When debt becomes completely unmanageable and nothing in the near term offers hope for a solution, people often mull over filing bankruptcy, the nuclear option for personal finance.
Chapter 7, the section of the U.S. bankruptcy code that wipes away much of an applicant’s debt, is the most extreme solution for those with serious problems, but the courts don’t allow just anyone to file for it.
To weed out those who might be able to partially repay what they owe with a plan that restructures debt, the U.S. Bankruptcy Court uses a formula called a “means test.”
The means test compares a debtor’s income for the previous six months to what he or she owes on debts. If a person has enough money coming in to gradually pay down debts, the bankruptcy judge is unlikely to allow a Chapter 7 filing. The higher an applicant’s income relative to debt, the less likely a Chapter 7 filing will be approved.
Instead, it could be converted from Chapter 7 to Chapter 13, the section of the bankruptcy code that allows debtors to keep certain assets but requires a portion of what is owed to be repaid in a three-to-five year period.
The test has two steps. The first considers whether the filer’s income is less than the median in the state where the petition is filed. If income is less than the median for the prior six months and there is no reason to assume it will soon increase, the test is passed, and the Chapter 7 filing can proceed.
The vast majority of applicants pass the test on step one. Those who don’t, move to step two.
Step two requires a petitioner to document how much of his or her money was spent on essentials like rent or a mortgage, food, clothes and medical bills. These are deemed allowable expenses since they are essential to living.
What’s not on the allowable list is discretionary income – money spent on non-essentials that could be diverted to debt payments.
If you’re among those who must complete step two, be careful. The courts carefully study your accounting, looking for mistakes and miscategorized entries. It will then compare your expenses to government data to determine whether what you’re spending is excessive. If you pass the spending test and your disposable income is low enough, you can proceed with a Chapter 7 filing even if your income exceeds your state’s median.
How does this work for a potential bankruptcy petitioner? Here is a hypothetical example:
Julie rents an apartment for $1,300 a month and spends $600 a month for groceries, $300 a month for clothes and an average of $200 a month in medical-related expenses. She earns $48,000 a year as a school teacher, is single and has no children, but has accumulated $90,000 in consumer debt and is unable to meet her required payments.
In order to determine her eligibility for a Chapter 7 filing, she needs to first consider her income. She lives in a state with a median income of $53,000, so she meets the Chapter 7 means test. But if she had lived in the state adjacent to hers, where the median single-person household income is $45,000, she would have to present an accounting of her expenses which the court would use to determine if her essential expenses are high enough to qualify for the Chapter 7 filing.
One more thing to keep in mind: You might not be eligible to file for personal bankruptcy if your debt is largely the result of a business problem. A business bankruptcy is necessary if most of your debt is related to a business, including a partnership, a limited liability company or a corporation. Some of a personal filer’s debt can be business related, but most of it must be consumer debt.
Consider Jerome, who is a self-employed electrician. He owns a truck through a limited liability company he created and owes $25,000 on the vehicle. He earns about $56,000 a year and owns his home, which has a $250,000 mortgage and a balance of $30,000 on a home equity line of credit. He has both business and consumer debt and is unable to meet his minimum payments.
To determine whether he is eligible for a Chapter 7 filing, he must separate his business expenses from his personal debt. If most of his troubles are related to the electrical business. To determine this, he would need to add up all the business debts, including what he owes on the truck and the tools that he uses as part of his work. If most of his debt is connected to the business, he would file a business bankruptcy. If not, he would begin a means test to learn whether he is eligible to file for personal Chapter 7 bankruptcy.
Keep in mind that bankruptcy is usually reserved for those with crippling or insurmountable financial problems. Before proceeding with a filing, consider other options. You can contact your creditors to propose a debt settlement or you could visit a nonprofit debt management or debt counseling company.
If you decide to pursue bankruptcy, contact an attorney who specializes in bankruptcies for more information.
In 2017, 765,863 nonbusiness Chapter 7 and Chapter 13 bankruptcies were filed, with Chapter 7 cases dominating. Far more people dealt with financial problems by negotiating with their creditors.