Chapter 7 Bankruptcy Preliminary Concerns

By Douglas A. Crowder

CERTIFICATION.  The author has been approved by the State Bar of California as an MCLE Multiple Activity Provider. (Provider Number 13474.)  The author certifies that this activity conforms to the standards for approved education activities prescribed by the rules and regulations of the State Bar of California governing minimum continuing legal education.  This activity qualifies for one (1) hour of self-study MCLE credit, which can be earned by reading the following article and answering the accompanying test questions.
INTRODUCTION AND SUMMARY

This article is designed to give the bankruptcy practitioner a checklist of preliminary concerns in counseling a client on whether to file a Chapter 7 bankruptcy.  The five main points are:

ONE.  Are the debts that the client wants to handle dischargeable?

TWO.  Is the client eligible for a Chapter 7 discharge?

THREE.  Income-wise, does the client qualify for a Chapter 7?

FOUR.  Will the client lose any property in a Chapter 7?

FIVE.  Are there other disadvantages to filing a Chapter 7?

GENERAL BANKRUPTCY INFORMATION

My definition of Bankruptcy is:  A federal court proceeding which can either discharge (eliminate) all or part of one’s debt, or force one’s creditors to take a payment plan on all or part of one’s debt.

The two most common types of bankruptcy are Chapter 7 and Chapter 13.  A Chapter 7, also called a “liquidation,” will “discharge” (effectively eliminate) most debts so that the debtor does not have to repay anything.  Under a Chapter 13, the debtor makes monthly payments to a court appointed trustee for a period of 3 to 5 years, and the creditors get paid back all, or usually only a portion of, the amount owed to them.  [See NOTICE TO CONSUMER DEBTOR(S) UNDER 342(b) OF THE BANKRUPTCY CODE]

WHAT IS A “DISCHARGE?”

A discharge is an order from the Bankruptcy Court which

(1) Voids any judgment for personal liability of the debtor with respect to any discharged debt.

(2) Operates as an injunction against the commencement or continuation of any action to collect, recover or offset any such debt as a personal liability of the debtor. [11 USC Sec. 524(a)].

In other words, the debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order prohibiting the creditors of the debtor from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters, and personal contacts.

Although a debtor is not personally liable for discharged debts, a valid lien (i.e., a charge upon specific property to secure payment of a debt) that has not been avoided (i.e., made unenforceable) in the bankruptcy case will remain after the bankruptcy case. Therefore, a secured creditor may enforce the lien to recover the property secured by the lien. [See BANKRUPTCY BASICS, a publication of the Bankruptcy Judges Division of the Administrative Office of the U.S. Courts, section on The Discharge in Bankruptcy, available at http://www.uscourts.gov/FederalCourts/Bankruptcy/BankruptcyBasics.aspx]

STEP ONE:  ARE THE DEBTS WHICH THE CLIENT WANTS TO HANDLE DISCHARGEABLE IN BANKRUPTCY?

Generally, the debtor’s purpose of filing a Chapter 7 is to obtain a discharge of his debts.  Thus, one of the first concerns is to determine whether the debts the debtor wishes to discharge can be discharged.

11 USC Sec. 523 lists several types of debt that are non-dischargeable.  Those most commonly encountered include:

  1. a) TAXES

A tax debt for personal income tax is dischargeable if it meets these four criteria:

  1. The return was due more than 3 years before the date of the filing of the petition. The 3 years starts running when the return was due. For example, if the 2008 tax return was due on April 15, 2009, then the 3 years runs on April 16, 2012.  If, however, the debtor obtained an extension to file the 2008 return until October 15, 2009, then the 3 years does not run until October 16 2012.
  2. The tax return was actually filed more than 2 years before the date of the filing of the petition.
  3. The tax was assessed within 240 days before the date of the filing of the petition. “Assessed” means that the taxing authority has determined how much is owing and made a demand for it. If the debtor was undergoing an audit, the assessment would probably not be made until the audit was done.
  4. The debtor’s return was not fraudulent. [See 11 USC 523(a) and 11 USC 507(a)(8)]

Taxes of types other than income tax are beyond the scope of this article, and should be researched if encountered.

