Bankruptcy

From TaxAlmanac

OVERVIEW

When a client accumulates debts that he or she cannot effectively manage or repay, filing for bankruptcy relief may be appropriate. Congress intended bankruptcy to provide a “fresh start for the honest debtor,” and in many cases, clients emerge from bankruptcy with greatly reduced debt and the ability to manage their finances more efficiently.

Bankruptcy relief is available for both individuals and businesses, but different rules apply to both situations. This article discusses the basic features of common bankruptcies and explains the three most common bankruptcy chapters. Pre- and post-bankruptcy tax planning advice for individual taxpayers is also discussed.

Note: On April 20, 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. This sweeping bankruptcy reform legislation becomes effective 180 days after April 20th, 2005, and will change many aspects of bankruptcy for consumers. Probably the most significant changes in the new law will be in chapter 7, which allows debtors to exchange most of their assets for a liquidation of most or all of their debts. The new law will severely restrict this and requires the bankruptcy court to assess the debtor’s ability to repay some or all of his or her debt. If it is evident that the debtor can repay some or all of his or her debt, the debtor will be forced either to convert the chapter 7 bankruptcy to a chapter 13 bankruptcy (with a partial or full plan to repay the debt), or withdraw the bankruptcy altogether.

Debtors will have a 180-day “grandfather” period to file bankruptcy under the prior law. As a result, the changes in bankruptcy law probably will apply to some, but not all, taxpayers who file bankruptcy in 2005. Accordingly, it is important to understand the basics of bankruptcy under the prior law, as well as the many changes that will result when the new law becomes effective on October 17th, 2005.

Bankruptcy under the prior law, as well as significant changes caused by the new law, will be explained in this article.

INTRODUCTION

The Players in a Typical Individual Bankruptcy
Bankruptcies can be filed by either individuals or businesses. In a typical individual bankruptcy, which is almost always filed under either chapter 7 or chapter 13, there are four principal participants. They are:
• The debtor, who owes the debts and files the petition for relief under the bankruptcy laws.
• The creditors, which is the group of individuals and businesses to whom to debtor owes money.
• The bankruptcy estate, which contains all property in which the debtor has an interest. The estate comes into existence when the debtor files the bankruptcy petition, and dissolves after the close of the bankruptcy.
• The trustee, who represents the estate, manages the bankruptcy, and usually acts on behalf of unsecured creditors. An unsecured creditor is a person or business that loaned money to the debtor without collateral (such as a personal loan or credit card debt).

Did you know? According to the American Bankruptcy Institute (ABI), over 1,597,462 bankruptcies were filed in 2004. Of this total, 1,587,087 were filed under either chapter 7 or chapter 13.

The Procedural Format of a Typical Bankruptcy
Bankruptcies filed under different chapters follow different procedural formats. The format for chapter 7 bankruptcy is explained here, because it is the most common kind of case filed by individuals.

The bankruptcy proceedings begin with the filing of a petition with the bankruptcy court. The petition is a legal document in which the debtor expresses his or her intention to file bankruptcy. It is accompanied by several additional documents, including a mailing list of all creditors, the debtor’s monthly budget, and schedules which describe the debtor’s assets and each debt owed. Depending on the circumstances of a given bankruptcy, there could be many additional documents filed with the petition.

After the petition is filed, all creditors are given notice of the bankruptcy, and an injunction against almost all collection activity against the debtor arises. An injunction is a court order prohibiting something; in this case, collection activity. This injunction is called the automatic stay, and it remains in place until after the bankruptcy case is discharged (bankruptcy relief is granted), dismissed (bankruptcy case is terminated by the court without relief), or withdrawn (the debtor voluntarily ends the bankruptcy case).

Approximately 3 to 6 weeks after the bankruptcy case is initiated, a meeting of creditors is held. This meeting is commonly referred to as the §341(a) meeting, in reference to the section of the bankruptcy code in which it is provided. The debtor must attend this meeting, which is conducted by the trustee, and overseen by the United States Trustee or Bankruptcy Administrator (these officials are discussed on page 1.4). The debtor is placed under oath, and creditors are given the opportunity to appear and ask the debtor questions about his or her assets and financial affairs. The trustee also examines (interviews under oath) the debtor to ensure that he or she is aware of the consequences of seeking a discharge in bankruptcy. The meeting is audio recorded, and usually lasts between 10 and 20 minutes in chapter 7 cases.

