Understanding Debts

Bankruptcy gives you a handle on your debts. There are different kinds of debts. It helps if you have a handle on these differences.

 

Debts in Bankruptcy

If you are thinking about bankruptcy there’s no more basic question than what it will do to each of your debts. Will it wipe away all your debts or will you still owe anybody? What about debts you would like to keep like your car or truck loan or your home mortgage? What help does bankruptcy give for unusual debts like taxes, or child and spousal support?

The Three Categories of Debts

At the heart of bankruptcy is the basic rule of treating all creditors within the same legal category the same. So we need to understand the three main categories of debts. You may not have debts in all three of these categories, but lots of people do. A basic understanding of these three categories will help make sense of bankruptcy, and make sense of how it treats each of your creditors.

The three categories of debts are “secured,” “general unsecured,” and “priority.”   

Secured Debts

Every single debt is either “secured” by something you own or it is not. A secured debt is secured by a lien—a legal right against—that property or possession you own.  

Most of the time you know whether or not a debt is secured because you voluntarily gave collateral to secure the debt. When you buy a car, you know that you are signing on to a vehicle loan in which the lender is put onto your car’s title as its lienholder. That lien on the title gives that lender certain rights, such as to repossess it if you don’t make the agreed payments.

But debts can also be secured as a matter of law without you voluntarily agreeing to it. For example, if you own a home and an unsecured creditor sues you and gets a judgment against you that usually creates a judgment lien against the title of your home. Or if you don’t pay federal income taxes you owe, the IRS may put a tax lien on all your personal property.

For a debt to become effectively secured, either voluntarily or involuntarily, certain steps have to be taken to accomplish that. Otherwise the debt is not secured, and the creditor does not have rights against the property or possession that was supposed to secure the debt.

In the case of a vehicle loan, the lender and you have to go through certain paperwork for the lender to become a lienholder on the vehicle’s title. If those aren’t done right, the vehicle will not attach as collateral to the loan. That could totally change how that debt is treated in bankruptcy.

Finally, it’s important to see that debts can be fully secured or only partly secured. This depends on the amount of the debt compared to the value of the collateral securing it. If you owe $15,000 on a vehicle worth only $10,000, the debt is only partly secured—secured as to $10,000, and unsecured as to the remaining $5,000 of the debt. A partly secured debt may be treated differently in bankruptcy than a fully secured one.

General Unsecured Debts

All debts that are not legally secured by collateral are called unsecured debt.  And “general” unsecured debts are simply those which are not one of special “priority” debts that the law has selected for special treatment. (See below.) So this category of “general unsecured debts” includes all debts with are both not secured and not “priority.”

General unsecured debts include every imaginable type of debt or claim. The most common ones include most credit cards, virtually all medical bills, personal loans without collateral, checking accounts with a negative balance, unpaid checks, payday loans without collateral, the amount left owing after a vehicle is repossessed and sold, and uninsured or underinsured vehicle accident claims against you.

It helps to know that sometimes a debt which had been secured can turn into a general unsecured one. For example, a second mortgage that was fully secured by the value of the home at the time of the loan can become partially or fully unsecured if the home’s value falls. Or a general unsecured debt can turn into a secured one. For example, a general unsecured credit card debt can become secured debt if a lawsuit is filed against you, a judgment is entered, and a judgment lien is recorded against your real estate.

Priority Debts

As the word implies, “priority” debts are ones that Congress has decided should be treated better than general unsecured debts.

Also, there’s a strict order of priority among the priority debts. Certain “priority” debts get paid ahead of the others (and ahead of all the general unsecured debts). In bankruptcy getting paid first often means getting paid something instead of nothing at all.

This has the following practical consequences in the two main kind of consumer bankruptcy:  

In most Chapter 7 cases there is no “liquidation” of your assets for distribution to your creditors. That’s because in the vast majority of cases, all the debtors’ assets are protected; they are “exempt.” But in those cases where there ARE non-exempt assets which the bankruptcy trustee gathers and sells, priority debts are paid in full by the trustee before the general unsecured ones receive anything. And among the priority debts those of higher priority are paid in full before the lower priority ones receive anything.

