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Bankruptcy Chapter Choice for Individuals – 7, 11, 12 or 13?

Chapter Choice is Vitally Important

The following discussion applies only to individuals (not corporations, LLCs, part­ner­ships or other artificial business entities). Determining whether to file for bankruptcy, and the chapter under which the bankruptcy case should be filed, varies dras­tically between cases filed by individuals and cases filed by corporations, LLCs, partnerships or other artificial business entities.  See, Small Business Bankruptcy, for a discussion of bankruptcy filing by corporations and artificial entities.

The chapter choice (the decision to file under Chapter 7, 11, 12 or 13) is the most important initial decision in a small business or consumer  bankruptcy filing. Certain goals can be achieved under Chapter 7 which can not be done in a Chapter 11 or 13 case, and vice versa. The choice of whether to file under Chapter 7, 11, 12 or 13 should be made only after consulting with a qualified attorney.


Chapter 7

Chapter 7 allows the debtor to discharge debt, but does not permit the debtor to reorganize or change the terms of any loans or contracts. It is normally the proper option if you are current (or almost current) on all secured debts (such as home mortgages and vehicle loans) and have an unmanageably large amount of unsecured debt such as:

credit card debt;

medical bills;

unsecured consumer or business loans (except student loans);

deficiency claims on repossessed vehicles or foreclosed land;

federal income tax claims for tax years more than 3 years old, but only if the tax returns for those tax years were filed.

House & Vehicles. You can either: (a) keep houses, cars or other collateral for secured debts by continuing to make the normal contract payments; or (b) surrender the collateral, and discharge and further liability on the loan.  You can not reorganize or alter the terms of a secured loan under Chapter 7.  This can only be done under Chapter 11 or 13.

Abuse Test. A debtor will not qualify under Chapter 7 if:

(1) most of the debts are consumer debts (debts incurred by an individual primarily for a personal, family, or household purposes); and

(2) the debtor can afford to repay a significant portion of the debt he wants to discharge in bankruptcy.

The bankruptcy trustee can seek dismissal of the case as an abuse of the bankruptcy process if the debtor can afford to repay a significant portion of the unsecured debt.  This rule is designed to encourage debtors to file under Chapter 13 if they can afford to repay a significant portion of the debt.

Therefore, if the problem debts are unsecured consumer debts, consider filing under Chapter 11 or 13 only if you can not demonstrate an inability to repay any of it.  The rules for determining whether a debtor can afford to repay the debts are very complex and were significantly affected by the bankruptcy reform legislation effective for all cases filed af­ter October 2005.  The debtor must pass a complex “means test” to establish a right to a Chapter 7 discharge if he/she earns income above the median family income.

The abuse test only apples if most of the debt is consumer debt. If most of the debt is busi­ness related, the debtor may file under Chapter 7 even if he can afford to repay some or all of it.


Chapter 11

Chapter 11 is available to individuals, corporations and other artificial entities.  It permits individuals to reorganize their debt by proposing a plan which modifies or rejects the provi­sions of some loans (except for home mortgages) and contracts.  The main advantage of filing under Chapter 11 rather than Chapter 13 is that the debtor is not required to file or perform under a bankruptcy plan for between 4 to 6 months (or perhaps longer).  Individuals who need a significant period of time to catch their breath financially, and need time before they can propose or make payments under a repayment plan, will want to consider filing under Chapter 11.

There are no debt limits for filing a case under Chapter 11.  However, Chapter 13 cases can only be filed if total secured debt is less $1,081,400 and unsecured debts are less than $360,475.  Chapter 11 will be the only bankruptcy option for individuals if the debt amounts exceed these amounts.

A significant disadvantage to Chapter 11 is that the process is much more complex than Chapter 13.  As a result, it is more expensive and time consuming.  The legal fees and court costs in Chapter 11 cases are much larger than Chapter 13 cases, and will vary greatly, depending on the complexity of the case.  The debtor will also need to devote a substantial amount of time dealing with his attorney, obtaining documents and complying with court requirements and procedures.


