Chapter 7 Bankruptcy

Learn how Chapter 7 bankruptcy works for individuals and businesses.

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Chapter 7 bankruptcy works well when you don't have enough income to pay back your debt. Instead, the court sells property and uses the proceeds to pay back creditors. Businesses, as well as individuals, can take advantage of this type of bankruptcy; however, a discharge (debt forgiveness) is available only to individuals.

Individual Chapter 7 Bankruptcy

When possible, most filers (debtors) prefer to file a Chapter 7 bankruptcy for two reasons: It's quick—usually taking four to six months to complete—and unlike a Chapter 13 bankruptcy, the debtor doesn't pay into a repayment plan.

Other important aspects of a Chapter 7 bankruptcy include:

  • Debtors must qualify for relief. Not everyone can file this type of case. Individuals must show that their income is below certain limits by passing a test known as the "means test." The first part of the test evaluates whether the total family income is below the state median. The second portion allows a debtor whose income exceeds the state median to deduct expenses. If the remaining amount—called discretionary income—is enough to pay creditors some portion of debt, the debtor won't qualify.
  • Debtors keep some property. When an individual files a Chapter 7 case, the court doesn't take everything and leave the debtor destitute. Instead, an individual debtor can exempt (keep or protect) some property. These assets include clothing, household goods, a vehicle, some equity in a homestead, and other items a debtor will need for a fresh start. Each state chooses the exemptions its residents can claim. The debtor must turn over any nonexempt property but often the debtor can keep everything.
  • Debtors receive a debt discharge. In exchange for nonexempt property, the bankruptcy court grants the individual Chapter 7 debtor a discharge of qualifying debt, such as credit accounts, medical bills, overdue utility bills, and personal loans.

A Chapter 7 doesn't discharge all debts, however. A debtor with a car loan or home mortgage must keep paying it to keep the collateral (the house or car securing the loan).

Some debts, like recent income taxes, child support, and alimony, are never dischargeable. Others, such as student loans, can be discharged only if the debtor meets specific requirements. Still others, such as fraud-related obligations, get wiped out unless the creditor successfully brings a lawsuit opposing the discharge of the debt.

(Find out more by reading Chapter 7 Bankruptcy Timeline.)

Business Chapter 7 Bankruptcy

When a corporate business entity or partnership files for Chapter 7 bankruptcy, the business shuts down. The court will liquidate (sell) virtually all of the company's assets. Creditors of the debtor will file claims with the court, and the court will distribute the proceeds to the creditors. The company, in essence, ceases to exist.

A bankruptcy involving a sole proprietor, however, is a bit different. Because a sole proprietor is responsible for the company's obligations, a sole proprietor's individual finances will always be included as part of the bankruptcy. Also, the sole proprietorship might be able to remain open if the debtor can protect all of the business assets with exemptions. For instance, a company involving primarily labor, such as an accounting office, might survive bankruptcy.

A few other significant differences between individual and business bankruptcies include:

  • A debtor with primarily business debts (debts incurred to generate profit) doesn't have to take and pass the means test.
  • A business entity (other than a sole proprietor) isn't entitled to receive a discharge of debt.
  • Businesses rarely file for Chapter 7 bankruptcy unless it makes sense to have the trustee appointed by the court transparently liquidate property.
  • Partnerships are even less likely to file a Chapter 7 case because the assets of the individual partners might be available to pay the business debt.

Because of the complicated nature of a business bankruptcy, anytime a company is involved—even in an individual case—it's prudent to get the advice of a knowledgeable bankruptcy attorney.

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