The Most Important Things to Know If You Get Sued by a Creditor

Getting sued by a creditor starts a very fast-ticking time bomb. You should and you CAN prevent this bomb from going off.

 

A Lawsuit Should Catch Your Attention AND Spur You to Action

For certain economic reasons, most conventional creditors don’t sue you as quickly as they legally could. That means that if you are getting sued you are very likely in some significant financial trouble. Even if you feel like there is nothing you can do, there almost always is, and you owe it to yourself to treat it as a wake-up call. You will feel better if you are proactive and at the very least understand your options, instead of just avoid the situation out of understandable fear or embarrassment.

Most debts that people get behind on are at some point—often quite quickly—assigned by the original creditors to collection agencies. This can happen two ways. Either the creditor still owns the rights to the debt and the collection agency simply gets a percentage of what it collects, or the creditor sells all of its rights to the debt to a collection agency and then is legally no longer in the picture.

Either way, the collection agency then tries to get you to pay the debt. In most situations it is reluctant to sue you—at least at first—because a lawsuit costs it money that it doesn’t know if it will ever recoup from you. Instead—again at least at first—it will tend to aggressively contact you and try to make you pay whatever it can. Depending on the facts of the situation—including whether you have a job or real estate or other assets—the collection agency will then decide whether it’s worth suing you. If you ARE sued, there’s a good chance that the collection agency believes it can force payment from you by garnishing your paycheck or bank account, or by putting a lien on your home or by attaching other assets. Once you are sued, the collector has upped the ante and is signaling that it believes investing in a lawsuit is worthwhile to it.

This is a signal you need to pay attention to right away.

The Game Collectors Play

Collection agencies act out of their own self-interest. They don’t generally sue you without doing a cost-benefit analysis: they don’t invest the cost of a lawsuit without thinking that the odds are good that they’ll get a decent return on that investment—getting those costs repaid and the debt as well. After all, a collection agency that wastes too much of its money on lawsuits that don’t pay off won’t be in business long.

So if you’re sued, most likely the collector has its eyes on one or more potential ways it expects to force you to pay—such as a paycheck to garnish, or some real estate to put a lien on (to foreclose on or get paid when you sell or refinance). Even if you are not working now, your prior work history may make you a decent target. The collector has decided it would benefit from forcing you to pay the debt by court order and enforcement—through garnishment, forcing you to appear for a judgment debtor examination, placing a judgment lien on your real estate, and such.

In fact the collection agency is banking on you not taking the lawsuit seriously enough. The sad truth is that a large majority of the time people don’t respond to lawsuits so that judgments are entered against them by default. The collector is hoping to get a judgment against you, and then to use the force of law to start grabbing your income and your assets.

How to Beat Collectors at This Game

Don’t assume that there is nothing you can do. Don’t take the seemingly common sense but wrong approach that you owe them the money and so you have to take whatever they dish out. Find out what they can and can’t do to you, and how you can protect yourself. And do that before the time expires and the creditor or collection agency gets its judgment against you.

Don’t let your creditors take advantage of you and your lack of knowledge.  Most consumer or bankruptcy attorneys will give you a free consultation with honest advice about your options. Learn what’s best for you in light of your own personal goals and hopes. You can and ought to have a proactive game plan.

Timing is Absolutely Crucial

When you find out you’ve been sued, there is very little time to respond. If you don’t in time, you lose the lawsuit “by default.”

The judgment that results is much more than simply an admission that you owe the debt. The formal complaint in most creditor lawsuits consist of a statement that you owe a debt, and now owe the full balance, plus the interest accrued so far and into the future, plus whatever attorney fees and other costs paid by the creditor/collector to sue you.

Letting a default judgment be entered against you makes you forever legally liable based on whatever allegations the creditor put into its complaint, even if inaccurate or not supported by your contract or by the law.

The complaint may include admissions that can be even more dangerous, for example, that you incurred the debt through fraud, potentially making the debt not dischargeable even in bankruptcy.