  1. b) FRAUD [11 USC Sec. 523(a)(2)]

A debt incurred through false pretenses or actual fraud is non-dischargeable.  However, if the false representation is a statement in writing respecting the debtor’s or an insider’s financial condition, then, to render the debt non-dischargeable, the creditor must have reasonably relied on the false statement, and the debtor must have made the statement with intent to deceive.

  1. c) DEBTS INCURRED SHORTLY BEFORE FILING BANKRUPTCY PRESUMED NON-DISCHARGEABLE. [11 USC 523(a)(2)(C)]

Consumer debts owed to a single creditor of more than $500 for luxury goods or services incurred within 90 days prior to filing the petition, and cash advances of more than $750 incurred within 70 days prior to filing the petition are presumed to be nondischargeable.

  1. d) FIDUCIARY FRAUD [11 USD 523(a)(4)]

Debts incurred for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny are non-dischargeable.

  1. e) DOMESTIC SUPPORT AND DIVORCE OBLIGATIONS

Debts for child support or alimony are non-dischargeable under 11 USC Sec. 523(a)(5).  Other debts to a spouse, former spouse, or child incurred by the debtor in a divorce or separation proceeding or agreement are non-dischargeable under 11 USC Sec. 523(a)(15).  This includes property settlements, and attorney fees awarded to a spouse during a divorce proceeding.

  1. f) WILLFUL AND MALICIOUS INJURY [11 USC Sec. 523(a)(6)]

Debts incurred through willful and malicious injury by the debtor to another entity or to the property of another entity are non-dischargeable.

  1. g) FINES AND PENALTIES TO GOVERNMENT UNITS [11 USC 523(a)(7)]

A debt for a fine, penalty, or forfeiture which is not compensation for actual pecuniary loss, and not a tax penalty is non-dischargeable.

  1. h) STUDENT LOANS [11 USC Sec. 523(a)(8)]

Student loans are generally non-dischargeable unless excepting such debt from discharge would impose an undue hardship on the debtor and the debtor’s dependents.

As an aside, this writer represented a debtor who obtained a discharge of a student loan based on undue hardship.  The debtor in that case had low income, lived very frugally, and due to physical disability, was only able to work part time.

  1. i) DRIVING WHILE INTOXICATED [11 USC 523(a)(9)]

Debts incurred for death or personal injury caused by the debtor’s operation of a motor vehicle, vessel, or aircraft if such operation was unlawful because the debtor was intoxicated from alcohol or drugs are non-dischargeable.

IS CREDITOR ACTION REQUIRED TO MAKE A DEBT NON-DISCHARGEABLE?

Debts under paragraphs (2), (4) or (6) of 523(a) will be discharged unless a creditor files an action for the court to determine the debt to be non-dischargeable.  [11 USC 523(c)(1)]  These are the debts for false pretenses, willful injury and fraud.  The other types of debts listed are non-dischargeable without affirmative creditor action.

CAUTIONARY NOTE:   If your client has been sued prior to filing for bankruptcy, you should determine whether the suit includes any cause of action for fraud or intentional wrong-doing.   If so, there is a good chance that the creditor will file a complaint to determine dischargeability in the bankruptcy court.  This doesn’t mean that you should not file a Chapter 7 in such a case, since many non-dischargeability complaints can be beaten.  It just means that you should advise your client of the possibility of continued litigation despite a bankruptcy filing.

STEP TWO:  WILL THE DEBTOR BE ELIGIBLE FOR A CHAPTER 7 DISCHARGE?

As well as specific types of debts that are non-dischargeable under 11 USC Sec. 523, there are also circumstances where the debtor can be denied discharge of any debts under 11 USC Sec. 727.

