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Don't Bank on Bankruptcy

General Business News

July 2001

Don't Bank on Bankruptcy

In case you haven'??t noticed, there is an epidemic in this country that is preventable. We're not talking about AIDS or a new strain of the Flu. We are talking about people filing bankruptcy when perhaps there is no need to do so.

In the year ended December 31, 2000, 1,217,972 individuals filed for protection from their creditors under the U.S. Bankruptcy Laws. Not all of these people were unable to pay their bills. Some could pay their bills, but they would have to forego some of the lifestyles that piled up their mountain of debt. Not willing to take the time and make the sacrifice necessary to meet their obligations, some people opt to use the Bankruptcy Code to reduce or eliminate their debt. Sometimes, these can be quite wealthy individuals who retain a large portion of their wealth after completing the bankruptcy proceedings.

In general, the foregoing is the argument for reform used in recent debates over changing the federal bankruptcy law in the House of Representatives and the Senate. The arguments against changing the law generally center on the profits made by credit card companies and banks, along with the belief that those same credit card companies and banks have created many bankruptcies by indiscriminately issuing credit cards.

Whoever may be correct in the debate, the fact was on March 15, 2001, and the United States Senate approved a bill that made sweeping changes to the United States Bankruptcy Code. The Senate'??s version of the bill is now in the reconciliation process with the House'??s version of the bill.

At issue is the perception that the rich can use the bankruptcy laws to avoid paying their just debts while retaining substantial assets. On the face of it, this certainly seems unfair, and it is. However, any time laws targeting those who abuse the system are enacted, innocent people are often adversely affected. This bill is no different. Some of the provisions could negatively affect those; the Bankruptcy Code is meant to help while plugging some of the current system's holes. What follows is a review of some of the key points on the proposed laws as they now stand.

First, we need to define a few terms:

Chapter 7 - Available to business and non-business debtors, this portion of the Bankruptcy Code seeks to provide a fair distribution of assets by first paying off or reaffirming secured and priority claims. Unsecured debt that is not paid is discharged, and the debtor starts fresh.

Chapter 11 - Available for business and consumer debtors, this chapter of the Bankruptcy Code seeks to rehabilitate a business as a going concern or reorganize an individual's debts to allow for payment of the debts in a court approved plan.

Chapter 13 - Available to individuals with regular income and whose debts do not exceed a specified amount, this chapter of the Bankruptcy Code seeks to budget the individual's future earnings under a plan through which creditors are paid in whole or part.

Major Provisions of Proposed Legislation

Chapter 7 Provisions

One of the major points to the new bill is the automatic dismissal of a Chapter 7 case or (with the debtor's consent) conversion to Chapter 13 upon a finding of abuse. In general, a finding of abuse can occur in one of two ways:

  • If current monthly income, less allowable deductions, exceeds a specified amount, there is a presumption of abuse. There are two trigger points: 1) if monthly income less allowable deductions equal or exceeds $166.67, abuse is presumed regardless of the debtor's unsecured debt and, 2) if the debtor has $100 or more in available income and that available income will pay at least 25% of the unsecured debt over 5 years, abuse is presumed. The starting point for determining available income is the median income in the state where the debtor resides. Still, the debtor will have a chance to show the amount of available income is less than computed by statute based on special circumstances.
  • If the presumption of abuse does not exist, then a showing that the debtor filed the petition in bad faith or, based on the debtor's total financial picture, abuse is indicated, then the court can find abuse exists. The bankruptcy administrator, the U.S. Trustee, or the judge utilize this method to assert abuse. Creditors are limited in their ability to assert abuse only to cases where the debtor's monthly income exceeds the state median income.

A second and powerful weapon for creditors under the proposed laws is the addition of stiff penalties on the debtor's counsel. In general, the debtor's counsel will be subject to paying costs and fees to the trustee if the trustee can prove the attorney violated certain rules. Additionally, the debtor's counsel is subject to stiff penalties if counsel fails to follow new disclosure and record-keeping requirements.

Payment of family support obligations would be established as a priority ahead of the costs of administering the bankruptcy estate. Still, payment of property taxes is specifically mentioned as a priority ahead of family support obligations.

Other provisions would make it more difficult to reaffirm the debt or redeem the collateral. Trustee compensation would be based on a commission formula rather than factors applicable to other professionals.

Chapter 13

The reduction of secured claims to the value of their collateral will be limited. Depending on the bill's final version, reduction of debt to the value of the collateral for auto loans will be limited for autos purchased within three (Senate version) to five (House version) years of filing for bankruptcy. Both bills would preclude reduction to the value of collateral for debts incurred within one year of bankruptcy.

Where the debt can be reduced to the value of the collateral, the collateral must be valued at replacement (retail) cost.

The bills would also add certain categories of debts that could not be discharged, including unfiled, late-filed, or fraudulent returns; debt resulting from fraud, including credit card misuse; debt related to a creditor who was not timely notified of the bankruptcy; debt arising from embezzlement or breach of fiduciary duty.

Chapter 7 and 13 debtors would be required to file tax returns for the period most recently due as of the bankruptcy filing and any becoming due during the bankruptcy proceedings with the trustee. Any party in interest may also require an annual statement of income and expenditures for the prior tax year and showing the monthly income of a Chapter 13 debtor. These would be available to creditors, subject to maintenance of applicable privacy rights.

Chapter 11

Chapter 11 cases will be treated like Chapter 13 cases. Individual Chapter 11 debtors won't be discharged from bankruptcy until their plans are completed.

General Provisions

There are some general provisions. Among them is a requirement that Individuals cannot file for relief under any chapter of the Bankruptcy Code unless they have received credit counseling - through a court-approved service - within 180 days of the filing. Certain requirements must be met for the credit counseling services to be approved.

Provisions affecting the present homestead exemption are treated radically differently under each bill. The House version provides for an exclusion from the exemption of any value added to the home by the debtor, intent to thwart the creditor's claims during the 7 years before the bankruptcy filing. Additionally, value above $100,000 added to the homestead for the two years before bankruptcy filings would be available to satisfy creditors' claims. The Senate version would limit the amount of the homestead protected from creditors to $125,000.

The new law would take effect for cases filed 180 days after the date of enactment.

While there are numerous other provisions in the bills presently, it is clear the laws aim to reform the Bankruptcy Code in favor of creditors. The object, of course, is to reduce the abuse inherent in the present system. Whether this will ultimately benefit the country and consumers remains to be seen.

While we hope you will never have cause to deal with the bankruptcy court, it is wise to be aware of your rights as a potential debtor and a creditor. If you need any assistance in whatever role you may find yourself in, please give us a call. As always, we are here to serve you.


These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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