Reasons to Not Allow a Default Judgment

Quickly see an attorney as soon as you are sued because:

a) You should understand the consequences of the lawsuit, and your options for dealing with it. Know what your options are instead of assuming you have none.

b) You may have defenses so that you don’t legally owe the debt after all. Collection agencies routinely try to collect debts on which the statute of limitations has expired. They can sue the wrong person. They may include allegations which are not accurate or supported by law.

c) You may have a counterclaim—an argument that the creditor acted illegally in some way and actually owes you money for damages. At the least this could give you leverage to settle the debt under much better terms.

d) Once the time to respond expires and a judgment is entered, it is too late to deny the allegations in the complaint.   

e) By having an attorney review the lawsuit and your overall debt picture, and discuss your options, you may end up solving deeper problems. Most consumers do not have an attorney who they talk with regularly. So problems accumulate. You don’t have a chance to ask questions when they arise. This often leads to lots of confusion and anxiety. Seeing an attorney about a pending lawsuit could lead to addressing how to improve your entire financial life.  

 

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How Fast Can the “Automatic Stay” Stop a Wage Garnishment?

Bankruptcy stops a wage garnishment instantly. Except local laws and the exact timing determines what happens to any current paycheck.

 

Federal Bankruptcy Law and State Garnishment Law

Bankruptcy is in the U.S. Constitution, which was ratified 226 years ago this month. The Constitution gives Congress the power to make laws about bankruptcy. So it’s a federal proceeding governed by federal law. But we live in a federalist form of government, meaning that governmental power is shared between the national government and that of the various states. The impact of state law on wage garnishments with the filing of a bankruptcy is a good example of the mix of federal and state law.

The Necessity of a Judgment

Except in rare circumstances (involving income taxes and student loans, mostly), your wages cannot be garnished to take money from you in payment of a consumer debt until after the creditor sues you in court and gets a judgment. That would almost happen in state court. A large percentage of the time when debtors are sued in this way, they do not respond by the legal deadlines, so creditors win their judgments by default. Once your creditor has such a state court judgment in hand, it must then follow state law in collecting on it.

Diverse State Laws

States’ garnishment laws vary widely. Most states permit wage garnishment in some form, but some restrict it to only special kinds of debts (like child support, taxes, and/or student loans). Other states which permit wage garnishment for most debts nevertheless may favor some of those same special debts. State laws also protect paychecks for debtors to a different degree through “exemptions.” And finally state laws differ on their timing details and other quirks of garnishment procedure, which are often critical for the question being faced here: how fast a bankruptcy filing stops a garnishment.

The “Automatic Stay”

Simultaneous with the filing of your bankruptcy case, the “automatic stay” goes into effect. The filing itself operates to stop virtually all collection activity against you. It operates as an immediate and one-sided court order against creditors, stopping the enforcement of a wage garnishment.

Complications of Timing

What if a bankruptcy case is filed at court within just a day or two after the money has been taken out of your wages under a court garnishment order but not yet turned over by your payroll office to the creditor? What does the automatic stay require when it says that the bankruptcy filing stops “the enforcement, against the debtor or against property of the estate, of a judgment obtained before the commencement of the [bankruptcy] case”? (Section 362 (a)(2) of the Bankruptcy Code.)

Money that was taken out of your paycheck before your bankruptcy case was filed is not “property of the estate”—which is essentially all your assets at the moment your case is filed. But arguably it’s not your money to keep either because it was already legitimately taken from you by the garnishment order at the time your bankruptcy case was filed.

So can the creditor get that money that your employer is holding, or would that be a violation of the automatic stay? The answer likely turns on a careful reading of your state garnishment law—the statute itself plus possibly how the state’s courts have interpreted that statutory language.

Practically Speaking

Many creditors tend to be cautious about violating the automatic stay, and may back off when there is some legal ambiguity about whether it is entitled to funds from a garnished paycheck. Other creditors are more willing to be aggressive, especially if the state’s statutes and/or courts have given them some cover to do so.

To state the obvious, do what you can to avoid this whole situation by seeing an attorney in time so that your bankruptcy case can be filed before your payday, so that the wage garnishment can definitely be stopped in time.

 

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Chapter 13 Can Especially Protect Your Co-Signers

Chapter 13 “adjustment of debts” goes a big step further than a Chapter 7 case by protecting your co-signers and their assets.

