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Writing Off Income Taxes Forever through Bankruptcy

What income taxes can a Chapter 7 bankruptcy completely write off?

My last blog ended saying how Chapter 13 lets you pay off certain income taxes much more conveniently because you’re protected from the tax collector and can usually avoid paying substantial amounts of interest and penalties. But that’s for taxes you can’t write off. What exactly does it take to write off a tax completely?

It takes meeting four main conditions.

But before I list and describe these, I have to emphasize that this whole area—dealing with tax debts in bankruptcy—is a very complex one. I present the information in these blogs to you because the more you know the better. But part of being informed is knowing when you definitely need an attorney’s help. So, part of my job is to make very clear when you are in a particularly difficult area, when you truly need the help of someone who spends his or her professional life thoroughly understanding the complex rules, and constantly applying them in the real world. This is clearly one of those areas.

And now on to those four main conditions for writing off income taxes.  

1. Have three years passed since the tax return was due?

This one is pretty straightforward, because every income tax debt has a due date for the filing of its tax return. The important twist here: if you requested an extension of time—usually from April 15 to October 15—the three-year period does not begin until the extended due date.  

2. Have two years passed since the applicable tax return was actually filed?

It does not matter how ancient the tax if at least two years have not passed since the return was in fact filed. And a “substitute for return”—the common procedure in which the IRS in effect prepares a tax return on your behalf based on the (usually incomplete) information it has available—that doesn’t count as a filed return for this purpose.  

3. Have 240 days passed since assessment of the tax?

In most situations an income tax is assessed within a few weeks after you file it. Assessment is the tax authority’s formal determination of your tax liability, usually through its review and acceptance of your tax return. But sometimes the amount of tax is in dispute because of a tax audit or litigation about the amount. By the time the accurate tax amount is finally assessed, the above three-year or two-year time periods may have passed, but that tax cannot be written off unless that bankruptcy case is filed more than 240 days after the assessment. This 240-day period is also put on hold while a taxpayer’s “offer in compromise” is pending. Just like it sounds, that’s an offer to the IRS to settle the tax for less money or for specific payment terms.

4. Have you filed a fraudulent tax return or intentionally attempted to evade the tax?

Even if all the required time periods have passed, if you were dishonest on your tax return—such as not including some of your income or claiming invalid deductions–or tried to avoid paying a tax in some other way, that tax will not be written off in bankruptcy.

This discussion should give you a good idea whether any or all of your income tax debts can be written off in a bankruptcy. And in some cases applying these four conditions will give you the accurate answer. But there are some other considerations that can come into play. What if the IRS recorded a tax lien against your home and on your personal possessions?  How would a prior bankruptcy affect these timing rules? What about your appeal of a tax? What’s considered an honest mistake on a tax return instead of an intentional tax evasion? When can the taxing authority add a 30-day “tack-on” to the 240-day rule?

Bankruptcy can certainly write off income taxes under the right circumstances, but you need to have an experienced attorney review your personal situation to see if you truly meet those circumstances.

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Income Tax Refunds in Chapter 7 Bankruptcy

Can you keep your tax refund if you file a Chapter 7 case? It’s mostly a matter of timing.

 

Here are the bullet points:

  • Everything you own at the time your Chapter 7 bankruptcy case is filed becomes your “bankruptcy estate.” Usually, most or all of that “estate” stays in your possession and you get to keep because it’s “exempt,” or protected.
  • That “estate” includes not only your tangible, physical possessions, but also intangible ones—assets you own that you can’t physically touch—such as money owed and not yet paid to you.
  • Depending on the timing, a tax refund can be an intangible asset that becomes part of your bankruptcy estate. Then whether you can keep it or not depends on whether it is exempt.
  • Because an income tax refund usually consists of the overpayment of payroll withholdings, the full amount of that refund has accrued by the time of your last payroll withholding of that tax year. So even though nobody knows the amount of your refund until your tax return is prepared a few weeks or months later, for bankruptcy purposes it is all yours as of the very beginning of the next year.
  • So if you file a Chapter 7 case after the beginning of the following year and before you have received your tax refund, it is part of your bankruptcy estate and the trustee can keep it if it is not exempt, or can keep as much of it as it not exempt. That’s also true if you have received the refund and not done anything with it.
  • You can avoid this by filing your tax return and receiving and appropriately spending the refund before your Chapter 7 case is filed. DO NOT do this without very specific advice from your attorney. The bankruptcy system is very interested in what money you receive and precisely how you spend it before filing bankruptcy, and you can very easily get into trouble if this is not all done very carefully.
  • If the bankruptcy is filed so that the refund is an asset of the bankruptcy estate, whether or not it is exempt depends on how large it is and how much of an exemption is allowed in your state. In some cases, using all or part of an exemption for the tax refund may reduce the availability of the exemption for other assets.
  • Some states have specific exemptions applicable to certain parts of the tax refund, or laws that exclude them from the bankruptcy estate altogether, particularly regarding the Child Tax Credit or the Earned Income Tax Credit. These likely do not exist in a majority of the states, but it’s worth checking.  
  • Even if the refund, or a portion of it, is not exempt, the Chapter 7 trustee may still NOT claim it if he or she determines the amount is not enough to open an “asset case.” That is, the amount of refund to be collected is so small that the benefit of distributing it to the creditors is outweighed by the administrative cost involved. You might hear a phrase similar to the amount being “insufficient for a meaningful distribution to the creditors.” This threshold amount can vary from one court to another, indeed from one trustee to another, so be sure to discuss this with your attorney. But note that if the trustee is collecting any other assets, then most likely he or she will want every dollar of tax refunds that are not exempt.
  • There is a risk that you will not be able to claim an exemption if you don’t list the tax refund to which the exemption applies. So be sure to always list any tax refund to which you may be entitled.
  • Although I’m focusing on this issue now because we are in tax season, the same principles apply year-round. Frankly, it can be a little harder to wrap your brain around this as applied to, say, filing a bankruptcy in the middle of the year. As of July 1, you’ve had a half-year of tax withholdings deducted from your paychecks and forwarded by your employer to the taxing authorities. So, assuming the same amounts were withheld throughout the year, if you end up getting a substantial refund the following spring, for bankruptcy purposes about half of that had accrued by mid-year. So a bankruptcy filed on July 1, needs to take that into account. Some Chapter 7 trustees don’t push this issue much until the last quarter of the year, when that much more of the refunds have accrued. But regardless, tell your attorney about income tax refunds anticipated the following year, particularly if you have a history of relatively large tax refunds.

 

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Taxes in a Closed-Business Bankruptcy Case

Dealing with taxes from a failed business through a bankruptcy—that sounds complicated. But I’m going to keep it simple here. What are your basic options if you owe taxes after closing down a small business?

You have two choices (once it’s clear that you need to file a bankruptcy because of the amount of your debts):

1. File a Chapter 7 case to discharge (legally write-off) all the debt that you can, perhaps including some of the taxes, and then deal directly with the taxing authorities about the remaining taxes.

2. File a Chapter 13 case to discharge all the debt that you can, perhaps including some of the taxes, and then pay the remaining taxes through that same Chapter 13 case.

In real life, especially after a messy situation like the shutting down of a business, many factors usually come into play in deciding whether a Chapter 7 or 13 is better for you. But focusing here only on the taxes, it comes down to this core question: Would the amount of tax that you would still owe after completing a Chapter 7 case be small enough so that you would reliably be able to make reasonable arrangements with the Internal Revenue Service (or other applicable taxing authority) to satisfy that obligation within the following two years or so?

Chapter 13 protects you from the collection powers of the taxing authorities during the usual three to five years while you are fulfilling your obligations under the case.  You should be in a Chapter 7 case only if you don’t need that protection. That means your attorney needs to be able to tell you 1) what tax debts will not be discharged in a Chapter 7 case, and 2) what payment or other arrangements will you likely be able to make to take care of those remaining taxes.  

How reliably anyone can predict how a particular taxing authority will respond about a surviving tax debt depends on the circumstances. For example, the IRS has some rather straightforward policies about how long a taxpayer has to pay off income tax obligations below a certain amount. In contrast, predicting whether or not the IRS will accept a certain “offer-in-compromise” can be much more difficult to predict.  If you cannot get rather strong assurances that you will be able to reasonably handle what the taxing authorities will require, you may well be better off within the protections of Chapter 13.

Not only does Chapter 13 give you protection from the tax authorities, you would likely be permitted to pay less to them per month towards the not-discharged taxes. That’s because your living expense budget in a Chapter 13 case will likely be more reasonable than when you’re dealing directly with the IRS after a Chapter 7 case. Furthermore, unlike the after-Chapter 7 situation, penalties would not continue to accrue, and in most cases neither would interest. As a result, in a Chapter 13 case most likely you would pay less money to finish off the tax debt.

