How do Bankruptcies Work?

Did you know that bankruptcy affects a great number of people? One in ten persons is likely to file bankruptcy. In 2017 alone, 767,721 people have filed for bankruptcy in the United States.

Going through a bankruptcy is a painful and the process itself can be quite frustrating and stressful. In this article, we will try to address some of the main concerns you might have regarding bankruptcy and how they work.

Photo by Melinda Gimpel

Types of Insolvency

First things first: A bankruptcy is a procedure that aims at giving financial relief to a person who has reached a state of insolvency. This basically means that the person has reached a point where he or she is unable to pay back the debt that he or she owes. There are two types of insolvencies: cash-flow insolvency and balance sheet insolvency.

  • A cash flow insolvency means that a person is not able to meet debt repayments.
  • A balance sheet insolvency means that the debtor does not have assets to cover his liabilities.

Nonetheless, bankruptcy and insolvency or not synonyms. Bankruptcy is a legal status of a person. Not all insolvent persons are bankrupt. For a person to be bankrupt, a bankruptcy has to be filed with courts.

Declaring Bankruptcy

While a person can declare bankruptcy, often the bankruptcy process is initiated by a creditor. A bankruptcy process will differ between countries and states, but in general, the process is as follows:

  1. A petition is filed and approved within the judicial system.
  2. A trustee (most often a lawyer) is assigned to the estate and control over all assets moved under his control.
  3. The bankruptcy is announced in a public venue and creditors are asked to file claims on the estate.
  4. The trustee is tasked with monetizing the estate and distributing the proceeds to the claimants based on the seniority of their claims.
  5. Once claims have been settled and the estate has been wound down, the debtor is discharged. The timing of the discharge after the wind-down of the estate can differ greatly between countries.

Bankruptcy in the United States

In the United States, there are two main options to choose from when it comes to personal bankruptcy, namely Chapter 7 straight bankruptcy and Chapter 13 repayment plan case.

Chapter 7

The first option – namely chapter 7 – it enables you to have all your outstanding debt discharged, granted that some liquid assets have been utilized in order to repay part of the debt. The only situation in which you can file for this type of bankruptcy is if you can demonstrate that your current income is lower than the average income for a family in your home state.

Chapter 13

In case you don’t qualify for this, then you will have to choose chapter 13. This plan entails paying a specific portion of your debt in a payment plan of three to five years. As a rule of thumb, these payments are made to the courts.

In the position of a business, then you might file Chapter 1 bankruptcy. Through this option, you have the opportunity of restructuring and reorganizing through a court-appointed trustee. More specifically, you will have to follow a given plan to cope with your creditors.

Note that bankruptcy will remain on your file for five years – at the very least. Therefore, make sure you think this through before resorting to it.

Benefits of Going Bankrupt

The positive thing about bankruptcy is that it usually translates into a discharge. This will prevent your creditors from collecting on debts. Nonetheless, note that there are still some exceptions to the rule and some of these are alimony and child support obligations, recent tax liabilities, and so on and so forth.

Another potentially positive aspect associated with bankruptcy is, of course, the automatic stay. This represents a preliminary court decree that prevents creditors from actively trying to collect debts from you during the actual bankruptcy timeframe. This means you will not be contacted via mail or phone in this respect. Essentially, the automatic stay applies until the bankruptcy court decides to issue a discharge.

The Bottom Line

Bankruptcy is usually the last resort of a person in financial difficulties. There are many nuances when it comes to filing for bankruptcy and options to choose from. Therefore, getting legal and accounting counsel is paramount for anybody considering his or her options.