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Introduction to Bankruptcy

Definition of Bankruptcy

Bankruptcy is the court process by which a debtor seeks protection from creditors. The debts may be restructured or discharged, depending on the type of bankruptcy filed. It is important to understand the impact and consequences of bankruptcy as an option to handle debt.

When a debtor is overwhelmed with paying creditors and debt load, the debtor may seek the help of the federal government through bankruptcy, a court process by which a debtor, which can be an individual or a business entity, seeks protection from its creditors. Student loans and federal taxes are federally owed obligations that bankruptcy does not excuse. Bankruptcy typically remains on one's credit report for at least seven years, and it often precludes debtors from making major purchases, particularly home purchases. It is typical for bankruptcy to be part of the credit record for 10 years, but usually creditors will begin to extend credit to those with bankruptcy on their credit reports after about seven years. Creditors can use their own criteria to determine if a debtor is a trustworthy risk. They often base their decisions on the circumstances surrounding the bankruptcy and on whether the debtor has deposit accounts, income, or profits at the time of the new request.

Bankruptcy has an effect on an individual's credit rating and standing. Bankruptcy is also a viable option for businesses that encounter tremendous debt load compared to their cash flow. Although credit ratings also affect businesses, the effects are not always as great as they are on individuals. Businesses must consider the tax consequences of bankruptcy and think about whether the business will be able to continue. It is generally recommended that individuals and businesses seek legal advice before deciding to pursue bankruptcy protection.

The three types, or chapters, of bankruptcy are 7, 11, and 13. Chapter 7 is the most common form for individuals and businesses and uses liquidation, the process of converting assets into cash for the purpose of paying off creditors. Chapters 11 and 13 focus on reorganizing and restructuring debt. All forms of bankruptcy involve the plans and consideration of debtors and creditors. Usually neither comes out 100 percent whole, but the goal is a fair resolution suitable to both parties.

Bankruptcy Overview Table

Each chapter of bankruptcy filing has different designations of who can file under which chapter, and what repayment method is used for those respective chapters.

Who Can File for Bankruptcy?

The purpose of bankruptcy is to give a debtor relief. Bankruptcy allows a clean slate for debtors, releasing them from debts they probably could not pay. Anyone may file for bankruptcy, but it is not a tool to defraud creditors.
Bankruptcy laws exist to help both debtors and creditors. It is the goal of bankruptcy to preserve the property of the debtor as much as possible while allowing creditors to recover part of their investment.

Who Can File for Bankruptcy?

Both individuals and businesses are eligible to file for bankruptcy in the United States.
In the United States any person, corporation, partnership, or other business organization that conducts business, lives, or owns property there may file a voluntary or involuntary petition, which is an official request to seek relief from creditors under the federal Bankruptcy Code. The voluntary petition is when the individual or business entity files, and the involuntary petition is when a creditor or group of creditors petitions the court for repayment through the process of bankruptcy. Any debtor can file the petition, and the business or individual does not have to be totally insolvent (unable to pay debts) to file a petition. The filing must include a list of all creditors, a list of all debts owed to them, an income statement and balance sheet for business entities, and a personal financial statement for individuals.

Debtors can file under Chapter 7, the liquidation section. Typically in this chapter, individuals and business entities use their cash or wealth to repay the debt in accordance with established exemptions. An exempt asset is property or an asset that the debtor can keep during and after the bankruptcy proceedings, as approved by the court. The value of assets must be assessed to determine how much cash will be available. Often the creditors agree to accept less than the total amount owed to them. Debtors and creditors negotiate these types of determinations during creditor meetings. Federal law governs bankruptcy, but the states may set exemption levels. In other words, states may decree which types of property and wealth are exempt from the proceedings.

Filing under Chapter 13 allows individual debtors to reorganize and restructure their repayments. The court allows a proposed repayment, including all creditors, and it will usually run for three to five years. Once the creditors and debtor agree on the plan, the court approves or rejects it. Part of the repayment plan allows for the rest of the debt to be discharged, or dismissed, once the repayment plan is fulfilled.

Reasons for Bankruptcy

Individuals have a variety of reasons for using bankruptcy. Some of the most common reasons for an individual to file include overextension of credit, temporary employment, job loss, medical problems, ending of a relationship, financial mismanagement, and business failure.

Effects of a Discharge of Indebtedness

A court may issue a discharge of indebtedness, which permanently removes the legal obligation to repay the creditors listed in the bankruptcy. The debtor will need to rebuild their credit rating.

Once bankruptcy proceedings end, the debtor no longer has a legal obligation to repay the creditors outside the plan the bankruptcy court implemented. This is a discharge of indebtedness, which means the debtor no longer legally owes the creditor anything as long as the debtor has followed the court's plan. A nondischargeable debt cannot be settled through bankruptcy and is not part of the bankruptcy agreement, but all dischargeable debts are handled in this manner. Dischargeable debt is considered an option for complete release from creditors. The debtor then faces the challenge of rebuilding their credit rating. Each time the debtor requests new credit, the bankruptcy will appear on their credit record.

Typically, credit applications ask whether the person has filed for bankruptcy in the last seven years. Creditor records will usually keep the bankruptcy on file for 10 years, but the standard credit reporting agencies report for the minimum of seven years. However, it is possible for debtors to reapply for credit with lenders during this period of 7–10 years if the bankruptcy is under Chapter 7, and it is up to the individual creditors whether to extend credit. They typically consider income or profits, total assets, liquidity, and circumstances surrounding the bankruptcy. Circumstances that may make lenders more lenient include divorce, tragedy, and national financial crisis. It is more difficult to get new credit while under a repayment plan, as imposed under Chapters 11 and 13. Although a bankruptcy is beneficial for those who qualify, it can limit borrowing money for a time to ensure the consumer does not fall back into heavy debt. The consumer must complete an approved financial management course as part of the bankruptcy proceedings, and this course addresses most debt and consumption challenges.