Chapter 7 or Chapter 13? Choice Out of Your Hands

This week, Gail takes a detailed look at what type of consumers will really be affected by the new bankruptcy law.

Hi, Gail,

I’m embarrassed to say this, but my husband and I are talking about filing for bankruptcy. We are not the kind of people who live an extravagant lifestyle — we don’t have lots of electronic “toys,” go on fancy vacations (we’ve never taken the kids to Disneyland), or eat out a lot.

We are just trying to raise three decent kids in a loving home. Our financial situation began to unravel eight months ago when my husband (along with 80 others) got laid off because his company decided to consolidate and moved everything to a plant in another state. He’s really been trying to find a new job but there just aren’t a lot of opportunities for him in our area.

My job covers the basics — mortgage, food, gas for the cars, clothing — but we’ve had to let some other things slide: credit card bills, for instance. We always try to pay something, but we usually can’t even make the minimum payments on all of them.

Now we’re getting annoying and somewhat threatening phone calls from creditors.

I heard that the bankruptcy law has changed and I’m wondering how we would be affected. Any advice you have would be appreciated.

Thanks,

Cindy

Dear Cindy,

I really feel for you. Job loss is the second-most common reason people are forced to file for bankruptcy. (Catastrophic medical expenses are #1; divorce is #3.) Being out of work is always tough, but the added pressure of financial strain makes it even worse.

As you probably know, bankruptcy is not something to be taken lightly. It stays in your credit history for ten years and has wide-ranging implications that can haunt your personal life. For instance, as you might expect, having a bankruptcy on your record can affect your ability to get a loan. What most people don’t know is that prospective employers often order a credit report on you as part of the hiring process, so it could hurt your chances of getting a new job.

The new bankruptcy law was signed by President Bush on April 21. The date’s important because most of the provisions in the bill don’t take effect until 180 days (6 months) after that. So what I’m about to describe will not be law until Oct. 21 of this year.

First, a little history. While the number of businesses filing for bankruptcy has been fairly steady over the past 25 years, the number of personal bankruptcy filings has been rising sharply- from around 300,000 in 1980 to 1.5 million last year.

The real number is higher. One study found that nearly 32 percent of all bankruptcies involve couples who file together as a single entity. This means the number of individuals who filed for bankruptcy in 2004 was closer to 2 million.

There was an especially big spike in personal bankruptcy filings starting in the mid-1990s. At the time, attorney John McMickel, now in private practice in Washington, D.C., was the legal counsel to the Senate Judiciary Committee. He recalls that creditors were complaining about people abusing the system. In other words, folks who were making decent salaries and could afford to pay down at least a portion of their debts, were using bankruptcy “as a form of financial planning.” They simply filed Chapter 7, had their debts erased, and started fresh.

The point is, efforts to toughen the bankruptcy law were underway well before President Bush took office. This was not, as some would have you believe, an effort on the part of Republicans to pay back supporters in the business community. This legislation had widespread support from both parties in Congress.

The biggest change is that, starting Oct. 21 you will no longer be free to choose which type of bankruptcy procedure you wish. Under Chapter 7, certain assets (such as investments) are seized and liquidated, but all your debts are erased. Under Chapter 13, your debts are reduced, but you still have to pay some of them back.

Once the new bankruptcy law takes effect, there will be a “means test” to determine which form of bankruptcy you qualify for. Here’s how it will work:

If your income falls below the median income for your state, you qualify for Chapter 7. Based on historical data, the American Bankers Association estimates this includes about 80 percent of everyone who files for bankruptcy.

In other words, most folks will not be affected by the change.

However, 20 percent of bankruptcy petitioners whose incomes are higher than the median, will have to undergo an additional test to determine whether they end up in Chapter 7 or Chapter 13.

This is a tough test. The court looks at your income and subtracts your expenses to determine if there is at least $100/month available to re-pay creditors. If so, then you land in Chapter 13, baby. Which means you’re going to be put on a court-supervised re-payment schedule for at least some of your debt.