Again, the bottom line: once you know how much tax debt will survive a Chapter 7 case, do you have a reasonable and reliable means of paying it off or settling it within about two years? If so, do the Chapter 7 case. Otherwise, take advantage of the greater protection and likely more reasonable budgeting in Chapter 13.  

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“Asset” and “No Asset” Closed-Business Chapter 7 Cases

When the sole proprietor of a just-closed business files a personal Chapter 7 bankruptcy case, the trustee may or may not have assets to liquidate and distribute to the creditors. If NOT, the case will more likely be finished faster. But if the trustee DOES collect some assets, the extra time may be worth it for the former business owner.  

If you’ve closed down your business and as a result are now personally liable on large debts that you cannot pay, you may well be wondering whether bankruptcy is your best option. Assuming that you qualify for a Chapter 7 “straight bankruptcy,” one important issue to consider is whether your case would likely be an “asset” or “no asset” one.  An “asset case” is one in which the Chapter 7 trustee collects assets from you to sell, and then distribute their proceeds to your creditors. A “no asset case” is one in which the trustee does not collect any assets from you because your assets are either protected by “exemptions” or are not worth the trustee’s efforts and expense to collect.

Generally a “no asset case” is simpler and quicker than an “asset case,” although not necessarily better. It’s simpler because it avoids the entire liquidation and distribution process. A simple “no asset case” can be completed about three months after it is filed (assuming other kinds of complication do not arise).  In contrast, it takes at least a number of additional months for a trustee to 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 on the sale proceeds, object to any inappropriate claims, and then distribute the funds to the creditors.  Some assets—especially intangible ones such as a debtor’s disputed claims against a third party—can take several years for the trustee to negotiate and/or litigate in order to convert it into cash, with the bankruptcy case kept open throughout this time.

In spite of this seeming disadvantage, an “asset case” can be better for a former business owner in certain circumstances.

First, a business owner may decide to close down a business and file a bankruptcy quickly afterwards to hand over to the trustee the headaches of collecting and liquidating the remaining assets and paying the creditors in a fair and legally appropriate way. After fighting for a long time to try to save a business, the owner may well be emotionally spent and in no position to try to negotiate work-out terms with all the creditors. There is unlikely sufficient money available to pay an attorney to do this. And if there are relatively few assets compared to the amount of debts—the usual situation—it’s likely that after all that effort the former owner will still owe an impossible amount of debt.

And second, that former business owner may want his or her assets to go through the Chapter 7 liquidation process if the debts that the trustee will likely pay first are ones that the former business owner especially wants to be paid. The trustee pays creditors according to a legal list of priorities. Without going here into the details of that long priorities list, at the top of the list are child and spousal support arrearages. Also high on the list are certain employee wage, commission, and benefits claims, as well as certain tax claims. He or she may well feel a special responsibility to take care of the ex-spouse and children, former employees, and taxes. And the fact that he or she would likely continue being personally liable on these obligations after the bankruptcy is over undoubtedly adds some motivation.

A “no asset” personal Chapter 7 case can be a relatively quick and efficient way for a former sole proprietor to put the closed business legally into the past. While an “asset” case can take somewhat longer, it can help pay some of the special creditors you want to be paid anyway.

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The Far Limits of the Means Test

Very few people who want to file Chapter 7 bankruptcy need to take the means test all the way to its limit. But if you do, you better have some iron-clad “special circumstances” to defeat your “presumption of abuse.”

The means test triggers whether or not your case is presumed to be an abuse of Chapter 7. Each step of the means test gives you a way to avoid this presumption of abuse. So, you avoid the presumption IF ANY of the following apply to you:

1. your income is no more than the median family income for your state and your size of family;

2. your income is more than the applicable median family income, but, after subtracting a list of allowable expenses, your remaining monthly disposable income is less than $117 per month; or

3. your income is more that the applicable median family income, your remaining monthly disposable income is between $117 and $197 per month, AND when you multiply your specific monthly disposable income amount by 60, this total is less than 25% of your “non-priority unsecured debts” (debts not secured by collateral, excluding special “priority debts”—certain taxes, support payments, etc.).

(See my last few blogs about these earlier parts of the means test.)