 

The Regular “Automatic Stay”

The automatic stay—your protection against just about all collection efforts by your creditors—kicks in just as soon as your bankruptcy case is filed. It applies to all bankruptcy cases, including those filed under Chapter 7 and Chapter 13. It is one of the most powerful and important benefits of filing a bankruptcy case.

But it protects only you—the person or persons filing bankruptcy—and your assets. It does not protect anybody else who may also be legally liable on one of your debts.

The Very Special “Co-Debtor Stay”

The very first section of Chapter 13—Section 1301—also deals with the automatic stay, but adds another layer of protection—applicable to your “co-debtors, or co-signers—that only applies to cases filed under Chapter 13.

Section 1301 states that once a Chapter 13 case is filed, “a creditor may not act, or commence or continue any civil action, to collect all or any part of a consumer debt of the debtor from any other individual that is liable on such debt with the debtor.” (Emphasis added.)

A creditor on a consumer debt is already prevented by the regular automatic stay from doing anything to collect a debt directly from the debtor. Now, under Chapter 13 only, and only on consumer debts, that creditor is also prevented from collecting on the same debt from anybody else who has co-signed or is otherwise also obligated to pay that debt.

A Very Special Protection

If you think about it, that’s rather powerful, and quite unusual. The person being protected—your co-signer—has nothing to do with your bankruptcy case filing. The co-debtor stay gives you the power to protect that person—likely somebody you really care about—who is not filing bankruptcy and so is not under the direct jurisdiction of the court. The person may not even know that you are protecting them from the creditor.

Conditions and Limits of the Co-Debtor Stay

Besides being limited to consumer (not business) debts, the “co-debtor” protection:

1. Does not protect spouses from joint liability on income taxes. That’s because income tax debts are not considered “consumer debts” for this purpose.

2. This protection does not extend to those who “became liable on… such debt in the ordinary course of such individual’s business.”

3. Creditors can ask for and get permission to pursue your co-debtor to the extent that:

(a)  the co-debtor had received the benefit of the loan or whatever “consideration” was provided by the creditor (instead of the person filing the bankruptcy)—in effect that you were co-signing for him or her; or  

(b)  the Chapter 13 plan “proposes not to pay such claim.”

4. Even if a creditor does not seek or get the above permission, this co-debtor stay expires as soon as the Chapter 13 case is completed, or if it’s dismissed (for failure to make the plan payments, for example), or converted into a Chapter 7 case.

Conclusion

Choosing between Chapter 7 and 13 often involves weighing a series of considerations. If you want to protect a co-signer or someone liable on a debt with you from being pursued for that debt, seriously consider Chapter 13 because of the co-debtor stay. 

 

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Are You Eligible to File a Chapter 7 Bankruptcy Case? How About a Chapter 13 One?

Eligibility depends on 1) the kind of debtor, 2) the kinds and amounts of debts, 3) the amount of income and 4) of expenses.

 

1) The Kind of Debtor

If you are a human person, you may be eligible for either a Chapter 7 “straight bankruptcy” or a Chapter 13 “adjustment of debts” case. You and your spouse may also be eligible to file one or the other of these together in a joint case.

However, if you are the owner or part-owner of a business partnership, corporation, limited liability company or other similar business entity, that business entity could not file its own Chapter 13 case. But it could file a Chapter 7 one. Regardless what your business entity itself could file, you could individually file either a Chapter 7 or 13 case, to address your own personal liabilities (beyond whatever liability for which the business itself would be responsible).

2) The Kinds and Amounts of Debts

If your debts are “primarily consumer debts” (more than 50% by dollar amount), then to be able to file a successful Chapter 7 case you have to pass the “means test.” That’s a test related to your income and expenses (discussed more below.)  If 50% or more of your debts are not consumer debts, than you can skip the “means test.”

Chapter 7 does not limit the amount of debt you can have to be eligible to file a case. However, you cannot file a Chapter 13 case if your debts exceed the maximums of $383,175 in unsecured debts and $1,149,525 in secured debts (or if you do file a case it will very likely be “dismissed” (thrown  out)).

