- Bankruptcy is a legal procedure that gives individuals or businesses options when they can't pay their debts.
- The U.S. bankruptcy code has six types of bankruptcy, each tailored to specific situations.
- While a bankruptcy filing can provide immediate debt relief, it will hurt your credit for up to 10 years.
Bankruptcy is a legal process that allows individuals and businesses to resolve outstanding debts owed to creditors while offering them some protection during the process. There are restrictions on the types of bankruptcy you're allowed to file. How you file depends on whether you are an individual or a business, your level of income, and the kind of debt you have.
Overview of bankruptcy
The purpose of bankruptcy is two-fold. First, it assists creditors in dealing with an insolvent debtor. Second, it allows individuals and businesses a chance to start fresh after a financial downfall. Bankruptcy can also preserve a business's assets by allowing distressed companies to reorganize rather than liquidate.
"Congress has created courts of specialized jurisdiction — federal bankruptcy courts — to handle such cases in accordance with a statute, the United States Bankruptcy Code, which Congress enacted in 1978," says Keith Sharfman, professor of law and director of bankruptcy studies at St. John's University.
Bankruptcies generally fall into two main categories: liquidations and reorganizations. Liquidation refers to selling off some property to pay for most debts, while reorganizations allow businesses or individuals to restructure their debt and repay it over time.
Businesses or individuals can declare bankruptcy when they cannot repay their debts with their income. When an individual files for bankruptcy, a court decides to either sell off their assets to pay for their debts or to reorganize their debt to make repayment possible.
Types of bankruptcy
The United States Bankruptcy Code establishes six different ways to declare bankruptcy. However, "many of these six types of bankruptcies ultimately don't apply to the average individual," says Ben Michael, an attorney at Michael & Associates. Choosing the right type of bankruptcy requires careful consideration.
The most common types of bankruptcies are Chapter 7, Chapter 11, and Chapter 13. These are the chapters available to businesses and individuals to file.
Here's a brief overview of the bankruptcy chapters commonly filed, followed by more detail below:
| Chapter 7 | Chapter 11 | Chapter 13 | |
| Individuals | Liquidate assets and discharge remaining debt (only for people under a certain income level) | Only available to people with debts exceeding $2.75 million | Reorganize finances and create payment plan over three to five years |
| Businesses | Liquidate assets and shut down business | Reorganize debts while staying in business | Unavailable |
Overview of Chapter 7 bankruptcy
Chapter 7 bankruptcy is known as liquidation bankruptcy, as it involves the liquidation of a debtor's assets to pay off unsecured debts such as credit cards, personal loans, and medical bills, explains Terry Duncan, a bankruptcy attorney and board-certified specialist in consumer bankruptcy at Duncan Law. Open to businesses and individuals, Chapter 7 is usually the fastest and least expensive way to declare bankruptcy, making it an attractive option for many distressed debtors.
Eligibility requirements
You must have a significant amount of debt, primarily consumer debt, and your monthly income over the past six months has to be lower than the median income for a household of the same size in your state. Basically, you have to show that you can no longer afford to pay your creditors and have accumulated significant debt.
Under Chapter 7, debtors may have their unsecured debt discharged, but it comes at a high cost. Debtors who file for Chapter 7 bankruptcy are normally required to sell many of their non-exempt assets, explains Miriam Galston, a law professor at George Washington University Law School who teaches bankruptcy.
Although liquidating assets sounds scary, Rosenblum says that many individuals can protect most, if not all, of their assets by having them classified as exempt from liquidation. Property considered essential, such as a car or house, is usually exempt and protected from liquidation. Non-exempt property includes vacation homes, luxury cars, and collectible items. However, exempted property varies by state, so this won't hold true in every situation.
Process and duration
During Chapter 7 proceedings, a court-appointed trustee sells all non-exempt assets. "After these assets are sold and the proceeds distributed, most remaining debts are discharged or eliminated," Duncan says. This process usually takes four to six months. It may be a good choice for those who cannot pay their debts because it's a relatively fast and inexpensive way to declare bankruptcy.
