As you look at all the options for debt relief, you may come across bankruptcy.
Bankruptcy is one of the few ways to guarantee debt forgiveness. However, it is also a serious legal process that can come with some big downsides.
There are several types of bankruptcy. However, the most common type for individuals is Chapter 7, or “liquidation.” In a liquidation bankruptcy, your assets are sold off to pay your creditors.
With this type of bankruptcy, it is assumed that you can’t afford to pay off debt on your own. This means that there are rules around how much income you’re allowed to earn while filing for Chapter 7.
The Chapter 7 Bankruptcy Means Test
The basic rule of thumb is that you must earn less than the median income in your state to file for Chapter 7 bankruptcy. The federal government’s U.S. Trustee Program (UST) maintains a list of the median income of each state that you can use as your point of comparison.
Important: Consulting with a lawyer is highly recommended if you plan to pursue a bankruptcy filing. A lawyer will be able to help you determine if you qualify for Chapter 7 bankruptcy and if it is the best option for you.
If you’re looking for a place to start, the American Bar Association (ABA) has a list of free and low-cost legal resources.
Calculating Income for the Chapter 7 Bankruptcy Means Test
Income is calculated a bit differently for Chapter 7 bankruptcy than it is for other means tests.
Instead of telling the government what you expect to earn each month, you report your income for the last six months. The six-month window means that holiday bonuses can push you over the edge if you file at the wrong time.
You also use your gross (pre-tax) income, rather than your net (post-tax) income when determining whether you qualify for bankruptcy. The following kinds of income must be included in your calculations:
- Wages or salary, before taxes and deductions
- Alimony
- Child support
- Regular financial help from others, such as money from your partner, parents or friends
- Business and self-employment income, including rental income
- Unemployment benefits
- Retirement or pension payments, including Social Security
The things that you can leave out are:
- Supplemental Security Income (SSI)
- Social Security Disability Insurance (SSDI)
- Military-related benefits
Once you have your total income, compare it to the median income in your state.
Under the Threshold
If you are under the threshold, you might be eligible to file for Chapter 7 bankruptcy.
Online services may guide you to the correct forms and even give basic instructions for how to fill them out, but they can’t offer you legal advice.
Instead, it is recommended that you consult with a lawyer to help you navigate the bankruptcy process.
Over the Threshold
If you’re above the median income in your state, the process becomes more complicated.
In part two of the means test, you subtract expenses from your income. However, in most cases you’re limited to subtracting IRS “standard” expenses rather than your actual expenses. You can find the latest numbers for standard expenses on the UST website.
On top of the standard expenses, you may be able to subtract:
- Payments to secured or priority creditors: If you plan to keep a piece of property (like your car or house) that secures a debt, you can deduct the payment from your income. You can also deduct payments on priority debts, which are debts that won’t be discharged by bankruptcy.
- Actual expenses: If you can prove that your necessary and reasonable expenses are larger than the IRS standards, you may be able to increase your deduction. You can also deduct some court-ordered domestic support obligations.
- Administrative expenses: The purpose of the means test is to see whether your creditors would receive more if you filed under a different chapter of bankruptcy. Therefore, you can subtract the administrative expenses that would be part of a Chapter 13 (payment plan) bankruptcy.
The final step is an analysis of what is left over after your expenses. If what you have left over would pay off less than 25% of your debts over a hypothetical five-year Chapter 13 payment plan, you may be eligible for Chapter 7 bankruptcy.
What Gets You Disqualified From Filing Chapter 7?
Failing the means test will disqualify you from filing Chapter 7 bankruptcy. There are also other ways that you might be disqualified. The most common of these is failing to attend credit counselling.
Since the government wants bankruptcy to be a fresh start, you must attend a credit counselling course before you file.
Filing for bankruptcy too often in the past is another common disqualification for bankruptcy. You can’t file for bankruptcy now if you completed bankruptcy under Chapter 7 within the last eight years, or under Chapter 13 in the last six years.
What Not to Do Before You File for Chapter 7 Bankruptcy
Making large purchases or taking out new loans shortly before filing bankruptcy can make it seem like you’re committing bankruptcy fraud. If the judge decides that you are, your case may be dismissed.
Unfortunately, dismissal of a bankruptcy case might mean you can never attempt to discharge the debts in your case again.
Another thing to keep in mind is that you are required to treat your creditors fairly and equally. That means that you can’t pay your family and friends back before you file. Doing so is considered an “insider payment,” and they may be required to give the money you paid them back to the bankruptcy court.
Finally, it is a bad idea to do anything that may seem like you’re hiding or protecting assets. Large cash withdrawals may be scrutinized. The court might also find it suspicious if you try to turn unprotected assets (such as cash) into a protected asset (such as a car) right before you file for bankruptcy.
Final Thoughts
Filing for Chapter 7 bankruptcy is a serious step. While it can wipe out specific debts, it also comes with strict rules and lasting consequences.
The means test is one of the biggest hurdles to qualifying for bankruptcy. Even if you qualify, the court will review your financial history closely.
Before you decide on whether to file, it’s best to speak with a qualified bankruptcy attorney who can explain your options and guide you through the process. With the right help, you can understand whether Chapter 7 is the right path toward a financial fresh start.