A large percentage of people who want to file Chapter 7 avoid the presumption of abuse on the first step—having sufficiently low income. Many others do so because their monthly disposable income is low enough at the second step, or their monthly disposable income is low enough in comparison to the amount of their debt.

BUT, if after all this you still have a presumption of abuse, your case will either be dismissed (thrown out) or else changed into a Chapter 13 case (requiring payments to your creditors). Your last chance to avoid this is if you can show “special circumstances.” The Bankruptcy Code lays out this law as follows:

[T]he presumption of abuse may only be rebutted by demonstrating special circumstances, such as a serious medical condition or a call or order to active duty in the Armed Forces, to the extent such special circumstances… justify additional expenses or adjustments of current monthly income for which there is no reasonable alternative.

So when pushed to the limit, a test that is supposed to be an objective way to decide who qualifies to file a Chapter 7 bankruptcy comes down to a very subjective question about whether any “special circumstances” apply.

To be fair, much of the means test IS objective, in the sense that it involves a whole lot of number-crunching to see if you can escape that dreaded “presumption of abuse.” But when a lot of those numbers—such as the allowed expense amounts, or the above-mentioned $117 and $195 amounts—appear arbitrary or do not accurately reflect your honest reality, then that “objectivity” has gotten away from the purpose for which it was supposedly intended.

Regardless, if you want to file a Chapter 7 case and, after going through all the steps of the means test, you are among that small minority of people still with a presumption of abuse, how likely are you going to be saved by the remaining subjective step in the process? Will you be able to persuade the judge that your “special circumstances” defeat the presumption of abuse?

This is a prime example of when you want a very experienced and conscientious bankruptcy attorney at your side. Why? Because the ambiguousness of the law, as you saw in the excerpt above, means that your attorney will need to 1) know how the local bankruptcy judges are interpreting this law, 2) carefully apply that to the details of your case when advising you about your options before filing your case, and then 3) if necessary be persuasive in making your case for “special circumstances” in court.  

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The Arbitrariness of the “Objective” Means Test

The means test is supposed to be an objective way to decide who qualifies to file a Chapter 7 bankruptcy. So what’s so objective about whether your “monthly disposable income” is less than $117 or more than $195? Sounds pretty arbitrary to me.

Before getting to this step of the means test, let me bring you back to its beginning.  I can’t emphasize enough that many, many people qualify for Chapter 7 strictly based on their income.  As I explained a few blogs ago, if your income is no more than the published median income for your state and family size, you skip the rest of the means test. You’re presumed to qualify for Chapter 7.

So if and only if your income is more than the median, you take the next step of the means test—deducting expenses from your monthly income. These allowed expenses are based on a terribly complicated set of rules I discussed in my last blog. After deducting these expenses, that leaves you with your “monthly disposable income,” a very important amount.

This brings us to those $117 and $195 “monthly disposable income” amounts mentioned above. And here’s where the “objective” rules get quite arbitrary. Catch this:

1) IF your “monthly disposable income” is $117 or less, then you are presumed not to be abusing the system to be filing a Chapter 7 case. In other words, you’ve passed the means test.

2) IF your “monthly disposable income” is more than $195, then you are presumed to be abusing the system to be filing under Chapter 7.

3) IF your “monthly disposable income” is between $117 and $195, then whether or not you are presumed to be abusing the system depends on one more step. You ARE presumed to be IF you multiply that specific “monthly disposable income” by 60, and the resulting amount is enough to pay at least 25% of your “non-priority unsecured debts.” (Priority debts are a category of special debts like certain taxes, support arrearage, and such.) If that resulting amount pays less than 25% of that set of debts, then you are presumed not to be abusing the system to be filing under Chapter 7.

So where do those critical two numbers—come from? Notice they amount to a difference of only $78 per month between being presumed to be able to file a Chapter 7 case and being presumed not to be able to.

Well, let’s take it a step further. Multiply the monthly amounts of $117 and $195 both by 60 months (the length of a maximum-length Chapter 13 case) and you get close to $7,025 and $11,725, respectively. (These used to be $6,000 and $10,000 when the law passed in 2005, and has been adjusted for inflation. The current amounts are good until April 1, 2013.) The effect of this set of rules is that:

1) if you theoretically CAN’T pay at least $7,025 to your “non-priority unsecured creditors” within 5 years of monthly payments (60 months), than it’s OK for you to be in a Chapter 7 case and write off those creditors;

2) if you theoretically CAN pay $11,725 or more to those creditors within 5 years, than it’s NOT OK for you to be in a Chapter 7 case, and instead you should be in a Chapter 13 case paying your disposable income to those creditors; and

3) if you theoretically can pay somewhere in between those two amounts in 5 years, then whether you should be in a one Chapter or the other turns on whether or not the total to be paid to the creditors would amount to at least 25% of the “non-priority unsecured debts.”

