Bankruptcy 101: All You Need To Know

Last Updated: January 25, 2019
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There are companies, such as Ashley Stewart and Kodak, that filed for bankruptcy but were able to continue doing business as usual. Many individuals who have filed for bankruptcy were able to emerge in one piece too. Here's all you need to know about bankruptcy

Bankruptcy doesn’t sound pleasant to the ear and it’s often the last option for people and businesses.  There are companies, such as Ashley Stewart and Kodak, that filed for bankruptcy but were able to continue doing business as usual.

Many individuals who have filed for bankruptcy were able to emerge in one piece too.  Bankruptcy seems to denote hopelessness but in reality, it’s just poorly understood.  So let’s talk about how it affects your finances or the finances of companies you are familiar with.

What Is Bankruptcy?

In the United States, bankruptcy is a legal process provided by federal law to give individuals and companies a “fresh start” from debts they could no longer manage. Companies can also use it to wind up the business so that they can liquidate their assets in an orderly and equitable manner.

Although bankruptcy carries a stigma to the public and people often fear or hate it, it is actually integral to the functioning of a progressive economy. Bankruptcy helps ease the weight of excessive debt to borrowers and helps to keep the credit transactions active in the economic system.  Believe it or not, this concept originated from the country’s Founding Fathers who had the foresight to see the need for a way to start anew.  They actually provided in the Constitution authority for Congress to establish the bankruptcy system.

As a rule, individual and companies seek relief through bankruptcy when they see that it is currently impossible for them to meet their debts.  Many would be quick to assume that these parties are poor stewards of money and take out too much credit card debt.  Of course, that happens a lot but that is not the general situation.  Often times, they file for bankruptcy because they’ve suffered a catastrophic financial blow. They could lose a lawsuit, technology might render their business obsolete, they might get a negative public image, or a person might have an unexpected serious illness or accident.

In the U.S., the bankruptcy system falls under the laps of the United States Bankruptcy Courts.  These courts are technically under the federal district court system.  You can find a bankruptcy court in every federal district of the United States.

The Goal of Bankruptcy

An individual who files for bankruptcy desires to see the process all the way to a debt discharge. A debt discharge relieves the debtor from personal liability to certain specific types of debts.  The bankruptcy court will issue the order prohibiting any creditor from collecting a debt against you.  People in the financial arena also know this as a bankruptcy injunction.

However, you must take note of this important aspect:  the debt discharge is permanent but it is not universal.  This means that the order does not cover all debts because the court, by law, cannot discharge some types of debts.  These include most tax debts, child support, spousal support, government fines and penalties, debts for willful and malicious injuries to other persons, to name a few.

You can see that the bankruptcy discharge is a very potent remedy but the court will only grant it to honest debtors who disclose all of their assets and debts.

Basic Types of Bankruptcy

The common understanding that bankruptcy erases any and all debt obligations and therefore frees the borrower from any liability is not at all entirely accurate.  He still has to pay up but how he’ll pay up will depend on the type of bankruptcy he filed whether it’s Chapter 7, Chapter 13, or Chapter 11.  These are the most common types but you might encounter other specific bankruptcies such as Chapter 12 for fishers and fishermen.

First Type:  Chapter 7 Bankruptcy

A Chapter 7 Bankruptcy is the simplest type and the easiest to file that’s why people often call it a “straight” bankruptcy.  In this type, a Trustee tries to liquidate the debtor’s eligible properties and then distributes the proceeds to his creditors according to the order of priority.  The creditors, after receiving payment, will then discharge the appropriate debt.

Take note that federal and state laws exempt certain properties from this process.  And here’s the catch:  some debts are not dischargeable such as guaranteed student loans and domestic support obligations.  If you are a creditor, you have to realize that most Chapter 7 bankruptcies are “no asset” bankruptcies which means that the debtor has no more assets to liquidate therefor leaving creditors hoping for nothing.

Higher income debtors who want to file a Chapter 7 must take a new Means Test to see if they qualify – otherwise, they should file for a Chapter 13 Bankruptcy.

Second Type:  Chapter 13 Bankruptcy

Unlike in a Chapter 7 proceedings, the debtor will retain possession of the assets in a Chapter 13 case, hence the name.  A court will confirm the debtor’s eligibility if he can prove he has sufficient income to support a 3-5 year plan to repay the debts regularly through a Trustee.  The Trustee is responsible for paying off the creditors who have filed for claims to retire secured debts such as mortgages and auto loans (with arrears).

Following a priority list, the Trustee will also pay non-dischargeable items and unsecured debts although they might end up with small portions off the monthly payments.  Chapter 13 provides debtors on the brink of foreclosure relief to somehow suspend the process while looking for other plausible remedies in or out of the Bankruptcy Laws.  The bad news is that fresh data indicate that as high as 50% of all Chapter 13 plans never get to see their completion all the way to discharge.

Note that the Law sets overall limits as to how much of his secured and/or unsecured debt a debtor may have and still use for a Chapter 7 or 13 Bankruptcy.

Third Type:  Chapter 11 Bankruptcy for Business

A Chapter 11 Bankruptcy is basically a form bankruptcy reorganization that is available to individuals, partnerships, and corporations.  It helps businesses that are in debt to restructure and be able to repay their creditors.

In a nutshell, the court provides an automatic stay for the debtors so that they can have a temporary sanctuary from debt collection moves including foreclosure.

Many debtors find this helpful as they are able to eventually find a permanent solution to their debt woes.  This is what is meant by the “fresh start” for which reason US lawmakers promulgated the bankruptcy laws.

What Happens to Your Credit In Case of Bankruptcy?

Plain and simple, your credit score will nose-dive when you avail of a bankruptcy remedy.  The higher your previous score, the more it will plummet.  According to FICO estimates, if you have an original score in the mid-700s, you might see it drop by more than 100 points.  And you know what will happen when you have a low credit score – it will set you for a financially inconvenient life in more ways than you could imagine.

As a rule, your credit report will retain Chapter 7 and 11 Bankruptcies for ten years while a Chapter 13 will stay on the report for seven years.

Most of the time, when the bankruptcy smoke clears, the court has discharged most of the debts but some will still remain.  For example, student loans are not dischargeable in a bankruptcy proceeding.  According to Sutton Law, these are other non-dischargeable debts:

  • Taxes
  • Alimony and child support
  • Divorce-related debts which include property settlement debts
  • Debts arising from some fines or penalties
  • Debts for personal injury or death due to drunk driving

There have been cases when the court discharged a student loan after bankruptcy but they passed a federal test for hardship.  The Department of Education reports that this is a very rare occurrence.

How do I Declare Bankruptcy?

Most filers follow the common route and that is to voluntarily file for bankruptcy.  The second route happens when creditors ask the court to order a person or entity bankrupt.

There many ways to file for bankruptcy and each one has its own pros and cons.  The best thing is to get legal or professional advice before making a move so you can choose the best recourse according to your specific financial condition.

Bottom Line

Most people will struggle to admit that they need help getting out of the debt hole they’ve dug themselves in, or their helplessness to do it on their own.  This is why the government has these bankruptcy laws.  They are there not just to protect the creditors but the debtors as well.  If you’re overwhelmed by debts and losing sleep over them, it is a sign that you need to confront the reality.  You can only ignore the ringing phone and walk past the pile of unpaid bills for so long – they won’t go away.

However, you could be making matters worse by not filing for bankruptcy.  If you have a good lawyer and the correct information at your fingertips, filing for bankruptcy could really help.  It can give you a solid financial foothold so you can get a fresh start (or re-start).  What we mean is this:  raising the white flag in surrender could be the beginning of a better chapter in your financial journey.