3) Amount of Income

You can quickly and easily satisfy the “means test” and be eligible for a Chapter 7 case if your income is no more than the regularly adjusted and published “median income” for your family size and state.

To be eligible for Chapter 13 you must have “regular income.” That is defined not very helpfully as income “sufficiently stable and regular” to enable you to “make payments under a [Chapter 13] plan.”

Also for Chapter 13, if your income is less than the “median income” for your family size and state of residence, then the plan generally must last a minimum of three years (but in many situations it can last longer, especially if you need it to, but for no longer than five years). If your income is at or above the applicable “median income” amount, the plan must almost always last five years.

4) The Amount of Expenses

In Chapter 7, if your income is NOT less than “median income” for your family size and state of residence, then you may still pass the “means test” and be eligible for filing a Chapter 7 case IF, after accounting for all your allowed expenses, you don’t have enough money left over to pay a meaningful amount to your creditors.

In Chapter 13, a similar accounting of your allowed expenses determines the amount of your “disposable income,” the amount you must pay into your plan each month.

Summary

Once you recognize that you need relief from your creditors, choosing between Chapter 7 and 13 is often not difficult. But because there are many, many differences between them, the choice can sometimes turn into a delicate balancing act between the advantages and disadvantages of those two options. That’s why when you have your initial meeting with your bankruptcy attorney, it’s smart to be aware of and communicate your goals, but also be open-minded about how best to accomplish them.

 

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Business Disputes that Follow You Into Your Bankruptcy Case

A creditor can challenge the discharge of its debt in bankruptcy. This is not common, but is more so after a debtor closes a business.

 

Why Creditor Challenges Are More Common in Closed-Business Bankruptcies

For the following reasons, creditors tend to object more to the discharge of their debts in bankruptcy cases that are filed after the debtor has operated and closed a business:

  • The amount of debt owed, and thus the amount at stake, tends to be larger than in a conventional consumer case, making objection more tempting to the creditor.
  • In the business context some debtor-creditor relationships can be very personal, so when the business fails, these creditors take it personally. Consider debts between former business-partners who are blaming each other for the failure of the business, or between a business owner and the business’ primary investor who believes the owner drove the business into the ground, or between the contract buyer of a business and its seller in which the buyer feels that the seller misrepresented the profitability of the business. In these situations the aggrieved creditor is more personally motivated to fight the discharge of its debt.
  • The owners of businesses in trouble find themselves desperate to keep their businesses afloat. So they make questionable decisions which then expose them to objections about fraud and such once they file bankruptcy.
  • In the kinds of close creditor-debtor relationships mentioned above, the creditor often has hints about the business owner’s questionable behavior, and so is more likely to believe it has the legally necessary grounds to object.

But Objections to Discharge Are Still Not Very Common

When former business owners hear that any creditor can raise objections to the discharge of its debt, they figure an objection would very likely be raised in their case. But in reality these objections occur much less frequently than might be expected, for the following reasons:

  • The legal grounds under which challenges to discharge must be raised are quite narrow. To be successful a creditor has to prove that the debtor engaged in rather egregious behavior, such as fraud in incurring the debt, embezzlement, larceny, fraud as a fiduciary, or intentional and malicious injury to property. These are not easy to prove, so creditors do not tend to try unless they have a strong case.
  • In his or her bankruptcy case the debtor publically files a set of papers containing quite extensive information about his or her finances, and does so under oath. The debtor is also subject to questioning by the creditors about that information and about anything else relevant to the discharge of his or her debts. If the information on the sworn documents or gleaned from any questioning reveals that the debtor truly has no assets worth pursuing, a rational creditor will often decide not to throw “good money after bad” by raising an objection.

Conclusion

In a closed-business bankruptcy case there are these two opposing tendencies. Challenges to discharge are more likely, especially by certain kinds of closely related creditors. But these challenges are still relatively rare because of the narrow legal grounds for them and the financial practicalities involved. A good bankruptcy attorney will advise you about this, will prepare your bankruptcy paperwork to discourage such challenges, and will help derail any such challenges if any are raised.   

