Bankruptcy Basics

en Español

Bankruptcy is a proceeding in which a court administers the estate (the property and other assets) of a debtor for the benefit of creditors.

A debtor (a person or business who owes money to others) may choose to file a bankruptcy proceeding to resolve a hopeless financial situation or to stave off the collection of debts for a period of time to allow for financial reorganization.

Individuals or businesses may file for bankruptcy. In some cases, a creditor (a person or business that is owed money) may force the filing of a bankruptcy proceeding, although these "involuntary" proceedings are very rare.

What Law Applies to Bankruptcy?

The United States Constitution authorizes Congress to adopt "uniform laws" on bankruptcy. The federal bankruptcy law has two goals:

• To obtain fair treatment for creditors
• To obtain a fresh start for both consumer and business debtors involved in bankruptcy proceedings

Federal bankruptcy law governs bankruptcy proceedings, except, when Congress has chosen to defer to state law.

Should I File Bankruptcy?

There's no magic formula for deciding when bankruptcy is the right choice. It's an option you might consider if you:

• Are paying only minimum amounts on your bills
• Can't budget yourself out of debt within five years
• Are getting notices that your mortgage or loans are being foreclosed
• Have had a severe financial setback, such as losing your job or a major client, a divorce or a costly illness

Alternatives to Bankruptcy

Alternatives to bankruptcy include:

• Trying to negotiate with creditors to reduce monthly payments or to skip some payments
• Getting help from a nonprofit credit counseling group

Consequences of Bankruptcy

A debtor may not be fired from a job because of filing for bankruptcy. However, creditors may take a past bankruptcy into consideration when deciding whether to extend credit. Many creditors regard a person who has filed for bankruptcy to be a higher credit risk and may either refuse to extend credit or only extend credit on less favorable terms. In general, a bankruptcy will stay on one's credit report for 10 years.

While the bankruptcy laws vary from state to state, every state has exemptions that protect certain kinds of assets, such as your house, your car (up to a certain value), money in qualified retirement plans, household goods and clothing. Most people pass through a bankruptcy case and keep everything they have. If you have a mortgage or a car loan, you can keep those as long as you keep making the payments.

Bankruptcy doesn't get rid of all debts. Among those excluded are:

• Alimony
• Child support
• Recent back taxes
• Student loans
• Recent large purchases
• Fines or penalties of government agencies
• Fraudulent debts

What Are the Kinds of Bankruptcy?

Federal bankruptcy law contains several different groups of provisions called "Chapters," governing specific types of bankruptcy proceedings. The following are the six basic types of bankruptcy cases:

• Chapter 7, also known as straight bankruptcy, allows individuals or businesses to give up nonexempt assets and walk away from most debts
• Chapter 9, also known as municipality bankruptcy, works like a Chapter 11 and allows municipalities to reorganize debt
• Chapter 11, also known as reorganization, ordinarily is used by businesses that desire to continue operating and repay creditors concurrently through a court-approved plan of reorganization
• Chapter 12 provides debt relief to family farmers and fishermen with regular income
• Chapter 13 is designed for an individual debtor who has a regular source of income and permits the payment of debts pursuant to a repayment plan
• Chapter 15 (replaces Section 304) is the newest chapter of the Bankruptcy Code that was added by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 and is designed to provide effective mechanisms for dealing with cross-border bankruptcy proceedings

Bankruptcy Chapters for Individuals

Chapter 7 and Chapter 13 are the two bankruptcy chapters most often used by individuals. These two chapters are described in more detail below.

Chapter 7 offers an orderly, court-supervised procedure by which a trustee takes over the assets of the debtor's estate, reduces them to cash and makes distributions to creditors, subject to the debtor's right to retain certain exempt property. In most chapter 7 cases, the debtor receives a discharge that releases him or her from personal liability for certain dischargeable debts within a few months after the petition is filed.

The new bankruptcy law that was passed in 2005 includes a "means test," which is a formula to determine whether or not the consumer should have enough money available to make some minimal payment to creditors in a Chapter 13 bankruptcy plan. An individual must pass the means test to be eligible for Chapter 7 relief.

Chapter 13 allows a person to keep and use all property, whether exempt or not, and to pay some or all debts according to a plan approved by the court. Unlike chapter 7, the debtor does not receive an immediate discharge of debts. The debtor must complete the payments required under the plan before the discharge is received.

What is a Discharge in Bankruptcy?

A bankruptcy discharge releases the debtor from personal liability for certain specified types of debts. In other words, the debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order prohibiting the creditors of the debtor from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters and personal contacts.

What is an Automatic Stay?

An automatic stay, which is gained instantaneously in most cases upon the filing of a bankruptcy petition, may be one of the most valuable features of a bankruptcy because it forces an abrupt halt to creditor actions against the debtor, including most repossessions, garnishments or attachments, utility shut-offs, foreclosures and evictions. The stay is also an effective way to end creditor collection efforts.

Questions for Your Attorney

• I would like to file for bankruptcy so that I can make payments to my creditors based on a plan but I don't know if I should file for Chapter 11 or Chapter 13 petition, which chapter is preferable and why?
• Does a Chapter 7 bankruptcy remain on my credit history for ten years from the date that I file a petition for bankruptcy or ten years from the date that I receive a bankruptcy discharge?

Sherrie Bennett is the former director of Student Legal Services at the University of Washington in Seattle.

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