Chapter 7 Bankruptcy: What It Is, How It Works, Ramifications

What Is Chapter 7 Bankruptcy?

Chapter 7 bankruptcy is a legal process where a debtor's non-exempt assets are liquidated to pay off creditors. This type of bankruptcy allows individuals or businesses to discharge most of their debts, providing a fresh start. However, it may require the forfeiture of certain assets to satisfy creditors.

How Does Chapter 7 Bankruptcy Work?

In Chapter 7 bankruptcy, the absolute priority rule stipulates the order in which debts are to be paid. Under this rule, unsecured debt is separated into classes or categories, with each class receiving priority for payment. Secured debt is debt backed or secured by collateral to reduce the risk associated with lending, such as a mortgage.

Unsecured priority debts are paid first. Examples of unsecured priority debts are tax debts, child support, and personal injury claims against the debtor. Secured debts are paid next. Last is the payment of nonpriority, unsecured debt with funds remaining from the liquidation of assets. If there are not sufficient funds to pay the nonpriority unsecured debt, then the debts are paid on a pro-rata basis.

The Bankruptcy Process Explained

The bankruptcy process consists of the following four steps:

Step 1: Counseling and Forms

Filers must first undergo credit counseling within six months of filing before they begin the Chapter 7 bankruptcy process. If there is no approved counseling agency in the district, they may forgo this step. Other exceptions may apply depending on the debtor’s circumstances.

The applicant must complete several forms, including a petition to the court, to begin the official Chapter 7 proceedings. The forms detail personal information, such as the debtor’s finances, creditors, assets, income, and expenses. After filing the petition, an automatic stay is in effect that prevents creditors from collecting on their debt. The stay also halts and prevents income garnishments.

Step 2: Trustee Appointment and Meeting of Creditors

The bankruptcy court will appoint an unbiased trustee to oversee the entire bankruptcy process. They will review assets and determine which assets can be liquidated to pay creditors. The trustee then schedules meetings with the creditors, where the validity of the petition and finances is confirmed. As the name suggests, the “meeting of creditors” allows them to meet with the trustee and the debtor to ask questions.

Step 3: Debt Repayment

The bankruptcy trustee reviews the personal assets and finances of the debtor. Exempt property—or property necessary to maintain basic standards of living—is retained by the debtor. Nonexempt property is seized and liquidated to pay creditors. Property exemptions vary in each state. However, in many cases debtors are allowed to keep their primary home, personal possessions, and car. The trustee then oversees the liquidation of all other property.

Step 4: Discharge of Remaining Debt

Most debts are discharged under a Chapter 7 bankruptcy. The discharge of debt will release the debtor from any personal liability for payment. Once a deficit is discharged under Chapter 7, the creditor may no longer seek future restitution from the creditor. Obligations relating to alimony, child support, some government debts, income taxes, and federal student loans are not allowable for release during bankruptcy. The law is very restrictive on discharging money owed for income taxes and student loans. The United States Bankruptcy Code lists 19 categories of debts that are not dischargeable. In most instances, filers receive a discharge approximately two months after the creditors meet.

Qualifying for Chapter 7 Bankruptcy

Eligibility for Chapter 7 bankruptcy primarily hinges on passing the means test, a financial assessment tool used to determine whether an individual's income is low enough to qualify for debt relief under Chapter 7. We'll talk more specifically about that means test in the next section.

Apart from income requirements, other criteria affect eligibility for Chapter 7 bankruptcy. As mentioned above, debtors must complete a credit counseling course from an approved agency within 180 days before filing. This course helps ensure that individuals understand their financial situation and explore possible alternatives to bankruptcy. Additionally, debtors cannot have had a Chapter 7 discharge within the previous eight years or a Chapter 13 discharge within the previous six years. These time restrictions prevent abuse of the bankruptcy system.

Businesses can also file for Chapter 7 bankruptcy, but they are not subject to the means test. For a business, Chapter 7 involves liquidating assets to pay creditors and then closing down operations. This is often the best option for businesses with insurmountable debt and no viable path to profitability. Whether for individuals or businesses, meeting the eligibility criteria for Chapter 7 bankruptcy provides a pathway to financial relief and a fresh start.

Chapter 7 Bankruptcy and the Means Test

The means test for Chapter 7 bankruptcy is a financial assessment tool designed to determine whether an individual's income is low enough to qualify for debt relief under Chapter 7. This test was implemented as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

The first step in the means test is to calculate the debtor's current monthly income. This includes all sources of income, such as wages, salaries, bonuses, business income, rental income, interest, dividends, and any other form of monetary compensation received over the last six months. The total income is then divided by six to determine the average monthly income. This figure is then annualized by multiplying it by 12 to compare it with the state median income for a household of the same size.