In a Chapter 13 case, your proposed payment plan must demonstrate how you will pay all priority debts in full within the 3 to 5 years of your case. Then after the bankruptcy judge approves your plan, you must in fact pay them before you can complete the case (and discharge all or most of your general unsecured creditors). There is more flexibility about when the priority debts are paid with those 3 to 5 years.

Here are the most common priority debts for consumers or small business owners, from higher to lower priority:

  • child and spousal support—the full amount owed as of the filing of the bankruptcy case
  • wages and other forms of compensation owed by the debtor to any of his or her employees—maximum of $12,475 per employee, for work done in the final 180 days before the bankruptcy filing or close of business, whichever was first
  • certain income taxes, and some other kinds of taxes—some are priority but others are general unsecured if they are old enough and meet some other conditions

The next blog posts will discuss how debts in these three categories are treated in Chapter 7 and Chapter 13. 

 

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Business Litigation that Continues After You File Bankruptcy

If you shut down your business, and file bankruptcy, that often ends business litigation against you. But not in these three situations.

 

Lawsuits against You that Bankruptcy Ends

Many legal claims against you or your closed or closing business are resolved by the filing of your bankruptcy case. They are resolved either legally or practically, or both.

Claims that are legally resolved by your filing of bankruptcy are those intended to make you pay money. Or, claims to determine how much money you must pay. The discharge (the legal write-off) in bankruptcy of whatever debt you owe will usually result in you not needing to pay anything on the claim under Chapter 7 “straight bankruptcy.” There’s not much point to a lawsuit to determine whether you owe money or about how much you owe if any such debt will just get discharged in bankruptcy. That’s true regardless how much the debt amount is, and regardless whether there’s a court-determination of the debt or not.

Claims that are practically resolved by your bankruptcy filing are those that are simply not worth pursuing any further. For example, if you file a Chapter 13 “adjustment of debts” case in which the creditors are slated to receive only a few pennies on the dollar, that fact would hugely reduce the benefit of litigation to prove that you owe more money. A simple cost-benefit analysis would show that the very slight possible benefit of further litigation is not worth the addition time or money spent by the creditor.

Lawsuits that Bankruptcy Does NOT End

However, there are certain types of debts that would still need to be resolved by a court. In these situations the creditor would likely get permission from the bankruptcy judge to start a lawsuit or to continue one already started. Here are three types that need court resolution.

1) Determining the Amount of a Debt

If a debt is being discharged in a no-asset Chapter 7 case—one in which all assets of the debtor are “exempt” and protected—then, as indicated above, the amount of that debt makes no practical difference. Whatever the amount of the debt, it is getting discharged without payment of anything towards that debt.

But in an asset Chapter 7 case, in which the bankruptcy trustee is anticipating a pro rata distribution of the proceeds of the sale of assets, the amounts legally owed on all the debts need to be known for that distribution to be fair to all the creditors.  The same holds true in most Chapter 13 cases, in which the creditors are being paid a portion of their debts. That’s because the established amount of any single debt affects the amounts received by all the creditors. So litigation to determine the validity or amount of a debt needs to be completed, even if by a relatively quick settlement (acknowledging the reduced benefit of further litigation because of the reduced stakes at issue for any individual creditor).

2) Possible Insurance Coverage of the Debt

If a claim against a debtor may be covered by insurance, then the affected parties likely want the dispute to be resolved legally.

That’s because a court needs to determine 1) whether the debtor is liable for damages, 2) whether those damages are covered by the insurance, and 3) whether the policy dollar limits are enough to cover all the damages or instead leave the debtor personally liable for a portion. The following types of business litigation tend to involve insurance coverage issues:

  • vehicle accidents involving the business’ employees or owners, especially those with the complication of multiple drivers (and thus, multiple possible insurance coverages)
  • claims on business equipment damaged by fire or flood, or stolen

In these situations the bankruptcy court will likely give permission for the litigation to continue outside of bankruptcy court, while not allowing the creditor to pursue the debtor as to any amount not covered by the insurance policy limits.