To be fair, you will have a chance to argue that you can’t afford this. Laura Fisher, a spokesperson for the American Bankers Association, says “if you’re in the midst of a medical crisis or have been called up to serve in Iraq and your income’s being cut in half” you can still wiggle out of Chapter 13.

But if you want the judge to grant you permission to file under Chapter 7, you’ve got to have a darn good reason.

And forget about jacking up your expenses so it looks like you can’t afford to pay down your debt. What you really spend on food for your family doesn’t matter. The court has to use the same standards the Internal Revenue Service applies when it estimates how much of your over-due tax bill you can afford to pay each month.

For some expenses, such as clothing, food, “housekeeping supplies,” and “personal care products and services,” the I.R.S. uses the same number no matter where you live. It’s based on your gross income.

For example, if your monthly income is between $1,667 to $2,499, a family of four is allowed to keep $527/month for food and $127/month for apparel.

Then there are certain categories of “allowable” expenses that vary based on the county where you live. For instance, the monthly “Housing and Utilities” expense for a family of four in Custer County, Oklahoma $1,022. In Orange County, Calif., it’s $2,366.

(You can find all of these amounts on the Internal Revenue Service website, http://www.irs.gov. Type “Allowable Living Expenses” into the search window. Then laugh. Or cry.)

“Whoa!,” you might be thinking, “my kids are all on the high school football or swim teams and eat like there’s no tomorrow. And they’re growing like weeds. Every time we turn around someone needs new Nikes. We had to have a four-bedroom house to give each one his/her own bedroom, so we spend more on housing than you allow.

Too bad.

If you want the bankruptcy judge to grant you a bigger allotment in a certain expense category, you’re going to have to argue this in court. And you’re probably going to want a lawyer do this on your behalf. If you can’t justify why the court should increase your “allowable” expense, the family’s going on the hotdogs and beans diet.

You explain it to the kids. The message seems to be that you- not the government- got into debt up to your eyeballs. And don’t try to blame the credit card companies for tempting you with an endless stream of pre-approved cards. Among people who file for bankruptcy, only about 16 percent of their total debt is “bank card debt,” according to the American Bankers Association. Next time buy Keds for the kids.

And just to keep you honest (not that you’d try to hide any income or pad your living expenses), the law requires the Justice Department to randomly audit one in every 250 bankruptcy filings. “Doctors, attorneys and others with income they don’t want to disclose will have a harder time hiding it,” according to McMickel. Folks who claim above-average expenses will get extra scrutiny. Evidence of “fudging” the numbers, a.k.a. cooking the books, will get turned over to federal prosecutors.

In addition, attorneys who represent people in bankruptcy court can be held accountable if a client provides inaccurate or misleading financial information. According to McMickel, bankruptcy lawyers “will have to certify to the court that they have performed a reasonable examination” of their client’s income.

The new law also partially closes a loophole popular with some wealthy debtors. It works like this: when you know you’re going to file for bankruptcy, move to Florida, Texas, Kansas, Iowa, or South Dakota — all states that have an unlimited “homestead” protection. This means no matter how much your house is worth, it can’t be touched by creditors.

Say you’ve got $5 million in investments and other assets which you know will be seized and liquidated by the bankruptcy court. So you cash them in, buy a $5 million house on the beach in West Palm and move in. After waiting 6 months to establish “residency” you file for Chapter 7. Voila! $5 million worth of your wealth is now beyond the reach of your creditors.

In October, this is no longer possible. For your home to be considered an “exempt” asset, you have to live in it for at least two years before you file for bankruptcy.

In order to prevent people from getting into a purge-and binge debt cycle, they’ll have to attend some basic financial education classes provided by a federally-approved non-profit credit counseling firm. (The government will be putting together a list of providers as well as a curriculum.)