So where do these decisive $117/$195 and $7,025/$11,725 amounts come from? As far as I can tell, they are totally arbitrary.  Some creditor lobbyist or Congressional staff person likely just pulled a couple numbers out of his or her head. I can’t see any principled reason to pick those amounts to determine whether a person should or shouldn’t be allowed to file a Chapter 7 case.

Sensible or not (and the means test is anything but!), the law is the law: if your income is over the median then the amount of your monthly disposable income determines whether you are presumed to be abusing the bankruptcy system by filing a Chapter 7 case.

I will finish this series on the means test with one last blog. Because, even if you have too much disposable income resulting in a presumption of abuse, you might STILL be able to stay in Chapter 7 by defeating that presumption through “special circumstances.”

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The “Black Box” of the Means Test

What happens if you make too much money so that you are over “median income,” but you still want to file a Chapter 7 case?  You get to go through the “black box” that is the expenses side of the means test.

In the last couple of blogs I’ve covered the first part of the means test, the income part. That part says that if your income is no more than the medium amount for your state and your size of family, you can skip the rest of the means test and qualify for Chapter 7. But if your income is over the applicable median income amount, then you have to go through the convoluted expenses part of the means test to see whether you can still do a Chapter 7 case.

As much as I want in these blogs to help you understand how bankruptcy works, there is a limit to what can be effectively conveyed within the limitations of a blog. Much of the expenses part of the means test goes over that limit. So in this blog we will avoid that nitty-gritty. But here’s what you should know.

The concept behind the means test is pretty straightforward: debtors who have the means to pay a meaningful amount to their creditors over a reasonable period of time should be required to do so. But putting that concept into law resulted in maddeningly complicated and unclear rules. Not surprisingly, trying to apply those rules to real life has been challenging.

The expense rules got really complicated by trying to be objective. Congress assumed that it couldn’t trust debtors to list their anticipated expenses because they’d just show they had no money left over for their creditors. For a more objective standard, Congress could have picked between either the actual expenses a debtor in fact pays for food, clothing, etc., or else used some standard amount for expenses.

Well, Congress chose…  BOTH—a mix between actual and standard expenses. So now for some expenses we must use standard amounts, based on Internal Revenue Service tables. But this gets complicated quickly because some of those expense standards are national, some vary by state, and some even vary among specific metropolitan areas within a state. Then some other “necessary” expenses can be the actual amounts expected to be spent. And there are even some expenses which are partly standard and partly actual (certain components of transportation expenses). Add in deductions for secured debt payments (vehicle, mortgage) and priority debts (income taxes, accrued child support), and trying to figure out when they can and can’t be claimed, and you get an idea why I’m not going to get any deeper into this “black box.”

I WILL tell you in my next blog what happens at the other end of this “black box” of expenses—what happens if you have some disposable income after deducting expenses.

I’ll close today by emphasizing that the expense rules are not clear how they are to be applied to many common situations. The result is that different courts have interpreted these rules in inconsistent ways, requiring the U.S. Supreme Court to resolve these disputes one at a time.

So this is a prime example of why you want to have an attorney who fully understands these often confounding rules, and is also on top of the pertinent local and national court interpretations of these rules. There’s a lot riding on it—whether or not you qualify for Chapter 7, and how much and how long you have to pay into a Chapter 13 case. In other words, what’s potentially at stake is years of your life, and thousands, if not tens of thousands, of dollars.

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The Rigid “Means Test” Makes the Timing of Your Bankruptcy Filing Critical

Waiting just one day to file your Chapter 7 bankruptcy case can make qualifying for it much easier—or much harder!

How could such a small delay make such a big difference?

One of the main goals behind the huge amendment to the bankruptcy law in 2005 was to force more people to pay a portion of their debts through Chapter 13 payment plans instead of writing them off in a Chapter 7 “straight bankruptcy.” And the primary tool that is supposed to accomplish this is the means test. The rationale behind this test was that instead of allowing judges to make judgment calls about who was or was not abusing the bankruptcy system, a rigid financial test would ferret out who had the “means” to pay a meaningful amount to their creditors in a Chapter 13 case.