Usually, there is no benefit for most creditors to attend the §341(a) meeting in a chapter 7 case, because their position will not be improved by doing so. However, certain creditors often appear at the meeting to determine the debtor’s intention with respect to an asset sold to them on credit. The creditor may ask the debtor to reaffirm the debt, which means that the debtor keeps the asset and continues making payments. However, the debtor should make certain the creditor does not replace the initial contract with a new one, containing a higher interest rate or more severe default provisions.

After the meeting of the creditors in a typical chapter 7 case, absent any objections or motions by creditors in opposition, the trustee begins to gather and liquidate non-exempt assets of the debtor (exempt and nonexempt assets are discussed on page 1.6 of this chapter). Approximately 60 to 90 days after the meeting of the creditors, the court grants the debtor a discharge, and the case is closed.

COMMON BANKRUPTCY CHAPTERS

Because consumer and business bankruptcies differ procedurally, the chapter under which a debtor can file for bankruptcy depends on:
• Whether the debtor is an individual or business
• The kind of debts and assets the debtor owns, and
• The results the debtor seeks.
Debtors who need a fresh start and qualify for liquidation usually file under chapter 7. For individual debtors who do not qualify to file under chapter 7, or have debts that are not dischargeable in chapter 7, chapter 13 may be appropriate. Businesses may file under either chapter 7 or chapter 11, depending on whether the business will liquidate and close (7), or reorganize and remain open (11).

Chapter 7 Liquidation
The foundation of chapter 7 bankruptcy is the “trade” made between the debtor and his or her creditors. The debtor’s non-exempt assets are liquidated and the proceeds, if any, paid to creditors, in exchange for a discharge of most or all of the debtor’s remaining liabilities. The debtor in a chapter 7 case may be an individual, partnership, or corporation. An individual who files under chapter 7 is entitled by state or federal law to keep certain exempt property (discussed later in this article), but a business entity that files under this chapter must distribute all of its assets, net of administrative expenses, to its creditors. A business entity ceases to exist upon the completion of chapter 7 proceedings.

Chapter 11 Reorganization
The purpose of a chapter 11 proceeding is to provide protection from creditors while allowing the debtor to continue in business and formulate a plan of reorganization. Chapter 11 is available to individuals, partnerships, and corporations. When an individual files for chapter 11 protection, a bankruptcy estate is created; an estate is not created when partnerships or corporations file under this chapter.

Under chapter 11, the business debtor retains possession and control of the business assets, as a debtor-in-possession. A trustee can be appointed in chapter 11 cases, but this is highly unusual, and occurs at the request of an interested party, or if the court determines it is necessary. The debtor-in-possession has the same fiduciary duties as an appointed trustee. A creditors’ committee is usually formed to represent the interests of the various creditors.

The business is usually permitted to continue its operations under court supervision until a plan of reorganization is approved by two-thirds of the company’s creditors. However, if the company is insolvent when it files for reorganization, a majority of the shareholders (if any) must also approve the plan.

Rather than the asset liquidation and discharge formula seen in chapter 7, chapter 11 cases usually result in a negotiated reorganization plan for debt restructuring and repayment. A debtor has 120 days following the chapter 11 pleading to file the plan and 180 days following the pleading to have the plan approved by the creditors. Either time may be extended by the court.

Once the plan is accepted and completed, any dischargeable debts that are part of the plan are discharged.

Did you know? The three largest chapter 11 bankruptcies ever filed, in terms of pre-bankruptcy assets, were Worldcom, Inc. in July, 2002, with almost 104 billion in assets, Enron, Inc, in December, 2001, with over 63 billion in assets, and Conseco, Inc, in December, 2002, with over 61 billion in assets. (Source: Bankruptcydata.com)

Example: Wilbur’s Typewriter Repair, Inc. is insolvent, and needs to file for bankruptcy. If the business files under chapter 7, its assets will be liquidated by the trustee, the proceeds, if any, will be distributed to creditors, and the business will cease to exist when the bankruptcy court grants a discharge. However, if the business files under chapter 11, it can remain in business, negotiate with creditors to reorganize its debt, and if the plan for reorganization is approved by Wilbur’s creditors, shareholders, and the court, it can remain in business after the bankruptcy has concluded.

