on their income and ability to pay. The plan must be approved by the court. During the repayment period, debtors make monthly payments to a trustee, who then distributes the funds to creditors.
- Timeframe: Chapter 13 plans typically last 3 to 5 years.
- Discharge: Once the repayment plan is completed, any remaining unsecured debts may be discharged. Unlike Chapter 7, you can keep your property (such as your home or car), provided you stick to the repayment plan.
Chapter 11 Bankruptcy (Reorganization for Businesses and High-Debt Individuals)
Chapter 11 bankruptcy is primarily used by businesses but can also apply to individuals with very high debt levels who do not qualify for Chapter 13. Chapter 13 bankrupcty is often used to allow businesses to continue operations while restructuring their debts and creating a plan to repay creditors over time.
- Who Can File: Corporations, partnerships, and individuals with large debts.
- Process: The business or individual proposes a reorganization plan to the court. The plan might involve restructuring debt, selling assets, or negotiating with creditors. The debtor continues to operate the business while working under the court’s supervision.
- Timeframe: Chapter 11 cases can take months to several years to resolve, depending on the complexity of the business and the debt structure.
- Outcome: Successful completion of a Chapter 11 reorganization plan allows the business to emerge financially stable, with its debt either discharged, reduced, or reorganized.
Bankruptcy Process
The exact process can vary depending on the type of bankrupcty, the debtor, and how complex the case is. Below is a general outline that will be true for some, but not all, bankrupcty processes in the United States.
- Filing the Petition
Bankruptcy begins with the debtor filing a petition in U.S. Bankruptcy Court. The petition includes detailed financial information, such as a list of assets, income, debts, and recent financial transactions. - Automatic Stay
Once the petition is filed, an automatic stay goes into effect. This halts all collection activities by creditors, including wage garnishments, foreclosure actions, and lawsuits. The automatic stay remains in place throughout the bankruptcy proceedings. - Meeting of Creditors (341 Hearing)
After filing, the debtor attends a meeting with the trustee and creditors, called a 341 meeting. Creditors have the opportunity to ask the debtor questions about their financial situation, though they rarely attend. The trustee will review the debtor’s financial information and clarify any issues. - Asset Liquidation or Repayment Plan:
- In a Chapter 7 bankruptcy, non-exempt assets are sold, and the proceeds are used to pay creditors. The court discharges remaining applicable debts once the liquidation process is complete.
- In a Chapter 13 bankruptcy, the debtor follows a court-approved repayment plan, making monthly payments to a trustee, who then distributes the funds to creditors. Once the plan is completed, remaining unsecured applicable debts are discharged.
- Debt DischargeAt the end of the bankruptcy process, most debts are discharged, meaning the debtor is no longer legally obligated to pay them. Certain types of debts, such as student loans, tax debts, and child support, are not typically dischargeable.
Certain Debts Cannot Be Discharged in Bankruptcy
Some types of debts cannot be discharged in a bankruptcy case, including:
- Student loans (except in rare cases of undue hardship)
- Alimony and child support
- Certain tax debts
- Debts incurred through fraud
- Court-ordered fines or penalties
- Personal injury debts resulting from driving under the influence (DUI)
Impact of Bankruptcy on Credit Report and Credit Score
Bankruptcy has a significant and long-lasting effect on your credit score and credit report.
- A Chapter 7 bankruptcy stays on your credit report for 10 years from the date of filing.
- A Chapter 13 bankruptcy remains on your credit report for 7 years from the date of filing.
While your credit score will drop considerably after filing for bankruptcy, you can begin rebuilding your credit in various ways. Here are a few examples:
- Paying bills on time Establishing a history of timely payments can help improve your credit score.
- Secured credit cards These cards require a deposit and are easier to obtain after bankruptcy than normal credit cards, allowing you to rebuild your credit responsibly.
- Monitoring credit
Regularly checking your credit report ensures that any errors or inaccuracies can be spotted and addressed.
What is DIP?
Under United States bankrupcty law, a debtor-in-possession (DIP) is a person or corporation who has filed a petition for bankcruptcy, but is still in possession of property upon which a creditor has a lien or similar security interest.
One common example of DIP is when a corporation files for Chapter 11 bankrupcty but continues to operate the business.
In some situations, U.S. law permits a DIP to keep the property by paying the creditor the fair market value instead of the contract price. This can for instance be the case when the property is a personal vehicle which has gone down in value since the contract was signed, and where the DIP needs the vehicle to find or keep employment in order to earn money that will be used to pay down debts.
What is DIP financing?
DIP financing is a special type of financing that may be provided for companies in financial stress, e.g. during restructuring under a Chapter 11 bankcruptcy.
In the United States, the debt incurred by the company through DIP financing is usually considered senior to all other debt, equity, and any other securities issued by the company. The normal absolute priority rule is thus taken out of play for this specific type of debt, as a new debt (the DIP financing) will come in late but still be treated as if it has seniority.
DIP financing with seniority is not uncontroversal, and it only exists in certain countries, of which the United States is one. The idea behind allowing this type of action is to get in enough resources to keep the business in operation until it can be sold as an active – as opposed to closed down – business. If the business were to be shut down instead, and the individual assets sold off, it would be likely to bring in less money for the creditors. Therefore, DIP financing can, under certain circumstances, be in the best interest of the creditors.
Pros and Cons of Filing for Bankruptcy
Pros:
- Debt Relief: Bankruptcy can discharge most of your unsecured debts, providing a fresh financial start.
- Automatic Stay: Filing for bankruptcy provides an automatic stay that stops creditors from collecting, garnishing wages, or foreclosing on your home.
- Asset Protection: Depending on the type of bankruptcy and the exemptions in your state, you may be able to keep important assets like your home, car, and retirement accounts.
Cons:
- Credit Impact: Bankruptcy severely damages your credit score and remains on your credit report for several years, affecting your ability to get new credit, loans, or mortgage loans. Just like any poor credit score, it can also impact other areas of your life, e.g. your ability to get certain jobs, to rent a home or property, and the ability to negotiate better conditions for insurance policies.
- Public Record: Bankruptcy filings are public records, meaning that anyone can access information about your bankruptcy case.
- Cost: Filing for bankruptcy involves court and legal fees, and in some cases, hiring a bankruptcy attorney can add to the cost.
Alternatives to Bankruptcy
Before filing for bankruptcy, consider exploring other options to manage your debt:
- Debt Consolidation
Combining multiple debts into a single loan with lower interest rates may help simplify your payments and reduce the overall cost of your debt. - Debt Settlement
In debt settlement, you negotiate with creditors to reduce the total amount of debt owed, often paying a lump sum for less than what you owe. Creditors sometimes agree to this, since they deem it being more beneficial to them than you filing for bankruptcy. Of course, it is only possible if you actually have a lump sum of money to use for it. Some lenders that offer debt consolidation loans also offer loans to be used for debt settlement. - Credit Counseling
Credit counseling services can help create a debt management plan (DMP) that allows you to pay off your debts over time, often with reduced interest rates or waived fees. - Loan Modification
If you’re struggling with mortgage loan payments, a loan modification might help by adjusting the terms of your loan to make the repayments fit better into you budget.