Bankruptcy Definition: What Exactly Does It Mean?

When an individual or company files for bankruptcy, he or it is making a legal declaration of an inability to repay his or its debt to creditors. Once bankruptcy is declared, a debtor is absolved of most financial obligations; however, the bankruptcy will have an adverse impact on the individual's or company's credit history and ability to obtain credit in the future.

Types of Bankruptcy

A debtor can file for different types of bankruptcy depending on the circumstances of the debt. The following are the most commonly filed bankruptcies.

Chapter 7: Liquidation

Chapter 7 ranks number 1 for bankruptcy filings in the United States. Debtors who have qualified under the means test (which determines disposable income) and have attended a required credit counseling session are eligible to file for Chapter 7. An individual that files Chapter 7 will have all of his assets sold, with the exception of certain exempt property, such as necessary clothing and household appliances. The proceeds from the liquidation will go to creditors to pay off the debt. Chapter 7 does not absolve a debtor of certain obligations, including child and spousal support or student loans. All other debts can be discharged; however, the bankruptcy is reflected on a debtor’s credit report for 10 years. Chapter 7 bankruptcy is best suited to debtors who don’t own any real estate property.

Businesses can also choose to file for a Chapter 7 bankruptcy. The business operations will cease, and a Chapter 7 trustee will be appointed to the company's case to sell its assets. The money will be used to pay off the debt owed to the creditor. Unlike with an individual who files a Chapter 7 bankruptcy, the debt will not be discharged, as the company will go out of business completely.

Chapter 11: Reorganization

Reorganization bankruptcy usually involves a corporation or partnership. The debtor remains in control of business operations but with oversight from the court. Chapter 11 bankruptcy allows this debtor in possession to obtain a loan at a reasonable interest rate with a new lender. This new lender is given first priority on business earnings if the borrower defaults on the new loan. An automatic stay is also imposed, which allows the business to put other litigation on hold until it can be resolved in bankruptcy court. The court also requires a written disclosure statement and plan of reorganization. The plan must list all the claims against the company and how it will rectify each one. If a claim is not going to be paid in full, the creditor concerned can vote whether it is in agreement with the plan. Once all the votes are tallied, a hearing is held to determine if the plan is confirmed.

Chapter 13: Individual Debt Adjustment

Chapter 13 allows for an individual to keep his property and pay off his debt over a period of 3 to 5 years. The main reason a debtor would file Chapter 13 rather than Chapter 7 is to avoid foreclosure on his home. Any individual is eligible to file for a Chapter 13 bankruptcy provided that his unsecured debts are under $360,475 and that his secured debts are under $1,081,400. (These figures are current in July 2010.) A Chapter 13 trustee is appointed to the case and will collect payments from the debtor to be distributed to the creditor. An automatic stay is also imposed on other litigation; this includes preventing foreclosure proceedings and wage garnishments. A Chapter 13 bankruptcy will remain on a debtor’s credit for up to 7 years.

How to File Bankruptcy

To file bankruptcy as an individual, you must open a case at your jurisdiction’s bankruptcy court. A filing fee is required along with an administrative fee due at the time of filing. In order to complete the official bankruptcy forms, you must compile this information:

  • a list of all the creditors and how much is owed,
  • the source of your income and the frequency of payments,
  • a list of property you own and
  • a detailed list of your monthly living expenses.

This information will go into the statement of financial affairs and schedules portion of your bankruptcy petition. Expect to wait 20 to 50 days before a meeting is scheduled with you and your creditors to agree on a plan of action.

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