Pre-Filing – Information Gathering: The Chapter 7 Bankruptcy Process
Pre-Filing – Information Gathering is part 3 of a 10 part series on Chapter 7 bankruptcy and will provide general information regarding bankruptcy under Chapter 7.
At the initial interview, the lawyer should discuss with the client the various options available: 7, 11, 13, or not filing. The option of not filing should be explored fully. Bankruptcy should always be a last resort.
Certain disclosures must be given to the prospective debtor at the initial meeting. See § 527. Debtor’s counsel is also required to obtain a written fee agreement within five days of that meeting. § 528(a).
The lawyer needs to review the client’s financial picture in considerable detail: That is, what are the client’s assets, how much is owed (and to what types of creditors), what is the client’s historical and current income, and what are the client’s regular expenses.
The client needs to provide to counsel the information needed to prepare the bankruptcy schedules and statements. Bankruptcy forms software includes on-line tools for the client to input data and the attorney to then prepare bankruptcy schedules. The attorney may alternatively provide the client with a questionnaire that essentially matches up with the questions in the required bankruptcy schedules and statements.
1. The Assets and Exemptions.
Stated simply, the debtor must disclose on the bankruptcy schedules all assets, no matter how insignificant or speculative. Failure to do so may jeopardize the debtor’s discharge.
Be aware that “asset” means all property rights of any kind. Assets include intangible items such as personal injury claims and other tort or contract claims that could be pursued, even if recovery is speculative. If you don’t know whether something is an asset or should otherwise be disclosed in the bankruptcy schedules, always err on the side of disclosure. It cannot hurt your client to overdisclose. It can hurt severely if you underdisclose.
Unlike property interests held at the time of the bankruptcy filing, postpetition income from personal services is not an asset of the bankruptcy estate. The individual debtor is permitted to work and earn a living, with income earned free and clear of prepetition creditors whose claims are subject to discharge.
But take note that the assets of a sole proprietor include all of the business assets (and the creditors include all of the business debts). In most instances, a sole proprietor cannot operate the business once the Chapter 7 petition has been filed. In contrast, the asset of an individual shareholder of a corporation or member of an LLC is the corporate stock or LLC membership interest; the business assets are owned by the non-debtor entity and technically are not property of the bankruptcy estate—although if the debtor is the sole shareholder or sole member, the Chapter 7 trustee may still be able to liquidate the business assets. That said, the interest may have no value and thus would not be sold by the trustee, enabling the debtor to keep going with the business. The flip side is that the business debts are not discharged and entity creditor may continue to pursue claims against the company. If the company interest has value, it may be at risk of sale in the Chapter 7 case, and the client may want to look closely at options other than Chapter 7.
The prospective debtor always wants to know what assets will be lost in Chapter 7. In most cases, the answer is “none.” The ability to exempt property generally permits debtors without substantial assets to retain all they have at the time of filing.
Federal and state law provide that certain property is exempt from creditors. The two sets of exemptions differ significantly in places. The debtor’s attorney must select one or the other, depending on what types and amount of property the debtor has. For example, state law is more favorable in regard to homestead exemptions on personal residences (state = $125,000; federal = $23,675 [x 2 if joint filing]). On the other hand, the federal exemptions generally provide more protection for personal property. Federal exemptions are listed in § 522(d). State exemptions are generally in RCW 6.13 and 6.15.
The debtor must provide a complete itemization of all property, including liquidation values. In the case of larger items like houses, a recent appraisal is helpful. Debtor’s counsel should review the property valuations, and select the exemptions that provide the most benefit. If the trustee is in doubt about the debtor’s valuation, the trustee may decide to have an appraiser take a look.
In the case of joint filings by a married couple, some exemptions may be doubled up, but some may not. The wording of the exemption statutes must be carefully checked. One spouse may not choose the federal exemptions while the other chooses the state exemptions.
Exemptions are for individuals only. Entities that file bankruptcy do not get to exclude any property from liquidation.
Because the exemptions are typically sufficient to cover all the debtor’s assets, most cases are deemed to be “no-asset” cases and are closed without much activity. Upon reviewing the schedules and exemption claims, the trustee will make an initial determination as to whether the estate has any interest in the property which might be sold for the benefit of creditors. A trustee will not sell an asset unless there will be proceeds for unsecured creditors. For example, the state homestead exemption requires that the first $125,000 in net proceeds from the sale of a residence must be paid to the debtor. If a house is worth $550,000, and has liens against it of $400,000, and after deduction of say $50,000 for hypothetical costs of sale, $100,000 would be left over. Since the debtor is entitled to up to $125,000 as a homestead exemption, the trustee would not be able to sell the house.
If the prospective debtor knows there are nonexempt assets which are likely to be sold or otherwise turned over to the trustee, the debtor must consider whether it is possible to legitimately convert that nonexempt property into exempt property before filing. Such pre-bankruptcy planning is outside the scope of this outline, except to say that whatever is done, it should be done at arms’ length, for fair value, and be disclosed and justifiable if inquiry is made. Alternatively, if the debtor files with non-exempt assets and the trustee is inclined to sell property, the debtor can attempt to purchase the bankruptcy estate’s interest, by paying the trustee what the trustee would realize if the property were sold.