Chapter 13 Rehabilitation
Chapter 13 relief is available for individual debtors only. In chapter 13, debtors propose a plan to pay their debts in full (priority and secured claims) or in part (unsecured claims) over time, usually 3 to 5 years. There is no requirement for the plan to pay all of the debtor’s unsecured debts. Most plans end up paying only a small fraction of them, or none at all.

Generally, the plan consists of monthly payments of all the debtor’s income after payment of current living expenses. Unlike a chapter 7 case where the debtor’s non-exempt property is sold and the proceeds distributed to creditors, debtors in chapter 13 are allowed to keep their property. Creditors holding secured or priority claims receive monthly payments from the debtor’s future earnings, rather than a present payment from the sale of assets.

Not all individuals may file bankruptcy under chapter 13. For 2004, chapter 13 debtors had to have less than $307,675 in unsecured debt and less than $922,975 in secured debt.

A trustee is appointed for chapter 13 cases, but the role of the trustee is different than in chapter 7 cases. The chapter 13 trustee collects plan payments from the debtor, distributes them to creditors, and handles the overall administration of the plan, rather than collecting and selling the assets of the debtor as would be done in a chapter 7 case. The trustee also reviews each plan and challenges those that do not, in the trustee’s opinion, meet the required elements for confirmation. An estate is also established in chapter 13 cases.

The payment plan proposed by the debtor must be submitted in good faith, and it must meet two other tests—
1) it must pay unsecured creditors at least as much as they would have received if the debtor had filed a chapter 7 case (this is the best interests of the creditors test), and
2) all disposable income must be paid into the plan for at least 3 years (this is the best efforts test).
If the debtor’s plan meets these elements and is feasible, based on the budget of living expenses submitted to the court, the plan is usually confirmed.

Once the plan is confirmed, the debtor has few responsibilities. He must make timely plan payments, not incur new debt without court approval, and maintain insurance on assets that secure debt. If the debtor reaches the end of the plan and has made all payments, he or she will receive a discharge of all remaining debts, if any, that are dischargeable.

Example: Jasmine filed a chapter 13 bankruptcy on April 2, 2005. Due to her inability to use credit cards wisely, Jasmine had reached a point where she was unable to effectively deal with her creditors and pay her debts, and she needed a fresh start. According to bankruptcy schedules filed with the court, she has $300 per month in disposable income. Jasmine’s plan provides that all of her monthly disposable income will be paid to creditors, via her monthly plan payment. Because her debts are unsecured, Jasmine’s creditors will almost certainly receive more money in a chapter 13 case than they would in a chapter 7 case. Accordingly, Jasmine’s chapter 13 plan will likely be confirmed by the court, and she will receive a discharge upon completion of the plan.

Example: Amber filed for chapter 13 bankruptcy in 2002, but her case was dismissed because of her failure to make plan payments. She filed again in 2003, but her case was dismissed because she failed to appear at the meeting of creditors. She filed a third case in 2004, but she failed to list significant, unreported tip income in her plan. She also used several credit card cash advance checks she received in the mail a few months prior to filing her third bankruptcy case. It is likely that when the bankruptcy court reviews Amber’s case, it will be dismissed due to bad faith.

THE AUTOMATIC STAY AGAINST COLLECTION

In all bankruptcy proceedings, an automatic stay against collection is immediately placed in effect following the filing of a bankruptcy petition. It is “automatic” because the debtor does not have to do anything, except to file the petition, for the stay to commence. The automatic stay is an injunction which:
• Protects the debtor from further collection actions of creditors, as long as the bankruptcy case remains open.
• Prevents most parties from interfering with the debtor’s debts or property.
• Arises immediately upon the filing of the bankruptcy petition, and it dissolves after the bankruptcy case is closed.
• Can be lifted or modified by the Bankruptcy Court upon a showing of good cause.
• Is useful, in chapter 11 cases, because it allows the debtor’s business to operate during the proceedings. Property of the debtor can be used, leased, or even sold in the ordinary course of business, subject to court approval.

