The Ins and Outs of Bankruptcy

The decision to file bankruptcy should not be taken lightly. Other options should be considered including debt settlement, debt consolidation, financial counseling, and additional income streams. Going bankrupt has many long-term consequences that can’t easily be undone.

If you’ve exhausted your options and can’t see a way out of your financial problems, consult with an attorney who specializes in bankruptcy. While bankruptcy is usually a measure of last resort, once undertaken it will shield you from creditors and may save your business.

There are three primary forms of bankruptcy which provide different approaches to resolving financial difficulties. Chapter 11 is not addressed in this article because it is used mostly by large corporations. Careful consideration should be given in deciding how you will file.

Chapter 7

Chapter 7 essentially discharges most of your debts, allowing you to start over with a clean slate. With the exception of certain necessities of life that are exempt, your property is liquidated to pay off secured creditors by apportionment. Legal rights to pledged collateral are generally maintained by the secured creditors. Any remaining funds are applied to unsecured debts, such as medical bills, credit cards, signature loans, utility bills, and amounts owed to retailers.

Certain debts are normally not discharged, including alimony and child support, government-imposed fines and penalties, delinquent taxes, government education loans, and loans from tax-advantaged retirement plans such as 401(k) accounts. Chapter 7 is available to businesses and individuals, and once invoked, it can’t be used again for eight years.

Chapter 13

Chapter 13 is known as a restructuring or reorganization because the debt remains, but is paid off according to a revised plan approved by a court. Both businesses and individuals can qualify. Rather than discharging debts, payments are normally reduced and rescheduled to allow the debtor more time to recover. You retain your assets so that you can keep your business operating.

To qualify for Chapter 13, you must have an income stream that is verifiable and likely to continue for the foreseeable future. It must be sufficient to repay creditors based on the restructured payment plan. The secured creditors have priority over unsecured creditors when determining the proportional share of the projected income.

If payments are made as scheduled, any unsecured debt still remaining upon conclusion of the plan is discharged. Unsecured creditors cannot legally attempt to recover unpaid balances after discharge.

Set-off

If you have multiple accounts at the same bank, there is usually a right of “set-off” where the balance in a checking or savings account can be used to satisfy unpaid loans or lines of credit. While this is not a frequent occurrence, be aware that it can happen even if you don’t declare bankruptcy. The best way to counteract this is to establish a checking account with a bank where you do no other business, and put most of your cash in that account.

If you file for bankruptcy, a bank that holds your loans is likely to freeze all your accounts and impose a set-off to minimize its exposure. This could result in bouncing checks and more unpaid bills. The solution is to use the new account in a different bank for your current living expenses.

Mortgage

If you own a home, Chapter 7 will likely result in the sale of the home to satisfy all or part of the unpaid mortgage. The effect of Chapter 13 is more complex because the mortgage debt is not forgiven. Bankruptcy judges do not currently possess the power to rewrite a mortgage contract. However, a bankruptcy filing does put debt collections on hold and temporarily stops any foreclosure actions.

The judge does have the power to consolidate debt, including the mortgage, and devise a repayment plan that is administered by a trustee who distributes the money to the creditors. The borrower would no longer be making payments directly to any creditors, including the mortgagor. This helps you to focus on improving your financial circumstances since your creditors can no longer hound you for late payments. They will now have to deal with the trustee, but you are on the hook to keep your payments to the trustee up to date.

Credit rating

Chapter 7 will have the most negative effect because your debt is eliminated and some creditors may receive nothing. It will remain in your credit file for ten years, making any new credit difficult and expensive to obtain. The advantage is that it gives you the opportunity to learn from your experience, start over, and hopefully not repeat the same mistakes.

Chapter 13 will hurt your credit, but not as severely since you are still paying your debts although at a reduced pace. If you use this approach, make sure you stick to the plan or you could end up going through Chapter 7.

Also make sure you understand the tax consequences of debt relief and how it might affect your spouse. For debt incurred by one spouse without the consent of the other, a discharge of that debt will not affect the other spouse. Any loans or credit cards that have been cosigned are the responsibility of both spouses, and nonpayment will affect both. Discharged joint debts will affect both credit ratings.

Summary

This article only scratches the surface of what occurs during a bankruptcy. Before any filing occurs, you’ll be required to pursue credit counseling to explore other less onerous options. While bankruptcy provides an interim solution, it has long-term consequences that should be carefully evaluated.

Filing under Chapter 7 will not leave you destitute. The amount you will be allowed to keep is subject to many factors and the judge’s determination of your individual case. Before filing, make sure you have maximized your legal exemptions to protect as many of your assets as possible. This is where the counsel of a bankruptcy attorney is invaluable since timing of the filing may be critical in protecting those assets.

Also, don’t underestimate the stigma associated with going bankrupt. For some, the embarrassment is temporary and the bankruptcy is a springboard that completely turns their lives around. Understand the big picture and get good advice before taking that plunge.

Michael Sanibel is a freelance writer specializing in business, marketing, personal finance, law, science, aviation, sports, automobiles, entertainment, travel, and political analysis. He graduated from the United States Air Force Academy and is also licensed to practice law in California and New Hampshire. Michael wrote this feature article exclusively for Debbie May.com (www.DebbieMay.com), an organization dedicated to helping small businesses succeed.