PRIOR DISCHARGE RULES

The debtor is not eligible for a Chapter 7 discharge if the debtor was granted a discharge under a Chapter 7 or Chapter 11 case commenced within 8 years before the date of the filing of the petition [11 USC 727(a)(8)], or was granted a discharge under a Chapter 12 or 13 case commenced within six years before the date of the filing of the petition, unless payments under the plan in such case totaled at least 100 percent of the allowed unsecured claims, or 70 percent of such claims; and the plan was proposed in good faith, and was the debtor’s best effort [11 USC 727(a)(9)]

PRE-PETITION WRONGDOING

The debtor may be denied a discharge if it is established that:

The debtor, with intent to hinder, delay, or defraud a creditor transferred, removed, destroyed, mutilated, or concealed, or has permitted to be transferred, removed, destroyed, mutilated, or concealed property of the debtor, within one year before the date of the filing of the petition.  [11 USC 727 (a)(2)]

The debtor concealed, destroyed, mutilated, falsified, or failed to keep or preserve any recorded information, including books, documents, records, and papers, from which the debtor’s financial condition or business transactions might be ascertained. [11 USC 727 (a)(3)]

The debtor is unable or unwilling to explain satisfactorily, before determination of denial of discharge under this paragraph, any loss of assets or deficiency of assets to meet the debtor’s liabilities.  [11 USC 727 (a)(5)]

POST-PETITION WRONGDOING

Although beyond the scope of this article, it should be mentioned that there are several things the debtor can do after filing the petition which could also cause the debtor’s discharge to be denied.  Briefly these include transferring or concealing property of the estate after filing, making a false statement during the bankruptcy proceedings, failing to obey a lawful court order or failing to provide information or documents to the trustee.  [11 USC Sec. 727]

STEP THREE:  INCOME WISE, DOES THE DEBTOR QUALIFY FOR A CHAPTER 7?

Technically, the question is not whether a debtor “qualifies” but whether a “presumption of abuse” will arise if debtor files a chapter 7.

11 USC 707 sets forth the tests for presumption of abuse, which can be summarized as follows:

First.  Are the debts primarily consumer debts?  If not – i.e., if the debts are primarily business debts, then no means test qualification is needed.

Second.  Is the debtor’s income below the state median?  If so, the debtor meets the means test.

Third.  The debtor may still pass the means test if, after reducing the debtor’s current monthly income by allowable expenses, the income available for payment to creditors is still below a certain amount.

Allowable expenses are listed on form B-22A.  These include such things as taxes, mortgage and auto payments, child care, health care, life insurance, and charitable contributions.  If the amount left over is less than $6,000 (meaning $100 per month), then there is no abuse.  If the amount is greater than $10,000 (meaning $167 per month), there is presumed abuse.  If the amount is between $6,000 and $10,000, there is abuse only if that amount would be enough to pay more than 25% of the debtor’s unsecured debts.

Fourth.  If the Debtor passes the means test, it is still possible that the Chapter 7 case might be dismissed.

After notice and a hearing, the court, on its own motion or on a motion by the United States trustee, trustee, or any party in interest, may dismiss a case if granting relief would be an abuse of the Bankruptcy Code.  [11 USC Sec. 707(b)(1)]  The court shall consider whether the debtor filed the petition in bad faith; or the totality of the circumstances of the debtor’s financial situation demonstrates abuse.  [707(b)(3)]  If the debtor’s income is below the median income, only the judge or U.S. Trustee can file such a motion [707(b)(6)]   If debtor’s income is above the state median, any party in interest could file the motion.

The median income for the states is available from the Department of Justice website at:

http://www.justice.gov/ust/eo/bapcpa/20110315/bci_data/median_income_table.htm

At the time of this writing, for California, the median yearly income for a one-person family is $48,009, or $4,001 per month.  For a three-person family it is $59,659 per year, or $4,972 per month.

The median income is calculated from the 6 full months prior to filing the bankruptcy.  [11 USC Sec. 101(10A)]  For example, if debtor files bankruptcy on July 15, 2012, the 6 month period would be January through June, 2012.

STEP FOUR:  WILL DEBTOR LOSE ANY PROPERTY IF DEBTOR FILES A CHAPTER 7?