Example: Fred properly filed a chapter 7 petition on January 10, 2005. Included among his creditors is Big Dog Tattoo Studio, to which Fred owes $500. Big Dog’s proprietor, Paulie, has been calling Fred every day, demanding payment. Because of the automatic stay against collection that arose at the moment Fred’s petition was filed, Paulie must immediately stop all collection efforts against Fred.

Example: Sheldon properly filed a chapter 7 petitiono on March 23, 2005. He owns one asset, a 1970 Plymouth Barracuda. Because of the condition and rarity of the vehicle, it is worth approximately $50,000. Ira’s Mopar Shop, an automobile customizer, has threatened to seize the vehicle and sell it, because Sheldon refuses to pay for the custom paint work Ira’s did on the vehicle. The automatic stay prohibits Ira’s from taking any action with respect to Sheldon’s vehicle, including seizure and the placement of a lien.

THE BANKRUPTCY ESTATE

When an individual files a chapter 7, 11, or 13 bankruptcy petition, a bankruptcy estate is created. The bankruptcy estate is a legal device which contains all the debtor’s tangible and intangible property owned as of the date of filing a petition for bankruptcy. The estate technically becomes the temporary legal owner of all the debtor’s property.

The bankruptcy estate is a separate entity for tax purposes in individual chapter 7 and 11 cases. (No separate taxable estate is created when a business entity files under chapter 7 or 11, or when an individual files under chapter 13.) The court appoints a trustee to administer the estate in all chapter 7 and 13 cases, as well as chapter 11 individual cases. The trustee or debtor in possession is responsible for the preparation and filing of the estate’s tax return.

Notice: A very important aspect of bankruptcy case management is the issue of which party bears the risk of loss for assets which have been included in the estate. In other words, does the debtor or trustee have the duty to insure, and maintain insurance, on assets such as vehicles and personal property? In fact, both the debtor and trustee have responsibilities to insure certain assets at different points of the case. If in doubt, and unless prohibited by the court from doing so, debtors should maintain or renew insurance on assets until they can establish that either they are not required to insure a given asset, or that the trustee has insured the asset.

TRUSTEES AND BANKRUPTCY ADMINISTRATORS

The United States Trustee’s Office is responsible for the oversight of bankruptcy cases and private bankruptcy trustees. Duties of a United States Trustee include referral of suspected bankruptcy crimes to the United States Attorney and F.B.I. for investigation, supervision of chapter 11 debtors, and supervision of private trustees.

Because of the large volume of bankruptcy cases, the United States Trustee for a given region (there are 21 regions nationwide), appoints private trustees to handle the actual management of estates in a given region. Private trustees have duties similar to those of a fiduciary, including:
• Managing the estate (with direction of the court) for the benefit of creditors.
• Obtaining an employer identification number for the estate, if the debtor is an individual.
• Ensuring employment taxes are properly withheld and deposited for business debtors with employees.
• Filing all required employment tax returns, information returns, and income tax returns.
• Paying taxes and other debts to the extent and in the priority specified by the court.
• Collecting and distributing plan payments for chapter 13 cases.
• Collecting and liquidating assets for chapter 7 cases.
• Conducting the §341(a) creditor’s meeting.

Bankruptcy Administrators perform essentially the same functions as United States Trustees. As with United States Trustees, Bankruptcy Administrators appoint private trustees to perform duties at the case level. Bankruptcy Administrators operate in North Carolina and Alabama only.