If the debtor’s income is below the state median, they automatically qualify for Chapter 7 bankruptcy, and no further calculations are necessary. However, if the income exceeds the state median, additional calculations are required to determine the debtor’s disposable income. This involves subtracting allowable expenses from the average monthly income. If a debtor reports totals that are above the threshold, this indicates that the debtor has sufficient income to repay a portion of their debts, and they may be required to file for Chapter 13 bankruptcy instead. We'll discuss Chapter 13 bankruptcy later.

Advantages of Chapter 7 Bankruptcy

One of the primary advantages of Chapter 7 bankruptcy is the discharge of most unsecured debts including credit card debt, medical bills, personal loans, and utility bills. This discharge eliminates the debtor's legal obligation to repay these debts.

Filing for Chapter 7 bankruptcy triggers an automatic stay, which immediately halts most collection actions by creditors. This includes stopping wage garnishments, foreclosures, repossessions, and harassment from debt collectors. The automatic stay provides immediate relief and stability, giving the debtor time to navigate the bankruptcy process without the pressure of ongoing collection efforts.

While Chapter 7 involves liquidating non-exempt assets, debtors can keep certain exempt assets which vary by state. These exemptions ensure that debtors can maintain a basic standard of living post-bankruptcy. Plus, unlike Chapter 13 bankruptcy which requires a repayment plan, Chapter 7 does not involve a repayment plan.

Downsides to Chapter 7 Bankruptcy

Filing for Chapter 7 bankruptcy does have downsides, starting with the severe negative impact on a debtor’s credit score. The bankruptcy remains on the credit report for up to 10 years. The initial drop in the credit score can be substantial, affecting the debtor’s ability to make major purchases like a home or car.

Though a debtor may keep their exempt assets, they still lose their non-exempt assets. This liquidation can result in the loss of personal belongings and investments. Plus, not all debts can be discharged in Chapter 7 bankruptcy. Certain obligations such as student loans, child support, alimony, or recent tax debts may be non-dischargeable.

Chapter 7 bankruptcy does not protect co-signers from being pursued by creditors. If a debtor’s loan or debt has a co-signer, the creditor can still seek repayment from the co-signer even after the debtor’s obligation is discharged. In addition, filing for Chapter 7 bankruptcy is a matter of public record.

Chapter 7 Bankruptcy vs. Chapter 11 Bankruptcy

Chapter 7 and Chapter 11 bankruptcies serve different purposes. Chapter 7 involves the sale of the debtor’s non-exempt assets by a court-appointed trustee. The proceeds are used to pay off creditors. Chapter 11 bankruptcy, meanwhile, is often referred to as reorganization bankruptcy and is predominantly used by businesses, though individuals with substantial debts can also file.

Unlike Chapter 7, Chapter 11 allows the debtor to continue operating their business while developing a plan to restructure and repay debts. The debtor proposes a reorganization plan, which must be approved by creditors and the court. This plan may involve renegotiating terms, downsizing operations, or selling certain assets, but the goal is to return to profitability and continue business operations without liquidating everything.

Another key difference is the complexity and duration of the processes. Chapter 11 bankruptcy is usually more complex, expensive, and time-consuming than Chapter 7. It requires detailed financial disclosures, negotiations with creditors, and multiple court hearings. The reorganization plan can take several months or even years to implement fully. While Chapter 7 provides a quicker discharge of debts and closure, Chapter 11 focuses on long-term restructuring and recovery.

Chapter 7 Bankruptcy vs. Chapter 13 Bankruptcy

Chapter 7 and Chapter 13 bankruptcies differ primarily in how they handle debts and assets. Chapter 7 involves selling the debtor's non-exempt assets to pay off creditors. Chapter 13 bankruptcy, often called reorganization bankruptcy, allows debtors to keep their assets while repaying debts over three to five years through a court-approved repayment plan.

Under a Chapter 13 bankruptcy, debtors must have a regular income to propose a feasible plan that outlines how they will pay off creditors over time. This type of bankruptcy is particularly useful for individuals who are behind on mortgage or car payments, as it enables them to catch up on arrears and avoid foreclosure or repossession.

Another key difference lies in eligibility and the impact on the debtor's financial future. Chapter 7 is available to individuals and businesses with income below a certain threshold as determined by the means test. Chapter 13 is available to individuals with regular income and involves repaying a portion of the debts based on the debtor's income, expenses, and the value of non-exempt assets.

The Bottom Line

Chapter 7 bankruptcy allows individuals and businesses to eliminate most unsecured debts by liquidating non-exempt assets, with a court-appointed trustee overseeing the process. Debtors can retain exempt assets, while non-exempt assets are sold to pay off creditors.