The next consideration in determining whether to file a Chapter 7 is whether debtor has any property that is above the exemption to which debtor is entitled.

If, for example, debtor owns a home with $200,000 of equity, and debtor is only able to exempt $75,000 of that equity, there would be $125,000 of equity that the Chapter 7 Trustee could distribute to creditors.  If debtor were to file a Chapter 7, the Trustee would likely force a sale of the home, from which debto would receive his allowable equity of $75,000, and the remainder would be distributed to creditors.  Thus, this debtor might not want to file a Chapter 7.

Although most Chapter 7 debtors in California are able to keep all of their assets, in some instances, debtors still choose to file a Chapter 7, knowing that some of their assets were above the allowable exemptions.  It might be worthwhile, for example, to lose $5,000 worth of assets to get rid of $150,000 of debts.

This article does not contain a detailed description of exemptions, but the two sets of California exemptions can be found in California Code of Civil Procedure 703.140 et seq and 704.010 et seq.

STEP FIVE:  ARE THERE OTHER DISADVANTAGES TO FILING A CHAPTER 7?

PREFERENTIAL TRANSFERS

If debtor has recently made a large loan repayment to a friend or relative, debtor may not want to file a Chapter 7.

If any loan repayments are made to creditors within 90 days prior to filing a bankruptcy, the trustee might ask that creditor to pay the money back.  For example, if debtor pays $2,000 on your old dental bill on April 1, and then files for Chapter 7 on May 15, the trustee might ask the dentist to repay the $2,000 and sue him if he doesn’t.  If the creditor is an “insider,” meaning a relative or a business partner, then the preference period is 1 year rather than 90 days.  [11 USC Sec. 547(b)]

Reason:  the payment is considered a “Preferential Transfer” meaning that it prefers one creditor over another — and all creditors should share equally in the payment.

The Trustee cannot attempt to recover any preferential payment if, in the case of an individual debtor whose debts are primarily consumer debts, the aggregate value of all preferential transfers is less than $600; [527(c)(8)] or less than $5,000 if the debts are not primarily consumer debts. [527(c)(9)].

As a practical matter, the amount of transfer would have to be large enough to make it worthwhile for the trustee to spend the time and money to go after.

FRAUDULENT TRANSFERS

As discussed above, if the debtor transfers property with intent to defraud a creditor, the debtor may be denied a discharge.  However, a seemingly innocent transfer – such as a gift to a relative or charity – could also have unwelcome consequences for a debtor in a Chapter 7.

A Chapter 7 Trustee may avoid any transfer made by the debtor within 2 years before the filing which was made (A) with actual intent to hinder, delay, or defraud a creditor, or (B) for which the debtor received less than a reasonably equivalent value and

(i) was insolvent on the date of transfer or became insolvent as a result of the transfer or

(II) had unreasonably small capital for a business or transaction that the debtor was engaged in, or

(III) intended to incur, debts that would be beyond the debtor’s ability to repay  [11 USC 548(a)(1)]

A charitable contribution is not considered a fraudulent transfer if

(A) The contribution does not exceed 15% of the gross annual income of the debtor for the year in which the transfer of the contribution is made; or

(B)  The contribution exceeded 15% of the debtor’s gross annual income but was consistent with the practices of the debtor in making charitable contributions.  [548(a)(2)]

The trustee may also use applicable state law to avoid a fraudulent transfer under 544(b)(1).  The statute of limitation under the California Uniform Fraudulent Transfer Act is generally 4 years.  [California Civil Code 3439 et seq., particularly 3439.09]

If the trustee goes after the recipient of a fraudulent transfer, that will not cause the debtor to lose money or property, but the debtor may not like the result.

Let’s say, for example that on July 1, 2009, Joe gives $20,000 to his brother Bob just for the purpose of helping Bob survive, and not with the intent of defrauding creditors.  If Joe files a Chapter 7 on July 1, 2012 (three years after the transfer), the Chapter 7 Trustee may ask Bob for the $20,000 back.  Of course, if Bob is judgment proof, that may not make much difference.