However, Chapter 7 won't cover all debts. "Student loans, most taxes, child support, and alimony usually can't be discharged," under Chapter 7, Duncan says. It's not impossible to get your loan discharged if your student loan is in default, but it is difficult given that you'll need to meet the definition of what the U.S. Bankruptcy Code calls an "undue hardship."
Additionally, secured debt, such as a house purchased with a mortgage, is not dischargeable, Galston says. Instead, a creditor can seize a secured asset and sell it to recoup some of what they are owed. Any remaining debt then becomes unsecured. That means that even if your house is considered an essential asset, a bank may still be able to seize your home if you are behind on your mortgage payments.
Pros and cons of Chapter 7
Once Chapter 7 proceedings are over, individuals get a clean, debt-free slate, although they may lose many of their possessions and see a significant hit to their credit score. However, it's not for everyone. "Individuals with significant assets they don't want to lose should avoid Chapter 7 bankruptcy," Duncan says. It's also possible to make too much money to qualify for Chapter 7. Like property exemptions, income maximums also vary by state.
Filing for Chapter 7 bankruptcy typically costs about $400, although there may be other fees, including paying an attorney if a debtor uses one. When businesses file for Chapter 7, they liquidate their assets and cease to exist.
Overview of Chapter 13 bankruptcy
Chapter 13 bankruptcy allows debtors to reorganize their debts. This type of bankruptcy is "designed for debtors with regular income who can pay back at least a portion of their debts through a repayment plan," Duncan explains. Open exclusively to individuals, it's often chosen as an alternative to Chapter 7.
According to Duncan, most people who chose Chapter 13 bankruptcy make too much money to file for Chapter 7, have a house or car they want to keep, or they want to keep other non-exempt property that they would be required to liquidate under Chapter 7.
Eligibility requirements
Chapter 13 distinguishes itself from other types of bankruptcy by requiring debtors to develop a plan to pay back creditors, Duncan says. Chapter 13 repayment plans allow debtors to catch up on mortgage or car payments, develop a plan, and pay off non-dischargeable debts like most taxes and child support payments. Those who file for Chapter 13 "sometimes pay only pennies on the dollar on their unsecured debts," Duncan says. However, the debtor must agree to pay at least as much as a debtor would have received under Chapter 7 liquidation proceedings. Significantly, creditors cannot seize their assets as long as debtors make payments under their repayment plans.
Process and duration
Chapter 13 bankruptcy is for individuals only. The process usually takes three to five years, depending on the repayment plan terms, Duncan says. Filing for Chapter 13 bankruptcy costs under $400, but other fees will vary, including attorney's fees. It is usually more expensive than undergoing Chapter 7 bankruptcy but "is considerably cheaper than Chapter 11," says Rosenblum.
Pros and cons of Chapter 13
Your credit score will decrease if you file for Chapter 13, although your overall financial situation will likely improve. Chapter 13 is not a good choice for those who do not have sufficient income to make regular payments under a repayment plan or who cannot commit to making payments over several years.
Overview of Chapter 11 bankruptcy
Chapter 11 bankruptcy allows corporations to restructure their debt and stay in business. While individuals can file for Chapter 11 bankruptcy, this is rare and usually only makes sense for some very wealthy individuals, says Rosenblum.
Eligibility requirements
Although Chapter 11 bankruptcy is available to almost anyone who wants to reorganize their finances when a distressed company chooses Chapter 11, it retains control of its assets and can stay in business, says Jonathan Carson, CEO of bankruptcy services firm Stretto. Under Chapter 11, a corporation develops a plan to reorganize its finances and operations, he says.
Process and duration
When undergoing Chapter 11 proceedings, many types of business debts can be renegotiated, such as credit card debt, unsecured loans, and some taxes. However, "creditors get to vote on whether or not to accept the plan of reorganization," which can involve a lot of negotiations, according to Rosenblum. Individuals filing for Chapter 11 undergo the same process of developing a repayment plan and restructuring their finances.
Pros and cons of Chapter 11
One of the most attractive features of Chapter 11 bankruptcy is that filers get an automatic stay when they file for Chapter 11. An automatic stay means that the creditor cannot attempt to collect any debts until bankruptcy proceedings are over. However, any debt that has not been renegotiated will still need to be repaid eventually.
