What is Bankruptcy? Easy Explanation
By Vladana Donevski
June 19, 2023
When sifting through information on bankruptcy, people tend to consider it a horrifying and lengthy legal process that can leave them in permanent financial ruin from which they can never fully recover.
They may also assume that declaring bankruptcy will act as a magical off-switch and bring financial relief to anyone on the road to financial disaster by eliminating all of their debts.
Neither of these assumptions is necessarily true, as the definition of bankruptcy simply involves legally declaring that you can no longer repay your debts.
This article will seek to dispel these myths by providing information to ultimately answer the question: what is bankruptcy?
Bankruptcy Explained
Bankruptcy is a legal action whereby a person or a company can legally declare that they can no longer repay their debts in front of a bankruptcy court. By doing so, they may be granted relief by being discharged from bankruptcy.
In the United States, bankruptcy proceedings are governed by federal law under six specific chapters of the US Bankruptcy Code. Claiming bankruptcy is achieved by filing under a specific bankruptcy chapter. However, only four are meant for individuals and businesses out of six chapters, as Chapter 9 deals with municipalities, and Chapter 15 is used in foreign cases. Our focus will be on chapters 7, 11, 12, and 13.
These four different bankruptcy types are categorized based on the parties to the bankruptcy: whether they are an individual or company and the type of legal action or relief sought. Bankruptcy proceedings are achieved through two types of legal action: liquidation and reorganization.
Liquidation happens when you file for bankruptcy, and your assets are sold and the proceeds distributed to creditors to repay debts. Filing for Chapter 7 bankruptcy, which is the most common filing, leads to the liquidation of your assets. However, claiming bankruptcy is not limited to declaring that you can’t pay your debts and then asking the court to sell your assets to pay the creditors back.
Filing for bankruptcy can also mean seeking assistance from the court in reorganizing your property to allow you to pay off individual or company debts.
Reorganization bankruptcy filings are different from liquidation filings because, in most circumstances, they allow individuals and companies to keep their property.
The different bankruptcy types and their legal implications are summarized below:
- Chapter 7 – Personal or liquidation bankruptcy, best for individuals and businesses
- Chapter 11 – Business or large reorganization bankruptcy
- Chapter 12 – Debt relief for family farmers and fishermen
- Chapter 13 – Wage earner’s plan, best for individual income earners
Millions of people file for bankruptcy each year. The purpose of filing for bankruptcy and the end goal of any related proceeding is to be discharged from bankruptcy.
Common reasons for filing for bankruptcy are large medical bills, unemployment, loss of a family member, natural disaster, or business failure.
What Happens if I Declare Bankruptcy: Individual Bankruptcy Explained
Filing for bankruptcy involves submitting a bankruptcy petition to the bankruptcy court clerk. The court may liquidate or restructure some of your property depending on the type of bankruptcy you’ve claimed. The discharge will ensure that creditors will not chase that debt again in a few years if you do not have sufficient assets to cover your debts.
Chapter 7 bankruptcy, for example, will allow the court to gather and sell your assets to pay your creditors and create relief by preventing them from taking further action to collect debts, such as harassing you or pursuing legal action against you.
In case of any bankruptcy filing, creditors must stop all action, including legal action to recover the debt and broad measures such as debt collection calls, letters, and personal contact.
Your bankruptcy petition must disclose and outline all your financial and personal information, including a detailed list of all assets and liabilities, a list of creditors and the amounts owed to each party, and any income statements and tax records, including the latest tax returns.
It’s important to note that filing and administrative court fees are involved. Depending on your circumstances, the court may waive filing fees or require you to pay the fees in installments.
What Happens After Filing for Bankruptcy?
The court assigns a bankruptcy trustee to meet with you to evaluate your financial situation and arrange for the collection of your assets. The trustee then sells non-exempt assets and redistributes the proceeds to your creditors.
The total length of bankruptcy proceedings can average between three to six months. Upon completing the case, you will be discharged from your debts.
Being discharged from bankruptcy means that most remaining debts are fully forgiven. This includes almost all types of unsecured debts:
- Credit card debt
- Unsecured loans
- Personal loans
- Medical bills
- Utility bills
As well as some secured debts such as:
- Home mortgages
- Auto loans
- Tax liens
When dealing with secured debts, the ones backed by mortgage or collateral, you’ll usually have a choice to make. You can allow creditors to repossess the property that secures the debt, continue to make payments to your creditor, or pay a sum equal to the collateral’s replacement value.