2. The Debts.
The debtor must prepare and file schedules listing all creditors with amounts owing. At the first conference between attorney and client, debtor’s counsel needs to know approximately how much is owed, and to whom. If the debt owed is predominantly nondischargeable (e.g., taxes, student loans), Chapter 7 may not be the answer. Secured debts must be identified and decisions made as to what to do about lien claims.
While credit reports are very helpful, they may not be a complete listing of all creditors. The attorney needs to probe for all types of debts to all types of creditors.
In preparing schedules, the creditor’s correct mailing address is the critical piece of information. It is crucial that the creditor be notified of the bankruptcy filing, so that collection actions cease and the debt will be discharged. Be sure that the address used in the filing is the correspondence or mailing address, not the payment lockbox.
All debts must be listed, even debts to family members and friends. Disputed, contingent, and unliquidated debts need to be scheduled.
3. Income and Expenses.
The individual debtor’s monthly income and expenses will show up in two different places on the bankruptcy schedules.
First, the debtor will disclose a budget of income and expenses, based upon estimated monthly cash flow going forward. This appears on Schedules I and J.
Then there is the “means test,” outlined in § 707(b)(2), and found collectively in three forms that are parts of overall Form 122A. These forms are attached to this outline. A full volume may be written about this “test,” which is difficult to parse through and is the subject of an ever-growing body of case law. For “basic bankruptcy” purposes, here is what one needs to know:
The means test only applies to individual debtors with “primarily consumer debt,” which is debt incurred for personal, family, or household purposes. § 101(8). “Primarily” means 50% plus $1.00. Tax debt is not consumer debt. Mortgages on personal residences are consumer debt. Mortgages on rentals may be nonconsumer investment debt if the property was purchased solely for investment purposes and was never used as the debtor’s residence.
If the means test is inapplicable, the debtor must file the exemption form (Form 122A1-supp). That should be the end of the matter, but be aware of a slowly developing set of cases holding that a case may be converted from Chapter 7 to Chapter 11 under §706(b) where an individual who is not a consumer debtor has the capability of repaying his or her debts in Chapter 11. If you have an individual with primarily nonconsumer debts and significant monthly income, you will want to review this area of law.
The means test is intended to determine whether a consumer debtor has sufficient excess income over expenses on a monthly basis that he/she could make a meaningful payment in Chapter 13. If the debtor has that income, and elects to file Chapter 7, the filing is presumed to be an abuse of the chapter and the case is vulnerable to dismissal.
Income is measured by taking the monthly average of all funds received by the debtor over the six calendar months preceding the month of the bankruptcy filing. If that amount, which is defined as “current monthly income,” multiplied by 12, is less than the median income for a household of the same size as that of the debtor, there is no presumption of abuse and monthly expenses need not be considered.
Median income tables may be found on the U.S. Trustee’s web site and elsewhere, and are periodically adjusted. They are based on the number of persons in the “household,” an undefined term. Courts generally take a practical attitude to assessing household size, preferring, say, an actual “heads on beds” count rather than the number of deductions claimed on a federal tax return. For cases filed after April 1, 2020, here are the medians in the State of Washington:
Household of 1: $67,511
Household of 2: $80,251
Household of 3: $92,568 9,000,400
If the debtor’s income is “above median,” monthly expenses are considered to arrive at a bottom line net available disposable income. These deductible expenses are a mix of certain types of expenses permitted under IRS standards (including fixed amounts for food, utilities, and transportation costs) and certain actual expenses (including payments on secured debts).
If the income after expenses exceeds a certain percentage of the debtor’s unsecured debt, abuse is presumed, certain parties have standing to seek dismissal, and the debtor might be better off selecting Chapter 13.
As a practical matter, in nearly all consumer cases either the debtor will be below median or the allowed expenses will exceed the monthly income. Generally, the means test is a hurdle, not a roadblock, to a Chapter 7 filing.
Note: Even if the debtor satisfies the means test, the trustee or U.S. Trustee still may seek dismissal of a consumer case for bad faith or if the totality of circumstances indicates “abuse,” a term undefined by the Code. § 707(b)(3). An example would be where the debtor passes the means test by gaming the system, such as by intentionally deferring substantial income until the postpetition period.
A considerable amount of information about the means test, including links to the data used for filling in the forms (data that will be built into bankruptcy forms software), and information regarding the U.S. Trustee’s position on certain line items, is at www.justice.gov/ust/means-testing.
The debtor needs to give to counsel copies of the most recent federal tax return, “payment advices” (that is, pay stubs) for the sixty days prepetition, and bank statements that include the date of filing. All of these need to be provided to the Chapter 7 trustee, at least one week prior to the § 341 meeting, per Local Rule 4002. The best practice is to have the client provide not only these documents, but at least six months’ worth of wage and bank statements and the last two tax returns. They should be reviewed carefully for transfers, sources of income, investment accounts, and other items that may be required to be disclosed in the bankruptcy filing.
Contact the bankruptcy attorneys at Wenokur Riordan PLLC today at (206) 724-0846 to discuss your situation.
This article is intended to provide you with enough detail to give you a good basic understanding of the process, without snowing you under with too much information. Obviously, there are exceptions and nuances to just about everything described in this outline. The Bankruptcy Code, Federal Rules of Bankruptcy Procedure, and reported case law are the primary sources of information. All section references here are to the United States Bankruptcy Code, 11 U.S.C. § 101 et seq. All Rule references are to the Federal Rules of Bankruptcy Procedure.