Rosenblum cautions that Chapter 11 bankruptcy proceedings are expensive. Filing for Chapter 11 costs about $2,000. In addition, "$30,000 in legal fees would be considered low," Rosenblum says. The process can also take several years, depending on the terms of the reorganization plan.
Other types of bankruptcy
The other types of bankruptcy are less common than those mentioned above. They include:
- Chapter 9: Municipalities like cities, towns, or villages can file for bankruptcy using this type of bankruptcy. Orange County, California, infamously filed for Chapter 9 bankruptcy in 1994.
- Chapter 12: This type of bankruptcy focuses on offering debt relief to family farmers and fishermen.
- Chapter 15: Cross-border cases go under Chapter 15, such as when a US court must recognize and work with a foreign court.
Overview of Chapter 9 bankruptcy
Chapter 9 bankruptcy is only available to municipalities and is the only bankruptcy chapter distressed municipalities can use. For purposes of Chapter 9, the term "municipalities" includes a range of entities such as cities, counties, townships, public improvement districts, and school districts. Chapter 9 protects municipalities from creditors while they develop a plan for repaying their debts, explains Wayne Bechtol, a Certified Finance Professional and Senior Tax Accountant with Fiona.
Because municipalities are obligated to provide essential services to constituents, they often cannot sell off assets. Instead, this protection comes in the form of an adjustment plan. The adjustment plan can extend the amount of time a municipality has to pay off its debt, reduce the amount of principal or interest the municipality owes, or allow the municipality to obtain a new loan with more favorable terms to pay off existing loans.
Overview of Chapter 12 bankruptcy
Chapter 12 bankruptcy is similar to Chapter 13 in many ways, but only farmers in distress can apply for bankruptcy under this chapter.
To qualify for Chapter 12 bankruptcy, distressed farmers must have "regular income." Bechtol explains that Chapter 12 allows farmers to develop a repayment plan and liquidate assets. Typically farmers will have three to five years to repay their creditors under Chapter 12. While undergoing Chapter 12 bankruptcy, farmers can continue operating their farms.
Some farmers opt to file Chapter 12 bankruptcy instead of Chapter 13 because they have more rights under Chapter 12. For example, under Chapter 12, farmers can take more time to develop their repayment plan and may have more time to pay off some debts than they would under Chapter 13.
Overview of Chapter 15 bankruptcy
Chapter 15 bankruptcy is relatively new. It was added to the Bankruptcy Code in 2005. The goal of Chapter 15 bankruptcy is to "promote cooperation and communication between US courts and parties of interest with foreign courts and parties of interest in cross-border cases," according to the United States Bankruptcy Court.
Typically, Chapter 15 is used by a foreign company in financial distress that has assets in the US. By filing for Chapter 15 bankruptcy, foreign companies undergoing insolvency proceedings in their home country may be able to have those proceedings recognized in the United States and obtain relief from American creditors. According to Rosenblum, Chapter 15 bankruptcies are very rare.
The bankruptcy process
There are two ways to get into bankruptcy for an individual: by filing a bankruptcy petition voluntarily or through a petition filed by their creditors. While creditors can force an individual debtor into bankruptcy, it's far more common for them to file a voluntary petition, Sharfman says.
Filing for bankruptcy is a highly complicated process that will require an attorney.
Initial steps and filing
As the quickest and, as a result, cheapest bankruptcy to declare, Chapter 7 is the most common bankruptcy filing. It's a popular option for people declaring medical bankruptcy. That said, Chapter 7 bankruptcy isn't available to all individuals.
To qualify for Chapter 7 bankruptcy, you must pass a means test, which consists of two stages. If you can prove that you make less than your state median income, you qualify for Chapter 7. If your income exceeds the state median, you need to subtract your monthly expenses from your income. The more money you have left over, the less likely you'll pass. If you cannot pass the means test, you can still file for Chapter 13 bankruptcy.
If you're filing for Chapter 13 bankruptcy, you must submit a payment plan proposal showing how you will pay off your debts over the next three to five years.