EXEMPT PROPERTY

Under state and federal bankruptcy laws, individuals are entitled to keep certain exempt property, or exempt a portion of the value of certain assets, from inclusion in the bankruptcy estate. Both federal and state bankruptcy laws provide exemption amounts. Often, the state exemption amounts for certain assets are higher than the federal amounts, and in some states, debtors may elect to use either the federal or state exemption amounts. In some states, there is no exemption amount for certain assets. Examples of exempt property include:
• One motor vehicle (usually limited to a certain value).
• Household goods and personal effects.
• Tools used on the debtor’s job.
• The cash value of many insurance policies.
• Employer-provided retirement benefits that are qualified under ERISA, such as a 401(k), and sometimes IRAs.
• Public benefits such as welfare, social security, or unemployment compensation.
• Home equity up to a certain dollar amount (or no limit, which is discussed later).

Classification as exempt does not prevent seizure if the asset in question has been pledged to secure a debt. For example, a heavily mortgaged house that is exempt from seizure under state law will still be within reach of the mortgage lender, due to the fact that the mortgage lender holds a security interest in the property. However, the secured creditor is still barred from taking collection action as long as the automatic stay is in effect.

Usually, the maximum value of exempt property is set by statute. The exemption limits are set out by class of asset. Property with value above the maximum amount is not exempt.

Tax professionals do not have to determine what property is exempt; these determinations are calculated by the debtor’s attorney and the Bankruptcy Court. If all property is exempt, or there are no assets in the case, there will be no estate liquidation or sale to report on the debtor’s tax return (discussed later in this chapter). If property is only partially exempt (as in the example below), a sale is reported on the estate’s return, regardless of how the proceeds are distributed. With the permission of the court, an individual debtor may sell exempt property outside the estate, in which case the sale is reported on the individual’s tax return.

Example: Debtor Theresa Markham resides in Ohio and files a chapter 7 bankruptcy there. Her automobile has a fair market value of $9,500, and she owns it outright. The state exemption amount for a motor vehicle in Ohio is $1,000, and the federal amount is $2,775. Regardless of which set of exemptions Theresa elects to use, she cannot exempt the full value of her vehicle. Because the full value of the car is not exempt, the chapter 7 trustee may take possession of the vehicle, sell it, and take for the creditors any proceeds of sale above the exempt amount. Any proceeds of sale below the exemption amount are returned to the debtor and are considered exempt property.

Homestead Exemption
The bankruptcy exemption for the equity in a debtor’s home is called the homestead exemption. The homestead exemption allows a debtor to exempt equity in his or her residence from inclusion in the bankruptcy estate.

The 2004 federal homestead exemption was $18,450, which means that the debtor may exempt up to $18,450 in home equity from inclusion in the bankruptcy estate. The debtor gets to keep this equity after the bankruptcy case is concluded. Most states also have homestead exemption amounts, which vary widely in amount.

As stated above, some states allow debtors to elect to use either the federal or state exemption amounts, depending on which set gives them the greatest advantage in bankruptcy. One state that does not allow debtors to make this election is Georgia, where the state homestead exemption is $5,000. Other states are more generous, such as California, where the state exemption amount is $50,000 for unmarried debtors and $75,000 for married debtors.

Five states —- Florida, Texas, Iowa, Kansas, South Dakota, and the District of Columbia -— have unlimited homestead exemptions. Four others have no state homestead exemption—Delaware, Maryland, New Jersey, and Pennsylvania.

Did you know? The Florida and Texas state constitutions both mandate unlimited homestead exemptions. By providing for this in each state’s constitution, the legislature of each state is prevented from changing the homestead amount by statute; amendment of the constitution would be required.

Notice: Some states require that homeowners record their homestead exemption in the county recorder’s office, or recorder of deeds, where the property is located. For those states with this requirement, the homestead exemption cannot be asserted unless is it recorded before either the forced sale of the home or the filing of a bankruptcy petition.

Planning Point: In a joint bankruptcy, both spouses may claim the homestead exemption. In states where the exemption is limited, both spouses together can exempt $36,900, if using the federal amount, or much more using some state amounts. Accordingly, it is often advantageous to file a joint bankruptcy, even if one spouse may not need one.

Taxes and Bankruptcy

Good article on the discharge of taxes in BK

A much more recent article about Discharging Taxes in Bankruptcy (Post Bankruptcy Reform) http://www.martellelaw.org/dischargingtaxes.shtml

[CAUTION - that second link was added by a new user with no profile. Might be fine, but maybe should be checked out before relying on it.]