But in real life rigid rules can have unintended consequences. An experienced and conscientious lawyer will work to turn these consequences to your advantage, and avoid their disadvantages. Here’s an idea how this plays out with the means test.

In my last blog I explained the first part of the means test, which essentially compares the income you received during the six FULL CALENDAR months before filing bankruptcy to a standard median income amount for your state and your family size. If your income is at or under the applicable median income, then you get to file a Chapter 7 case (except in very unusual circumstances, which I’m not going to get into here). If your income is higher than the median amount, you may still be able to file a Chapter 7 case but you have to jump through a whole bunch of extra hoops to do so. And there’s a risk that you will be forced to go through a Chapter 13 payment plan.  So you can see that having income below the median income amount makes your case much simpler and less risky.

But how can filing the case a day earlier or later matter so much? Because of the means test’s fixation on those six prior full calendar months. And because the means test includes ALL income during that precise period (other than social security).  Virtually all money that comes into your hands during that period is counted, not just taxable income. 

So imagine that you received some irregular chunk of money, say an income tax refund, a few catch-up child support payments, or an insurance settlement or reimbursement.  Not a huge amount, say $3,000, received on July 15 of last year. Your only other income is from your job, where make a $42,000 salary, or $3,500 gross per month. Let’s say that the median annual income for your state and family size is $43,000.

So now we’re getting close to the end of January, your Chapter 7 bankruptcy paperwork is ready to file, and you’re anxious to get it filed so that you get protection from your aggressive creditors. BUT, if your case is filed on or before January 31, then the last six full calendar month period will be from July 1 through December 31 of last year, which includes that $3,000 extra money you received in mid-July. Your work income of 6 times $3,500 equals $21,000, plus that $3,000 totals $24,000 received during that 6-month period. Multiply that by 2 to make that an annual amount, and that equals $48,000, higher than the $42,000 median income. So you’d have failed the income portion of the means test.

But if you just wait to file until February 1, then the applicable 6-month period jumps forward by 1 full month to the period from August 1 of last year through January 31 of this year. Now that new period does NOT include the $3,000 you received in mid-July. So now your income during the 6-month period is $21,000, multiplied by 2 is $42,000. So now you’re under the $43,000 median income amount. You’ve passed the income portion of the means test, and you get to skip the awkward and risky expenses part of the means test. So you’re much more likely to breeze through your Chapter 7 case. Hooray!

Last thing: what if that $3,000 chunk of money was not conveniently received almost 6 months ago, but rather only a 2 or 3 months ago, and you’re desperate to file your case? You need to stop a garnishment or foreclosure and simply can’t wait another few months to file. Well if you file now, then you will be over the median income, and will need to go through the expenses part of the means test. You may still be saved there, or there may even be other ways of qualifying for Chapter 7. More about those in my next blog or two. But if you are concerned about this now, please call to set up a consultation with me right away. This blog should make clear that careful pre-bankruptcy planning is critical. The sooner we start, the more likely time will be on your side.

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Stepping Over the “Means Test” Hurdle Without Breaking Your Stride

Are you among the large majority of people whose income easily qualifies them for Chapter 7 “straight bankruptcy”? You can find out right here and now.

As you’ve likely heard, a few years ago Congress passed a major set of changes to the bankruptcy laws intended to make it harder for some people to file Chapter 7.  The idea was that those who have the means to pay a meaningful amount of their debt to their creditors in a three-to-five-year Chapter 13 payment plan ought to do so. So they shouldn’t be able to just write off all their debts in a Chapter 7 case. At least that’s the theory behind the means test.

In practice, for many people it’s quite an easy hurdle to step right over.  Most people who want to file a straight bankruptcy can still do so.

The means test is truly an odd one. It has two parts. The income part—the one I’m addressing here today—is relatively easy to figure out.

But the second part, involving living expenses, is one of the most complicated formulas imaginable. This law was worded so poorly that more than six years after it became effective there’s still a lot of debate about how it’s supposed to work. Fortunately, most people don’t need to get to that part of the test, and we won’t here.

That’s because if you pass the income part of the test, you can totally skip the expenses part.

So, the income part of the means test compares your income to a published “median income” for a household of your size in your state. If your income is no more than that median, then right away you’ve passed the test—you get to file a Chapter 7 case.

But even this easy part of the test has its quirkiness.