3) Nondischargeable Debts

Some of the biggest fights about business-related debts occur when a creditor argues that its debt should not be discharged in the bankruptcy case.  The grounds for objecting to discharge are quite narrow—in general the debtor must have defrauded the creditor, embezzled or stolen from the creditor, or intentionally and maliciously hurt the creditor or its property.

These discharge fights can happen in both Chapter 7 and Chapter 13. Chapter 13 in the past did not let creditors raise discharge challenges that were allowed under Chapter 7. That changed with the last major changes to the bankruptcy law (in 2005), which for the first time allowed those challenges to be raised in Chapter 13 as well. Since Chapter 13 is often a better solution for debtors who have closed a business (it’s often a better way to deal with business-related debts like payroll and income taxes, for instance), many of the dischargeability challenges by creditors now happen in Chapter 13 cases.

 

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If You Owe Lots of Business Debt You Can Maybe Skip the “Means Test” and Qualify for Chapter 7

One benefit of owing more business debt than consumer debt is that it gives you a largely free pass into a Chapter 7 bankruptcy case. 

 

The Role of the “Means Test”

If your income is too high, you have to pass a “means test” to discharge—legally write off—your debts through a Chapter 7 “straight bankruptcy.” The point of this test is to prevent you from discharging your debts if you have the “means” to pay a meaningful portion of them. So it’s essentially an income and expenses test.

If you don’t pass the “means test,” you could be found to be under a “presumption of abuse” of the bankruptcy laws. If so, you would not be allowed to continue with your Chapter 7 case.  

One way to get out of the “means test” is by having less income than the permitted “median family income” for your state and family size. Most people who file under Chapter 7 have low enough income to avoid the “means test.” But the “median family income” amounts are quite low. If your income is above permitted amount, you have to go through the “means test.” As a result you may be forced into a lengthy and relatively expensive 3-to-5-year Chapter 13 payment plan instead of a usually-less-than-four-month Chapter 7 case.

If You Owe More Non-Consumer Debts than Consumer Debts

Because the “means test” was intended for consumer bankruptcies not business ones, it only applies to consumer cases. What’s critical is how the law distinguishes between the two.

You can avoid taking the “means test” altogether—including the “median family income” step—if your debts are not “primarily consumer debts.” That’s the standard. If your debts are not “primarily consumer debts,” you would be eligible for a Chapter 7 case regardless of your income, even if it’s above the “median” amount.

In fact if you don’t have “primarily consumer debts,” you avoid other kinds of “presumptions of abuse” as well. You can avoid not just the income-and-expense “means test,” but also other ways that your Chapter 7 case could be challenged in a consumer case. Congress has apparently decided that if your debts are mostly from a failed business, you should be permitted an immediate Chapter 7 “fresh start” without the precautions in the law supposedly designed to prevent abuse of the bankruptcy laws by consumers.

What’s “Consumer Debt”?

To determine whether you can avoid the “means test,” we need to be clear what a “consumer debt” is. The Bankruptcy Code defines a “consumer debt” as one “incurred by an individual primarily for a personal, family, or household purpose.” (Emphasis added.)

The focus is on the purpose for which you initially incurred the debt, even if the debt would otherwise seem like a consumer debt. Small business owners often finance their business’s start-up and ongoing operation with their consumer credit—credit cards, home equity lines of credit and such. Given their purpose, these might qualify as non-consumer debts in calculating whether you have “primarily consumer debts.” This is definitely something to discuss with your attorney to learn how the local bankruptcy judges are interpreting this issue.

 What Does “Primarily Consumer Debts” Mean?

If the total amount of your “consumer debt” is less than the total amount of your debts that are not “consumer debts,” then your debts are not “primarily consumer debts.”

So you have to decide (with the help of your attorney) separately for each one of your debts whether it is a “consumer debt” or not. Then you add up the two columns of debts, and if the total for those that are not “consumer debts” is larger than the total for those that are “consumer debts,” then you do not owe “primarily consumer debts.” And you can skip the “means test.”