 

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Your Bankruptcy Options If You Owe Income Taxes After Closing Your Business

Most people who close down a failed small business owe income taxes. Chapter 7 and Chapter 13 provide two very different solutions.

 

Here are the two options:

Chapter 7 “Straight Bankruptcy”

File a Chapter 7 case to discharge (permanently write off) all the other debts that you can, and sometimes some or even all of your income taxes. If you cannot discharge all of your taxes, right after your Chapter 7 is completed you (or your attorney or accountant) would arrange for you either to make monthly payments to pay off those remaining taxes or to enter into a settlement with the taxing authority(ies).

Chapter 13 “Adjustment of Debts”

File a Chapter 13 case to discharge all the other debts that you can, and sometimes some or even all the taxes. If you cannot discharge any of your taxes, you then pay the remaining taxes through your Chapter 13 plan, while under continuous protection against the IRS’s or state’s collection efforts.

The Income Tax Factor in Deciding Between Chapter 7 and 13

In real life, especially after a complicated process like closing a business, often many factors come into play in deciding between Chapter 7 and Chapter 13. But focusing here only on the income taxes you owe, the choice could be summarize with this key question: Would the amount of tax that you would still owe after completing a Chapter 7 case (if any) be small enough so that you could reliably make workable arrangements with the IRS/state to pay off or settle that obligation within a reasonable time?

As just mentioned, in a Chapter 7 case you deal with the IRS/state about any remaining taxes after that Chapter 7 case is completed, when the protection against tax collection efforts against you have expired. In contrast Chapter 13 protects you from such tax collection during the three to five years while you are in the Chapter 13 case. 

Being in a Chapter 7 case only makes sense if you don’t need that ongoing protection.

Crucial Information from Your Attorney

To find out whether you need Chapter 13 protection, you need to find out from your attorney the answers to two questions:

1) What tax debts will not be discharged in a Chapter 7 case?

2) What payment or settlement arrangements will you likely be able to make to take care of those remaining taxes?

How reliably your attorney (or anyone else) can predict how a particular taxing authority will allow a tax debt to be paid or settled depends on the circumstances. For example, the IRS has some rather straightforward policies about how long a taxpayer can make monthly payments to pay off income tax obligation in full—and thus how much those monthly payments would have to be—as long as the balance owed is less than a certain amount. In contrast, predicting whether or not the IRS/state will accept a particular “offer-in-compromise” to settle a debt can be much more difficult to predict.  Your attorney (or tax accountant) should tell you the likely success of any proposed game plan.

When in doubt about whether you would be able to pay what the taxing authorities would require after a Chapter 7 case, or in doubt about some other way of resolving the tax debt, you may well be better off under the protections of Chapter 13.

Conclusion

Once you know how much in tax you would still owe after filing a Chapter 7 case, do you have a reasonable and reliable means of paying it off or settling it within a sensible length of time? If so, file a Chapter 7 case. Otherwise, take advantage of the greater protection of Chapter 13.  

 

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The Benefits of Both “Asset” and “No Asset” Chapter 7 After Closing Down a Business

A Chapter 7 case will wipe out all or most of your personal liability from a closed sole proprietorship, corporation, LLC, or partnership.

 

If you have closed down a business, or are about to do so, filing a Chapter 7 “straight bankruptcy” case can be the best way of putting the debts of that business permanently behind you.

That Chapter 7 case will likely be a simpler one if you have a “no asset” case instead of an “asset” one. But an “asset case” may be worth the extra time it would likely take.

“Asset” and “No Asset” Chapter 7

Chapter 7 is sometimes called the liquidation form of bankruptcy. That usually does NOT mean that if you file a Chapter 7 case something you own will be liquidated, or sold. Most of the time you can keep everything you own. That’s if everything you own is “exempt”—included within a set of property “exemptions,” those types and amounts of property that are protected from your creditors. If everything is exempt, you would have a “no asset” case, so-called because the Chapter 7 trustee has no assets to collect.

In contrast, if you own something that is not exempt, and the trustee decides that it is worth liquidating and using the proceeds to pay a portion of your debts, then your case is an “asset case.”