1. It is NOT based on your taxable income for the previous calendar year, or anything that simple. Instead it is based on the precise amount of income you received during the six full calendar months before your case is filed. So, for example, if your case is filed on January 25, 2012, we look at every dollar you received during the six-month period from July 1 through December 31, 2011. Then take that six-month total and divide it by six to come up with a monthly average.

2.The income included for this purpose is not just your “taxable income,” but rather every bit of income you’ve gotten from all sources during that period of time, including irregular ones like child and spousal support payments, insurance settlements, unemployment benefits, and bonuses. The exception: exclude all social security income.

Then multiply your six-month average monthly income by 12 to come up with your annual income. The last step is to compare that amount to the median income for your state and your size of family. You can find that median income in the table that you can access through this website. (This median income information gets updated every few months, so make sure you’re using the current table.)

If your income, as calculated in this precise way, is no more than the median income applicable to your state and family size, then you can file a Chapter 7 case. Congratulations—you’ve cleared the means test hurdle!

If your income is MORE than the applicable median amount, don’t despair. You may well still be able to file a Chapter 7 case. More on that in my next blog.  

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In a Chapter 7 Case, “The Only Thing We Have to Fear is Fear Itself”

There’s a lot you can do to help make your “straight bankruptcy” Chapter 7 case a straightforward one, but one thing you can’t control is your creditors’ reactions to it. You know that creditors can sometimes try to prevent you from discharging (legally writing off) your debts, so naturally you worry about this. Here’s why you shouldn’t worry.

Let’s first be clear that I’m not talking here about the kinds of debts that simply can’t be discharged, and don’t require any creditor objection for that to happen—for example, back child and spousal support, many taxes, and criminal fines. Instead I’m talking about the right of any creditor to object to the discharge of its debt, under certain limited circumstances.

You might figure that if your creditors have ANY chance to object to the discharge of their debts, it would jump at the chance to do so. Or at least enough of them would object to cause you trouble. But that is NOT what happens. Most Chapter 7 cases go through with NO creditor objections at all. Well, why not?

1. The legal grounds for creditors’ objections are quite narrow. They need to have evidence that the debt was incurred through your fraud or misrepresentation, arose out of a theft or embezzlement, as a result of your intentional injury to a person’s body or property, or was related to other similar bad acts. So creditors don’t object to the discharge of their debts simply because most of the time no such facts exist.

2. Even within such narrow grounds, relatively common situations such as bounced checks or the use of credit not long before filing bankruptcy can be seen as fraudulent, so creditors can object to these kinds of debts. But even in these situations, creditors often do not bother to object because they decide it’s not worth “throwing good money after bad”—spending more money for their staff time and attorney fees in the hopes of first getting a bankruptcy judge to agree with them, AND then still needing to get you to repay the debt.

3. One of the reasons why sensible creditors decide not to object even when they think they might have the legal grounds to do so is that they risk being ordered to pay your attorney’s fees to defend against their objection. That can happen if the judge thinks that “the position of the creditor was not substantially justified.” So creditors risk not only paying for their own costs to object, but also paying for your costs in fighting the objection.

So that’s why most creditors just write off the debt and move on.

But there ARE two exceptions.

1. Leverage: If a creditor thinks it has a decent case against you—such as with a string of bounced checks or a debt incurred shortly before the bankruptcy was filed—it may well object to the discharge of the debt knowing that YOU can’t or don’t want to pay attorney fees in fighting it, EVEN if you have a decent defense. So they’ll raise the issue in the hopes of forcing you to enter into a settlement quickly.

2. Axe to grind: If you have someone you owe money to who is simply very mad at you, so that your bankruptcy filing really aggravated him or her, then this creditor might be looking for an excuse to hurt you back. Ex-spouses and ex-business partners are the most common. Irrational anger by those types, not reined in by the financial realities, probably causes the messiest objections.

To reduce any anxiety you have about any of this, talk it over thoroughly with your attorney. If you have any concern about how you incurred any of your debts, or if someone has threatened you with any trouble if file bankruptcy, lay it all out. Often, your fear will not be justified. And if there are potential problems, being up-front about it may enable your attorney help reduce the risks.

A final bit of good news: creditors have a very limited time to raise objections: generally 60 days after the Meeting of Creditors. So, if whatever assurances given by your attorney still doesn’t stop you from worrying in the meantime, you’ll at least know that you can stop worrying after that date.

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