Some Business Debts May Be Larger Than You Think

Even after looking closely to see if some of your seemingly “consumer debts” may have actually had a business purpose, you may still believe that you have more of the “consumer debts.” But sometimes business owners have business debts that end up being larger than they thought they were. That could push their not-“consumer debt” higher than their “consumer debt.”

For example, if you had to break a commercial lease for your business premises when you closed your business, the unpaid lease payments projected out over the intended term of the broken lease could be huge. Same thing with a business equipment lease.

Or closing your business may have left you with other hidden or unexpected debts, such as obligations to business partners or unresolved litigation, with potentially large damages owed (and to be discharged in bankruptcy).

Conclusion

The potential good news about such larger-than-expected business debts is that they may result in your non-“consumer debts” outweighing your “consumer debts.” That would enable you to skip the “means test” and avoid other “presumptions for abuse.” That would allow you to discharge all your debts through a Chapter 7 case instead of being forced to pay all you could afford to pay of those debts under a lengthy Chapter 13 case.

 

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Resolve Your Income and Business Taxes through Bankruptcy While Continuing to Operate Your Business

Do you believe that your small business could survive, and even thrive, if you could just get better payment terms on your overdue taxes?

 

The Near-Universal Debt Challenge

If you are the owner of a struggling business, you likely have income tax problems.

When you are barely scraping by, needing every dollar to pay the absolutely necessary expenses to operate your business, it’s not surprising that there just isn’t enough money to pay the estimated personal income tax payments when they come due every calendar quarter. And so it’s also not surprising if those quarters of unpaid or underpaid taxes start piling up, and before you know it you are behind a year or two or more of income taxes.

The situation can be even worse if you have an employee or two. When you have some absolutely crucial business or personal expense to pay, it’s sometimes just too tempting to use the employee payroll tax withholding money to pay that expense instead of turning the money over to the IRS or the state.

Then your business improves so that you can begin to pay your ongoing estimated and withholding taxes. But you still don’t have the money to simultaneously pay both your current and past tax obligations. Plus penalties and interest keep accruing.

Catching up once you fall behind on your taxes is simply very hard to do when you’re trying to run a business.

The Fear Factor

 You likely already know that the IRS and the state taxing agencies have extraordinary collection powers that they can bring to bear against you, and against your business and personal assets. Besides the usual tools that they can use against individuals, they can do worse to you and your business. They can garnish your receivables—so that your customers find out that you are having serious tax problems. They can levy on—seize—your business equipment and inventory. They can “tap your till”—come onto your premises and seize whatever cash you have on hand.

It’s not that the feds and/or the state will take always such aggressive collection actions against every business or business owner who owes taxes. But they DO tend to be pushier with business-related tax debts, especially if they include tax withholdings.

The larger point is that if you own a business and are behind on taxes, the power of the taxing authorities to cripple your business legitimately makes resolving your back taxes your most urgent problem.

The Chapter 13 Solution

A Chapter 13 “adjustment of debts” helps resolve your tax debts, and so enables your business to survive. It does that by significantly reducing both your business and personal monthly debt obligations, and by sometimes reducing the tax debts themselves and/or giving you much more flexible payment terms.

Specifically as to the past due taxes:

  • some of the taxes and/or penalties may be permanently written off (“discharged”) altogether;
  • payments on the remaining tax debts may be stretched out over a longer period than the taxing authorities would otherwise allow, thereby reducing the amount you would need to pay each month; and
  • ongoing interest and penalties usually stop accruing, so that the payments you make pay the tax debts off more quickly.

Conclusion

Filing a Chapter 13 case almost always gives you immediate month-to-month relief, easing your business and personal cash flow. That’s because the IRS and state are immediately prohibited from collecting against you, including using the strong-arm powers that they have to force payment.

And Chapter 13 gives you long-term relief by almost always reducing the total you have to pay, and giving you time and flexibility in paying it.

