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.

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.

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.

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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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What Does a Discharge in a Chapter 13 Bankruptcy Mean to Debtors?


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LLC & Bankruptcy

A limited liability company (LLC) is a form of business organization created by the laws of the state that organized it. Although it is treated as a partnership for tax purposes, it is treated as an independent legal entity for bankruptcy purposes. Failing LLCs generally choose one of two main types of bankruptcy, Chapter 7 or Chapter 11. Creditors may force an LLC into bankruptcy.

What Will Happen to My Business If I File a Personal Bankruptcy?

Bankruptcy may be a viable solution if your have more debt than you can handle. However, if you are involved in a business, the impact of your decision to file for bankruptcy could extend beyond your personal affairs. When a small business owner, entrepreneur or corporate shareholder files for bankruptcy, there can be consequences for business management, its partners or shareholders and assets. Whether your business assets are vulnerable to claims by creditors depends on how your business is legally organized.

Laws on Debt Forgiveness Through Chapter 13

When debt piles up, individual debtors may need the structure of a bankruptcy case to get back on their feet again. If you qualify, bankruptcy offers protection from collection efforts and a chance to partially erase some debts while paying others. An online legal services provider can help you file your bankruptcy case.

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