Chapter 12

Chapter 12 is available to individuals, corporations and partnerships engaged in farming and fishing activities. It is limited to:

(1)  farmers with:

(a) total secured and unsecured debt of less than $3,792,650; and

(b) at least 50 percent of the total debt (except for mortgage debts for a principal residence) must arises out of farming activities.

(2)  fisherman with:

(a) total secured and unsecured debt of less than $1,757,475; and

(b) at least 80 percent of total debt (except for mortgage debts for a principal residence) must arise out of commercial fishing activities.

Chapter 12 largely mirrors the pre-reform (pre-BAPCPA) provisions of Chapter 13. Like Chapter 13, it permits a debtor to reorganize his debt by proposing a plan which modifies or rejects the provisions of loans and contracts.

The main difference between Chapter 12 and 13 (other than the requirement that a Chapter 12 can only be filed by a farmer or fisherman) is that Chapter 12 permits unlimited cram down and modification of secured debts on real and personal property, including home mortgages, and vehicle, equipment and boat loans. For example, under Chapter 12, a debtor can modify the provisions of a mortgage related to a home mortgage. Bankruptcy courts are not permitted to modify the terms of home mortgages in Chapter 11 or 13 cases.


Chapter 13

 Chapter 13 is the proper option for an individual (not a corporation) that falls behind on payments to secured creditors and wants to keep the property and/or alter unfavorable terms of the loan.

Arrearages on Home Mortgages and Vehicle Loans. An individual that falls behind on home mortgage or vehicle payments can stop the foreclosure or repossession process and repay the past due amounts under a bankruptcy plan over 3 to 5 years.

Cram Down. A significant feature of Chapter 13 is “cram down.” For most secured debts (except home mortgages and vehicle loans less than 2 & 1/2 years old), you can repay the lesser of the value of the property or the payoff amount due on the loan.  You can also dras­tically reduce the interest rate on the loan.  For example, assume you have a vehicle loan more than 2 & 1/2 years old.  The payoff amount due is $20,000.  The contract interest rate is 18 percent.  The market value of the vehicle is $10,000.  You can propose a bankruptcy plan which pays $10,000 at 5.25 percent interest (as of 11/2011).  The only issue subject to argument is the market value of the property.  The creditor must transfer the title free and clear of the lien when all plan payments have been completed.

Selective Repayment of Secured Debt and Contracts. You can retain certain property and repay the debt in installments, and surrender other property without paying for it.  For example, if you have a home mortgage and two car loans, you can keep the house and one car, and surrender the second car without payment.  If you have several leases or contracts, you can reject some contracts or leases, surrender the property, pay nothing on the rejected contracts, and assume other contract or leases and maintain the contract payments.

Small Business Reorganization.  You can also use Chapter 13 to reorganize a small business.  All of the benefits available in a consumer filing are available to reorganize a small business.  In business cases, a debtor can repay debts (or arrearages on loan pay­ments) in installments over 3 to 5 years.  A small business owner may also use the “cram down” provisions of the bankruptcy laws to reduce installment payments and the interest rate paid on secured debts.  A small business owner can also use Chapter 13 to selectively reject unfavorable contracts or unexpired leases.

A significant limitation on small business cases is that the small business must be or­ganized as a sole proprietorship. Only an individual may file bankruptcy under Chapter 13. Corporations, partnerships or other business entities are not allowed to file under Chapter 13, and can  reorganize only by filing under Chapter 11 or 12 (if they are family farmers or fishermen).  Chapter 11 cases are much more complicated than Chapter 13 cases.

Super Discharge. The rules concerning the discharge of debts in bankruptcy are much more liberal in Chapter 13 cases. A Chapter 13 discharge is commonly known as a “super discharge” because certain debts can be discharged in a Chapter 13 case that can not be discharged in Chapter 7. In Chapter 13 cases the following debts can be discharged: (1) malicious injury to another person or his property; (2) civil fines and penalties; (3) debts incurred in connection with a divorce decree.  These debts can never be discharged in a Chapter 7 case.

chapter 7 and 13

Side by Side Comparison

Chapter 7

Chapter 13

Payments to Creditors

No Payments. In a Chapter 7 case, no payments are made on the debt. The debt is discharged without any payment.