SUMMARY

When counseling a client on whether to file a Chapter 7 bankruptcy, the five main preliminary concerns are:

ONE.  Are the debts that the client wants to handle dischargeable?

TWO.  Is the client eligible for a Chapter 7 discharge?

THREE.  Income-wise, does the client qualify for a Chapter 7?

FOUR.  Will the client lose any property in a Chapter 7?

FIVE.  Are there other disadvantages to filing a Chapter 7?

Take Test for MCLE Credit

To receive 1 hour of MCLE Credit, answer the test questions below, then hit Submit. Correct answers and a CLE certificate will be sent to you via email.

Test for Chapter 7 Bankruptcy Preliminary Concerns
1. At the time of filing a Chapter 7, Joey owns a car worth $15,000, on which he still owes a secured creditor $10,000. When the chapter 7 is over and done, Joey will own the car free and clear, and the lien will be discharged. *
2. A Chapter 7 discharge eliminates a debtor’s personal liability for discharged debts. *
3. Taxes can never be discharged in bankruptcy. *
4. A debtor’s 2009 income tax could be dischargeable as early as January 1, 2012. *
5. At the time of filing a chapter 7, Sally owes her ex-husband Pat $10,000 in past-due alimony, and $20,000 due to a property settlement. The alimony cannot be discharged, but the debt from the property settlement can be discharged. *
6. If Joe files a Chapter 7, and owes parking tickets that are more than 2 years old at the time of filing, those parking tickets will be discharged. *
7. Student loans can be discharged if excepting such debts from discharge would impose an undue hardship on the debtor and the debtor’s dependents. *
8. If a creditor files a claim stating that Joe’s debt was incurred through fraud, then that debt will not be discharged in Joe’s Chapter 7. *
9. If debtor’s prior Chapter 7 bankruptcy, filed on January 10, 2004, resulted in a discharge entered on May 10, 2004, debtor cannot receive another Chapter 7 discharge unless he waits to file a new Chapter 7 petition until May 11, 2012. *
10. If debtor’s prior Chapter 13 bankruptcy, filed on January 10, 2009, resulted in a discharge entered on May 10, 2012, debtor cannot receive a Chapter 7 discharge unless he waits to file a Chapter 7 petition until May 11, 2015. *
11. If debtor gives $100,000 to his Aunt Agatha on June 15, 2012, in order to avoid paying that money to a judgment creditor, debtor is likely to get a Chapter 7 discharge if he waits until December 15, 2012 to file. *
12. If debtor destroys all the financial records of his failed gardening business on January 15, 2012, he can safely assume he can obtain a Chapter 7 discharge if he waits until January 17, 2013 to file. *
13. A debtor can be denied a discharge for making a false statement in connection with a bankruptcy proceeding. *
14. A debtor whose income is 150% of the applicable state median income whose debts are primarily from a failed business is not eligible to file a Chapter 7 bankruptcy. *
15. A debtor whose family income is above the state median will never be allowed to file a Chapter 7 bankruptcy. *
16. A repayment to a creditor made 89 days prior to the bankruptcy filing may be a preferential transfer which can be recovered by the trustee. *
17. A repayment to a creditor made 91 days prior to the bankruptcy filing cannot be considered a preferential transfer. *
18. If Bob repays a $10,000 loan to his mother-in-law on January 15, 2012, you should advise him to wait at least until December 15, 2012 prior to filing a Chapter 7. *
19. If a debtor makes a transfer of property with actual intent to defraud a creditor within two years prior to filing the bankruptcy, the trustee can avoid the transfer. *
20. If Sally’s gross income for 2012 was $100,000, and she donated $15,000 to Utopia State University (a qualified charitable organization) during that year, and if she files for Chapter 7 in 2013, the trustee can recover the donation from the University. *
21. If Sally’s gross income for 2012 was $100,000, and she has donated $25,000 to Utopia State University (a qualified charitable organization) during that year, (but she has also routinely donated 25% of her gross income during the last 10 years) and if she files for Chapter 7 in 2013, the trustee can recover the donation from the University. *

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