The Quick “No Asset” and the Drawn Out “Asset” Case

Generally, a “no asset case” is simpler and quicker than an “asset case” because it avoids the asset liquidation and distribution-to-creditors process.

A simple “no asset” case can be completed in about three to four months after it is filed (assuming no other complications arise).  That’s in contrast to an “asset” case which always takes at least a few months more, easily a year or so, sometimes even multiple years.

Why does an “asset” case take so long? Because it can take time for a trustee to locate and take possession of an asset, sell it in a fair and open manner with notice to all interested parties, give creditors the opportunity to file claims to get paid out of the sale proceeds, for the trustee to object to any inappropriate claims, and then to distribute the funds as the law provides.  Each of these steps can take extra time. Especially if you have unusual or intangible asset, such as a disputed claim against a third party—a claim arising from an auto accident, for example—it can take a few years for the trustee to resolve and convert such a claim into cash, keeping the bankruptcy case open throughout this time.

The Potential Benefits of an “Asset” Case

If the trustee does have some asset(s) to collect from you, that can be turned to your advantages.  Two situations come to mind.

First, you may decide to close down your business and file a bankruptcy quite quickly after that in order to hand over to the trustee the headaches of collecting and liquidating the assets and paying the creditors in a fair and legally appropriate way. If you’ve been fighting for a long time to try to save your business, you may well find it not worth your effort to negotiate work-out terms with all the creditors. And you likely have no available money to pay an attorney to do this for you.

Second, you may particularly want your assets to go through the Chapter 7 liquidation process if the debts that the trustee will likely pay first out of your assets are ones that you especially want to be paid. The trustee pays creditors according to a legal list of priorities. For example, at the top of that list are child and spousal support arrearages, with certain tax claims not far behind. You may well want to take care of claims by your ex-spouse and/or children and the tax authorities. That’s especially true if you would continue to be personally liable on these obligations after the bankruptcy is over. 

 

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Choosing the Right Solution in a Closed-Business Bankruptcy Case

Whether to file under Chapter 7 or Chapter 13 depends largely on your business assets, taxes, and other nondischargeable debts.

 

Hoping to File a Chapter 7 “Straight Bankruptcy”

Once you’ve closed down your business and are considering bankruptcy, it would be understandable if you preferred to file under Chapter 7 instead of under a Chapter 13 “adjustment of debts.”

After all you’ve been through the last few years trying to keep your business afloat, you just want a fresh, clean start, as quickly as possible. You likely feel like just putting the debts behind you. The last thing you likely want is to do is stretch things out for the next three to five years that a Chapter 13 case would usually take.

Likely Can File Under Chapter 7 Under the “Means Test”

The “means test” determines whether, with your income and expenses, you can file a Chapter 7 case. In my last blog I described how you can avoid the “means test” altogether if more than half of your debts are business debts instead of consumer debts.

But even if that does not apply to you, the “means test” will still not likely be a problem if you closed down your business recently. That’s because the period of income that counts for the “means test” is the six full calendar months before your bankruptcy case is filed. An about-to-fail business usually isn’t generating much income. So, there is a very good chance that your income for “means test” purposes is less than the published median income amount for your family size, in your state. If your prior 6-month income is less than the median amount, by that fact alone you’ve passed the means test and qualified for Chapter 7.

Three Factors about Filing Chapter 7 vs. 13—Business Assets, Taxes, and Other Non-Discharged Debt

The following three factors seem to come up all the time when deciding between filing Chapter 7 or 13:

1. Business assets: A Chapter 7 case is either “asset” or “no asset.” In a “no asset” case, the Chapter 7 trustee decides—usually quite quickly—that all of your assets are exempt (protected by exemptions) and so cannot be taken from you to pay creditors.

If you had a recently closed business, there more likely are assets that are not exempt and are worth the trustee’s effort to collect and liquidate. If you have such collectable business assets, discuss with your attorney where the money from the proceeds of the Chapter 7 trustee’s sale of those assets would likely go, and whether that result is in your best interest compared to what would happen to those assets in a Chapter 13 case.