Payment Plan Required. In a Chapter 13 case, the debtor must make payments to repay part or all of the debt. Payments are required over a 3 to 5 year time period.

Success Rate

 

99 Percent. Almost all debtors receive a discharge (release) of all debts without incident after about 4 months from the date of filing.

Less Than 50 Percent. More than 50 percent of all cases are dismissed for non-payment. Most Chapter 13 debtors fail to complete their payment plan because of an interruption in income.

Legal Fees

 

Total Fees – Lower. The total legal fee for most routine Chapter 7 cases will normally vary between $1,000 to $4,000, plus a $306 filing fee.  The fee will normally depend on the attorney and the complexity of the case .  About 85 percent of Chapter 7 cases are routine. Most lawyers charge higher fees for non-routine cases involving a business, high income debtors or pre-bankruptcy planning.

Total Fees – Higher. The total legal fee for a simple Chapter 13 case will normally be $3,500 plus a $281 filing fee. About 85 percent of Chapter 13 cases are simple. There is a much higher variance in the complexity and cost of Chapter 13 cases.  Complex Chapter 13 cases involving litigation can be expensive (in excess of $6,000).

Pre-Filing Fees – Higher. All fees and costs for a Chapter 7 case must be paid before the case is filed.  The fees are normally paid in installments over a two or four month time period prior to filing the case.

Pre-Filing Fees – Lower. Most lawyers charge an up front fee (between $0.00 and $500) before a Chapter 13 case is filed.  The remaining fees are normally paid after the case is filed, in monthly installments, through the bankruptcy plan.

Reorganization

 

No. Chapter 7 will not help a debtor reorganize or alter unfavorable terms of any loans or debts. Chapter 7 is the wrong choice if you are behind on payments on home mortgages, car loans or other secured (collateralized) debts, and you want to keep the property. In any Chapter 7 case, you can keep the collateral only if you continue to make payments in accordance with the contract.

Yes. In Chapter 13, a debtor can repay debts in installments and alter the unfavorable terms of most loan contracts. Arrearages on home mortgages and vehicle loans can be repaid between 3 to 5 years. On most installment loans (except home mortgages and vehicle loans less than 2 & 1/2 years old), monthly payments can be lowered by extending the loan term to as long as 5 years, and lowering the contract interest rate to the prime rate plus 2 percent. The debtor can selectively retain certain property and repay in installments, and surrender other property without payment.  Small businesses qualify, but only if organized as a sole proprietorship.  Corporations, partnerships and other business entities can not file under Chapter 13.

Cram Down

 

Yes – But Must Pay in Cash and Obtain Court Order.  On most installment debts (except for home mortgages), the debtor can tender a cash payment for the full market value of the property and force the creditor to deliver the title.  Payment must be made in cash (one lump sum).  Installment payments are not permitted unless the creditor agrees.  The debtor must obtain a court order permitting the redemption and establishing the payment amount if the creditor does not agree.

Yes – Can Pay in Installments. The debtor can alter the contract and force the creditor to accept the lesser of the market value or the payoff amount due on most installment debts (except for home mortgages and vehicle loans less than 2 & 1/2 years old).  Payments can be made in installments over a 3 to 5 year time period, depending on the debtor’s monthly income.

Discharge

 

Exceptions. The following debts can not be discharged: (1) fraud; (2) embezzlement; (3) theft or breach of fiduciary duty; (4) malicious injury to another person or his property; (5) civil fines and penalties; (6) debts incurred in connection with a divorce decree; and (7) tax debts if a required tax return is never filed.

Super Discharge. The discharge in Chapter 13 is broader than in Chapter 7 cases.  The following type of debts will be discharged in Chapter 13 if the debtor successfully completes the payment plan: (1) debts for malicious injury to another person or his property; (2) civil fines and penalties; (3) debts incurred in connection with a divorce decree.

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