What Is the Difference Between Insolvent & Bankrupt?

By Cindy Hill

The terms "insolvent" and "bankrupt" are used informally to mean an uncomfortable lack of assets and monetary resources. In legal terms, however, these words mean something more specific than simply being broke. Insolvency -- a tax code term -- relates to the ability to qualify for certain income tax benefits, and bankruptcy -- a legal process -- resolves debts with the court's oversight.

The terms "insolvent" and "bankrupt" are used informally to mean an uncomfortable lack of assets and monetary resources. In legal terms, however, these words mean something more specific than simply being broke. Insolvency -- a tax code term -- relates to the ability to qualify for certain income tax benefits, and bankruptcy -- a legal process -- resolves debts with the court's oversight.

Business Insolvency

There are two different types of insolvency related to business: cash flow and balance sheet. When a business experiences cash flow insolvency, it does not have the monetary assets to pay its bills or debts as they become due. Balance sheet insolvency means that a business's total debts outweigh its total assets. A business may be cash flow insolvent but still has significant non-cash assets such as real estate, equipment and inventory. As such, a business with long-term debt, like a mortgage, may be balance-sheet insolvent, but still capable of paying its monthly bills from cash-flow revenues. It is not unusual for businesses to operate successfully for an extended period of time in a state of balance sheet insolvency.

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Personal Insolvency

A person is insolvent when his total debts exceed the value of his total assets, but some insolvent individuals may be able to meet their monthly financial obligations even though their mortgage, student loans, credit card or medical debt exceed the value of their assets. However, individual insolvency usually means that a person cannot pay his bills on time. Under federal tax rules, canceled debts are considered taxable income, unless the taxpayer can demonstrate insolvency. Debt may be canceled by negotiation or asset repossession, and by virtue of a mortgage revaluation program. A taxpayer who can demonstrate insolvency by using the Internal Revenue Service insolvency worksheet may be able to exclude cancelled debt from his taxable income.

Bankruptcy

The term bankrupt is used colloquially to refer to the state of being in a bankruptcy proceeding, but as a legal term, bankrupt refers to the person who is the subject of a bankruptcy court action filed under the United States Bankruptcy Code. The bankruptcy court may extinguish some or all of the bankrupt's debts, or may restructure those debts, depending on the type of bankruptcy action filed and the bankrupt's assets and obligations.

Differences and Considerations

To receive the protection of the bankruptcy court in resolving debts, the person or business filing for bankruptcy must demonstrate insolvency. However, merely being insolvent does not make a person bankrupt. Some insolvent individuals and businesses avoid filing for bankruptcy by finding ways to pay their bills such as selling assets, taking on additional employment or renegotiating debt. Filing for bankruptcy brings negative consequences including lowering the bankrupt's credit score. Investors are warned away from investing in businesses involved in bankruptcy proceedings.

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Laws on Debt Forgiveness Through Chapter 13

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Can I File Bankruptcy if I'm Not Late on My Payments?

If a financial storm is brewing, you have the option to file for bankruptcy protection. The federal bankruptcy code allows individuals, couples and businesses to go through this process in order to discharge debts and get a financial fresh start, if absolutely necessary. The bankruptcy laws, and a sweeping bankruptcy reform passed by the government in 2005, govern who may file for bankruptcy.

Schedule F Bankruptcy Discharge

Bankruptcy means a fresh start – a court order protects you from collections and lawsuits, and eventually, the court discharges (cancels) some of your debts. You must report your assets and liabilities, and you will be required to sell your non-exempt property to repay creditors (in Chapter 7) or set up a repayment schedule (in Chapter 13). As your bankruptcy case begins, you'll complete a Schedule F, and it's vital to know the difference between a secured and unsecured debt when preparing this form.

LLC Bankruptcy Laws

The bankruptcy laws pertaining to limited liability companies are hazy. The United States Bankruptcy Code contains no specific provisions for LLCs, so bankruptcy courts often look to state laws to decide what to do when such a company files for protection. However, some trends have developed since states began to recognize LLCs as legal entities in the 1980s, even though there are few hard and fast rules.

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