Bankruptcy law is designed to provide a “fresh start” from debt and sets up alternative remedies defined by the chapters of the U.S. Bankruptcy Code. A Chapter 7 bankruptcy proceeding, popularly known as “straight” bankruptcy, cancels most debt and expedites the straightforward liquidation of the debtor’s assets for the benefit of creditors. Chapter 13 bankruptcy, also known as a “wage earner plan,” restructures the debtor’s obligations so the debtor can repay them over time.
Chapter 7 Bankruptcy
A Chapter 7 liquidation proceeding may commence by a debtor filing a Voluntary Petition or by the debtor’s creditors filing an Involuntary Petition. In either case, the petition is filed with the bankruptcy court assigned to the area where the debtor lives or where his business and assets are principally located. A trustee is assigned to administer the case and to liquidate non-exempt assets. Exempt assets are those that the debtor can keep such as a portion of the equity in his home or motor vehicle, while non-exempt assets are those he must forfeit such as stocks or a vacation home. Upon completion of the case, the trustee transfers the net proceeds of the liquidated assets, if any, to the unsecured creditors, and the debtor is discharged from all eligible debts. In the majority of Chapter 7 cases, there are no assets for the trustee to liquidate.
Chapter 13 Bankruptcy
In a Chapter 13 proceeding, the debtor does not seek general forgiveness of debts, but instead submits a repayment plan that calls for fixed installments to creditors via the trustee for a period of three or five years. Chapter 13 plans classify debts into three categories: priority, secured and unsecured. The plan must provide for payment in full of priority claims, such as most tax obligations, and must pay secured creditors at least the value of any collateral that the debtor elects to keep. A creditor is considered a “secured creditor” if the debtor has executed a written voluntary lien that gives the creditor an interest in his property, such a mortgage holder. The balance of the debtor’s income received during the period of the plan, after allowance for qualified expenses, is paid to the unsecured creditors.
Eligibility for Bankruptcy Protection
A debtor may not file for bankruptcy protection if a previous bankruptcy proceeding was dismissed voluntarily or for cause within 180 days of the current filing. The debtor must also have received approved credit counseling within 180 days before filing. Qualification for Chapter 7 is subject to a “means test,” which ensures that filers who have sufficient income to repay a portion of their debt do so. If the debtor’s average net monthly income for the preceding 5 years exceeds a statutory amount determined by the state, the debtor’s filing is presumed abusive and will either be converted to a Chapter 13 proceeding or dismissed, unless the debtor can overcome the presumption. Individuals, including those who are self-employed, may qualify for Chapter 13 as long as their unsecured and secured debts are less than statutory thresholds that are periodically adjusted to the consumer price index.
Advantages and Disadvantages of Chapter 7
The principal advantage of Chapter 7 is that the debtor is discharged from personal liability for most financial obligations as of the date of filing of the petition. Chapter 7 proceedings are usually concluded quickly. The primary disadvantage is that the debtor loses ownership of all but narrowly defined “exempt assets,” such as limited equity in a home. These exemptions vary from state to state.
Advantages and Disadvantages of Chapter 13
The principal advantages of Chapter 13 are that it immediately stops most collection and foreclosure proceedings and grants the debtor the option of retaining many assets, rather than turning them over to the trustee for liquidation. The primary disadvantage is that the debtor must repay creditors, at least in part, pursuant to the 3- or 5-year wage earner plan.
The filing of a petition for bankruptcy under Chapter 7 or Chapter 13 operates as an automatic but temporary stay of all collection or foreclosure actions against the debtor and the debtor’s property, buying the debtor time to better plan for the orderly disposition of debts and assets. However, there are lasting consequences to bankruptcy, including impact on credit rating for up to 10 years.