You have to attend the first class before you even are allowed to file for bankruptcy. As a Republican aide to the House Judiciary Committee explained, this is “to ensure the debtor exhausts non-bankruptcy options” such as allowing the credit counseling service to negotiate a reduced or extended payment schedule with your creditors. For obvious reasons (not making any money), this isn’t something a bankruptcy attorney is likely to suggest.

Regardless whether you file under Chapter 7 or Chapter 13, you must complete the second class in order to have your case marked “closed” by the bankruptcy court. These classes won’t be free, according to Catherine Williams, vice president of financial literacy for Money Management International, an association of credit counseling agencies. She says the government will determine a “reasonable” fee scale, probably in the range of $15 to $40, depending upon your income.

Her organization and others like it supported this bill because of the new requirement that bankruptcy filers receive counseling. She hopes this “will help people be more aware of basic money management.”

Another “lesson” of sorts will be provided by credit card companies. They’ll have to give consumers an example of how long it would take to pay off a debt if you just made the minimum monthly payment. It won’t specifically address the balance on your account. The point is to use a sample case to demonstrate the amount of interest you rack up over time.

As for the means test, Williams and others say it will screen out the people who can afford to pay back a percentage of their debt rather than having it completely discharged. These individuals, she says, “raise the cost of debt to other consumers.” In fact, the American Bankers Association estimates each household pays $400 more each year for goods and services because companies stung by debtors increase their prices to recoup their losses. (Think of it as $100 every quarter that you could spend in something really nice for yourself or your family.)

While this new law makes it tougher for some people to walk away from their debts, it introduces additional protections for all consumers.

Under existing law, money in most — but not all — company retirement plans is off-limits in a bankruptcy proceeding. This protection is being extended to SIMPLE and SEP plans.

Up to $1 million in your IRA will be exempt from creditors.

On top of that, an unlimited amount of money that you rolled into an IRA from another retirement plan is exempt.

John Fenton, an attorney with the National Underwriters Company and one of the authors of “Tax Facts,” points out that this could complicate matters for some bankruptcy filers.

The tax act passed in 2001, says Fenton, “allows you to combine regular IRA assets and your rollover assets into a single IRA.” If you have an IRA worth more than $1 million, “the bankruptcy court will have to find a way to trace the rollover amount and the earnings on that money.”

There are also protections for assets set aside for a child’s college education. Money contributed to a 529 plan or Coverdell Education Savings Account at least a year before you file for bankruptcy cannot be taken to re-pay creditors, provided certain conditions are met. (What kind of person stashes money in their kid’s college account just before they file for bankruptcy?)

So let’s recap things.

When all is said and done, 80 percent of the folks seeking bankruptcy protection will still qualify for Chapter 7. 20 percent will go through the exercise of having their income compared to their expenses. It’s estimated half of them will still end up in Chapter 7.

Which means that, starting Oct. 21, approximately 10 percent of all bankruptcy filers will end up in Chapter 13 and be required to adhere to a re-payment schedule.

Hmmm. Based on last year’s number (1.5 million personal bankruptcy filers), let me see... that’s 150,000 cases that will end up in Chapter 13. That’s it?!

While this sounds like a small number in light of the 500 pages this law takes up, supporters say those are individuals who tend to owe the most and have enough income to pay at least some of it back.

In your case, Cindy, it doesn’t sound as if the new law is going to have much of an impact. You will probably be allowed to file under Chapter 7. The only thing that could affect you is the credit counseling classes. If you want to avoid them, you’ve got to file before Oct. 21.

But before you head to bankruptcy court, do yourself a favor and schedule a meeting with a legitimate, non-profit, credit counseling agency in your area. You and your husband sound like the perfect candidates to have your payments reduced.

Frankly, what irks me most about this new law is that it’s not going to put an end to those annoying ads on radio and TV from the Joe-the-sleazy-bankruptcy-attorney types. In fact, bankruptcy lawyers will be in [greater] demand because of the additional paperwork and proof required.

Hope this clears things up,

Gail

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