So, Chapter 13 is often the best way to get you and your business tax-debt free.

 

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Practical Considerations about Accusations of Business Fraud and Bankruptcy

When a small business fails, allegations of fraud against the owner are not uncommon. But they are often handled well in bankruptcy.

 

There are practical reasons why the owner of an unsuccessful small business tends to be accused of causing or contributing to the failure through fraud or misuse of funds. If you are considering closing down your business or have already closed it down, and are getting such accusation or you fear getting them, you want to know how are those accusations going to be handled if you file a bankruptcy case.

Reasons Why Creditors of Business Owners Raise Fraud Objections

A bankruptcy filed after the failure of a business can stir up more objections than a regular consumer bankruptcy case for a number of practical reasons:

  • The relationship between the former business owner and his or her creditor is often more personal and emotional than a simple debtor-creditor relationship. Consider the relationships between the former business’s partners, between the owner and investors who were friends or relatives, or between the owner and an ex-spouse. Because of the mix of business and personal in these relationships, the business failure is taken more personally, with more of a tendency by the creditor to feel cheated. So the decision whether to fight the discharge (legal write-off) of the debt in bankruptcy is made less as a cost-benefit business decision than an emotional one.
  • The business context tends to provide many all-too-convenient opportunities for the debtor to blur the rules or act unscrupulously, especially when financially “desperate.”
  • If a business owner takes certain actions in good faith which could have resulted in success, but the business does not succeed, those same actions can look questionable in hindsight.
  • In these kinds of disputes, there is often more money at stake than in a consumer bankruptcy. At the same time these kinds of creditors, unlike conventional commercial creditors, may not feel that they just can take the loss and walk away. So they tend to fight even if it’s not such a wise business decision to do so.

What Happens in Bankruptcy?

So if you have been accused by a former business partner, investor, or similar business creditor of some sort of business fraud, or fear that you will be so accused, does this mean that you should avoid filing bankruptcy?

You need to discuss your unique circumstances thoroughly with your bankruptcy attorney, likely together with your business or litigation attorney if you have one.

But in general, perhaps surprisingly, for some practical reasons these kinds of accusations often go away, or at least are resolved relatively quickly, when you file bankruptcy.

Reason #1: The “Automatic Stay”

The filing of your bankruptcy case stops, at least temporarily, any litigation against you that is already in progress. And it stops, again at least temporarily, a new lawsuit from being filed against you (and against your business if it is a sole proprietorship). This pause in the litigation gives your creditor the opportunity to reconsider whether continuing to pursue you would really be worthwhile.

Reason #2: Much Harder to Make a Case against You

Your bankruptcy filing changes the legal issues in your favor. It’s more difficult for your creditor to prevail against you. It’s usually easy enough outside of bankruptcy for a creditor to prove that you owe money. But once in bankruptcy, the debt or claim will be discharged—forever written off—unless the creditor establishes much more: that the debt is based on some rather serious bad behavior by you. The creditor has to convince the bankruptcy judge that you owe the debt because you engaged in fraud, misrepresentation, embezzlement or theft, fraud in a fiduciary capacity, or by intentionally and maliciously injuring the creditor or his or property. Much more difficult to do, and unless there is a good case against you most creditors will realize that they are wasting their time and money to try.

Reason #3: Revealing Your Actual Finances

The documents you file under oath in your bankruptcy case should show your disgruntled creditor that even if the case against you succeeded, you don’t have the money to pay a judgment. Perhaps more important, it should show his or her attorney that it’s not economically sensible. Sensible people would think twice paying thousands of dollars in attorney fees and cost on a case that could be very hard to win, and then at best gets them a judgment that could never be collected. Or if it could be collected, it would be so slowly that the risk and effort would simply not be worthwhile.

Conclusion

Although there are reasons for some small business bankruptcies to be contentious, filing bankruptcy can give you big advantages if you are being pursued for an alleged business fraud. You decrease your creditor’s chances of winning and give him or her good reasons to stop pursuing you.

 

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