Can All Debts Be Forgiven?
Not all debts will be discharged or forgiven after declaring bankruptcy. Certain types of debts will remain:
- Student loans
- Court fees
- Child support
- Spousal maintenance/spousal support payments
- Obligations arising due to fraud
- Obligations arising related to personal injury claims
- Government fines and federal, state, and local taxes
Who Can Claim Chapter 7 Bankruptcy?
Chapter 7 bankruptcy is the most common claim for individuals. However, claiming bankruptcy this way may not be available to all. There is a presumption of abuse in place, meaning that you must pass the means test before filing. This test is compulsory and ensures the bankruptcy laws are not abused, and court resources are not wasted.
The means test prevents high-income earners from qualifying for Chapter 7. To pass the means test:
- Before claiming, your household income must be below your state’s median income for six months.
- You must carefully gather a list of all your expenses and divide them into allowable and non-allowable expenses.
Your non-allowable expenses are expenses that could be put towards paying off any debts. The remaining expenses and any of your disposable income must be low enough to qualify for filing.
A bankruptcy lawyer can assist you with going through your expenses and determining whether filing under Chapter 7 is the right course of action for you. Access to legal representation can be costly, but you can explore alternatives with our guide to the best online legal services.
Petitioning To Keep Your Property in Bankruptcy Proceedings
When declaring bankruptcy, you can petition to keep some of your property. This includes the furniture in your home, your clothes, and in some instances, your house and personal vehicle. What you get to keep when filing for bankruptcy could depend on the state you live in.
In the US, bankruptcy filings are governed by federal law, but the personal bankruptcy law on the excluded property varies from state to state. Therefore, the types of property you may get to keep will vary depending on where you live.
Bankruptcy lawyers are generally employed to assist you in successfully negotiating to keep your property. There is no hard and fast rule on what you will get to keep, as it depends on your circumstances.
Chapter 7 and Student Loans
Going through the bankruptcy process to relieve yourself from repaying student loans might not be the best idea, as bankruptcy won’t necessarily protect you from this obligation.
Student debt is considered unsecured debt and will not be automatically discharged by the court. Instead, you’ll need to commence additional legal proceedings known as adversary proceedings and successfully establish that the continuation of student loan repayments will cause you undue hardship.
The student loan provider may oppose your claim, and you will need to prove it according to legal standards set by the federal court.
Other Types of Bankruptcies: Chapters 11, 12, and 13 Explained
Bankruptcy chapters 11, 12, and 13 do not involve liquidation. Some companies and individuals may wish to restructure their finances to pay off their debts over the long term or decide on a different approach to bankruptcy.
Chapter 11 of the Bankruptcy Code allows companies and business partnerships to continue their operations and keep their property by asking them to create and carry out the terms of a formal plan to pay off their debts. This claim is commonly referred to as company bankruptcy, and it can force companies to completely restructure their operations.
Restructuring is usually achieved by encouraging leadership changes, closure of facilities, and the renegotiation of debts. The main benefit is that the company can avoid liquidating its assets in the short term and continue operations.
Chapter 13 of the Bankruptcy Code is also called a wage earners plan. It allows individuals to reorganize their debt through a formal debt repayment plan based on their income for the last three to five years.
Chapter 13 filing is limited to wage earners, allowing them to keep their property. Individuals must have a regular income and are expected to repay as much debt as possible through regular monthly installments.
Lastly, Chapter 12 of the Bankruptcy Code is similar to Chapter 13, except it’s only available to family farmers and fishers with regular annual income.
Final Thoughts
Bankruptcy may seem like a scary word, but it doesn’t have to be. By understanding the basics of bankruptcy and what it can do for you, you’ll be able to decide whether or not this is the right step for yourself or your business. If you’re feeling overwhelmed by debt and don’t see any other way out, bankruptcy could be the solution.
Personal bankruptcy filings may remain on your credit history report for 10 years and directly impact your ability to receive approval for future loans. Thankfully, there are alternative business loans for bad credit providers available.
Bankruptcy can provide a fresh start, but choosing the right chapter is important. If you are considering bankruptcy, it’s best to consult with an experienced attorney who can guide you through the process and protect your rights.