2. Taxes: It seems like every person who has recently closed a business and is considering bankruptcy has tax debts. Although some taxes can be discharged in a Chapter 7 case, many cannot. Especially in situations in which a lot of taxes would not be discharged, Chapter 13 is often a better way to deal with them. Which option is better depends on the precise kind of tax—personal income tax, employee withholding tax, sales tax—and on a series of other factors such as when the tax became due, whether a tax return was filed, if so when, and whether a tax lien was recorded.

3. Other nondischargeable debts: Bankruptcies involving former businesses get more than the usual amount of challenges by creditors. These challenges are usually by creditors trying to avoid the discharge (legal write-off) of its debts based on allegations of fraud or misrepresentation. The business owner may be accused of acting in some fraudulent fashion against a former business partner, his or her business landlord, or some other major creditor.  These kinds of disputes can greatly complicate a bankruptcy case, regardless whether occurring under Chapter 7 or 13. But in some situations Chapter 13 could give you certain legal and tactical advantages over Chapter 7.

These three factors will be the topics of my next three blogs. After reviewing them you will have a much better idea whether your business bankruptcy case should be in a Chapter 7 or Chapter 13.

 

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Close Down Your Small Business, Get a Fresh Financial Start

Closing down a business can leave you with huge debts and no income to pay them. Bankruptcy may be necessary, and be easier than you think.

 

A Business Bankruptcy Means a Messy One?

A bankruptcy cleaning up the financial fallout from a closed business can be more complicated than a consumer bankruptcy case. But is not necessarily so.

In the next few blog posts I will show how a business bankruptcy can be quite a simple and effective solution.

Today I present one way a business bankruptcy can actually be easier than a consumer one. 

How so? Because under certain conditions a business bankruptcy case can avoid the Chapter 7 “means test,” allowing you to legally write off (“discharge”) all your debts quickly.

The Purpose of the “Means Test”

The point of the means test is to require people who have the means to pay a meaningful amount to their creditors over a reasonable period of time to in fact do so. They aren’t allowed to simply discharge their debts.

Essentially this disqualifies people who do not pass the means test from going through a Chapter 7 case, which allows a quick discharge of most debts. Instead they must go through Chapter 13, which generally requires them to pay creditors all that they can afford to pay them over a 3-to-5-year period.

The Challenge of Passing the Means Test

To pass the means test requires either having a relatively low income (no more than the published median income amount for the person’s state and family size) or having enough allowed expenses so that little or no “disposable income” is left over. Again, otherwise you will be stuck in a 3-to-5-year Chapter 13 payment plan.

In many scenarios, a former business owner needing bankruptcy relief would not be able to pass the means test and so would have to go through Chapter 13. For example:

  • If, after closing his business, the owner of that business gets a well-paying job before filing bankruptcy, the income from that job may be larger than the “median income” applicable to her state and family size.
  • If the business was operated by one spouse while the other continued working and earned a good income, that employed spouse’s income alone may bump the couple above their applicable “median income” amount, thereby not passing the “means test.”
  • A former business owner who now earns more than median income can’t deduct monthly payments to secured creditors on business collateral she is surrendering—vehicles and equipment, for example—or for other business expenses, such as rent on the former business premises. This reduces the likelihood that she will have enough allowed expenses to pass the “means test.”

Skip the “Means Test” in Business Bankruptcies

The good news is that you do not have to pass the means test at all if your “debts are primarily consumer debts.” (Section 707(b)(1) of the Bankruptcy Code.) So if your debts are primarily business debts—more than 50%–you avoid the means test altogether.

Let’s be clear about the difference between these two types of debts. A “consumer debt is a “debt incurred by an individual primarily for a personal, family, or household purpose.” (Section 101(8).)  The focus is on the intent at the time the debt was incurred. So, for example, if you had taken out a second mortgage on your home for the clear purpose of financing your business, that second mortgage would likely be considered a business debt for this purpose.

Certainly there are times when the line between a business and consumer debt is not clear. Given what may be riding on this—the ability to discharge all or most of your debts in about four month under Chapter 7 vs. paying on them for up to 5 years under Chapter 13—be sure to discuss this thoroughly with your attorney. Find out if you can avoid the means test under this “primarily business debts” exception. 

 

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