Chapter 13, also called the wage earner's bankruptcy, is typically used in cases of high-earning individuals. Rather than liquidating assets, Chapter 13 reorganizes debt and creates a repayment plan over three to five years. One advantage of Chapter 13 over Chapter 7 is that debtors may be able to save their homes from foreclosure because they will start a repayment plan.
To be eligible for Chapter 13 bankruptcy, you must owe less than $2,750,000 between your unsecured and secured debts.
Once you have filed for bankruptcy protection, an automatic stay makes it illegal for creditors to pursue you to repay your debt. They can not contact you in any way without court approval.
Businesses have two main options for filing bankruptcy: Chapter 11 and Chapter 7.
Chapter 11 bankruptcy is the most common route for businesses going through bankruptcy. Chapter 11 gives businesses an opportunity to restructure their debts and finances while staying operational. If a business cannot successfully manage its finances, its filing converts to Chapter 7, in which it liquidates its assets and ceases to operate. Only individuals can discharge debts. Partnerships and corporations don't have that right because they can simply stop operating instead.
"Basically, what Chapter 11 does is ask the following question: Is this company more valuable if it continues as a going concern, or is it more valuable to creditors if it's liquidated?" says Sharfman.
While individuals can technically file for Chapter 11 bankruptcy, they need to have $2.75 million in debt.
Credit counseling requirements
As an individual filing for bankruptcy, you'll need to complete credit counseling with an approved agency and be able to provide the debt management plan created in counseling. When you submit your bankruptcy petition, you will need to include information on your income, expenses, debts, assets, and any outstanding contracts or leases.
Bankruptcy discharge
In Chapter 7, nonexempt assets are liquidated to pay off debts. Essential properties, such as your primary residence or even vehicles under a certain value, may be exempt from liquidation. Each state has its own set of exemptions for bankruptcies, so be aware of them when determining what would be considered an exempt asset if you're considering filing for bankruptcy.
Once those items have been sold off and the proceeds distributed to creditors, the debtor usually receives a discharge on their remaining debts, which means they aren't on the hook to pay back certain debts after the bankruptcy. Discharge occurs in 99% of individual Chapter 7 cases.
"For the honest but unfortunate bankruptcy debtor, most debts would be dischargeable to the extent that they can't be paid off with the assets available to fund an estate in Chapter 7," says Sharfman.
Some debts are nondischargeable, like student loans or child support.
Pros and cons of bankruptcy
Bankruptcy is not your only option for getting out of debt. Deciding whether to declare bankruptcy requires careful consideration.
"Anyone thinking about filing for bankruptcy should consider, with the help of competent bankruptcy counsel, both the benefits and the costs," says Sharfman. The potential consequences include a loss of privacy with the public disclosure of your assets and liabilities, and the inability to file again for a bankruptcy discharge for at least eight years.
Here are some of the main benefits and drawbacks of filing a personal Chapter 7 bankruptcy:
Pros | Cons |
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Bankruptcy can be a valuable tool for individuals or corporations struggling with debt they cannot afford to repay. It can provide a fresh start that many need to get back on track.
Alternatives to bankruptcy
However, bankruptcy is not the best option for everyone.
If you're drowning in debt, a few debt relief options may help keep you afloat, such as debt consolidation, debt settlements, or debt management plans. However, when the best debt settlement services fail to get you out of debt, filing for bankruptcy may be your last resort.
Frequently asked questions about bankruptcy
While you can theoretically file for bankruptcy without a lawyer, legal counsel is highly advised as the bankruptcy process is highly litigious.
Yes, there is no limit to how often you can file for bankruptcy. However, you will need to wait anywhere from two to eight years after your first bankruptcy, depending on the type of bankruptcy you previously filed and what you're filing now.
There are certain debts that just cannot be discharged in bankruptcy, like child support, alimony, and most student loans.
Yes, businesses can file for Chapter 7 bankruptcy, but Chapter 11 is more common for businesses seeking to reorganize their finances and stay in business.
A Chapter 7 or Chapter 11 bankruptcy will stay on your credit report for 10 years. A Chapter 13 bankruptcy will stay on your credit report for seven years.
