Tag Archives: debt relief & bankruptcy

Debt Forgiveness and Income Tax

Debt forgiveness, which is the cancellation of a debt that you owe to someone, often can lead the IRS to see an increase in your income tax bill. However, there is no simple rule to be applied to every situation. For example, if you are in bankruptcy, the IRS is unlikely to see income that can be taxed after debt forgiveness. On the other hand, when a commercial lender cancels your obligation to repay a debt, you may find yourself with income equal to the amount of debt forgiven. In this situation, you do not have any money in hand, but you can expect a tax bill on the amount of money that the lender decided could not be collected from you. Your former lender usually should send you an IRS Form 1099-C (“Cancellation of Debt”) to let you know that the debt that you no longer owe triggered an increase in income taxes at the time of debt forgiveness. Remember that the IRS also gets a copy of the 1099-C and is unlikely to forget the incomes taxes that you now owe.

You may wonder why you receive debt forgiveness income when you cannot repay a loan. One point that will be discussed later is that the IRS does not see income when a debt is cancelled so the explanation here is general. The idea behind debt forgiveness resulting in income begins with the fact that the funds you originally borrowed were not income since those funds represented money loaned to you that had to repay to the lender. When a debt is forgiven, you no longer have to have any obligation to pay back whatever amount of the loan remains unpaid – essentially, your wealth has increased now that you have money that you can keep.

As long as none of the exclusions or exceptions (which will be mentioned below) regarding debt forgiveness income applies, the formula for calculating income simply involves subtracting the fair market value of the property from the debt owed at the time that the lender took a specific action, such as foreclosure or repossession. Also, you may receive a capital gain due to foreclosure, for example; this is not debt forgiveness income but usually occurs when the property’s fair market value is greater than its adjusted basis (approximately your original purchase price plus the costs from major improvements). An amount could be excluded due to the length of time that this was your personal residence during the last five years – I won’t go into the details here because the focus is on debt forgiveness for the moment.

There are several exceptions when debt forgiveness does not lead to taxable income. The examples provide general rules about various exceptions, which could be subject to exceptions themselves – consulting with someone who handles these matters about your specific situation always is advisable.

In general, a debt that is cancelled through a gift, a bequest or devise, or an inheritance is not considered income. Certain student loans also provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers. If your student loan is canceled as the result of this type of provision, the cancellation of this debt isn’t included in your gross income. To qualify for this treatment, the loan must have been made by entities in one of three categories: 1) the federal government, a state or local government, or an instrumentality, agency, or subdivision of one of those governments; 2) a tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, having employees defined as public employees under state law; or 3) an educational institution (an organization that has a regular faculty and curriculum as well as regularly enrolled students who attended educational activities at that place). Other criteria have to be met for these loans not to be income if they are cancelled. One major reason for debt forgiveness here is to encourage students to serve in occupations or areas with unmet needs in which the services provided are for, or under the direction of, a governmental unit or a tax-exempt Section 501(c)(3) organization.

There also is an exception for deductible debts. Most individuals use the cash method of accounting so income is seen when the money is received while expenses are counted when money is paid for goods or services. Therefore, when a debt was supposed to be paid but the obligation to do so was forgiven, you would not realize income at that time if payment of the debt would have been a deductible expense for you.

The Home Affordable Modification Program (HAMP) also has some exceptions to debt forgiveness income. Reduction of your principal mortgage balance generally is not income when Pay-for-Performance Success Payments and PRA investor incentive payments are involved. Meanwhile, when the principal balance is reduced due to Principal Reduction Alternative under the same program, you should expect that you have taxable debt forgiveness income. Any exception to possible debt forgiveness income can become complicated; again, seeking a professional’s assistance is the best way to protect yourself from making costly mistakes in this area.

After any possible exceptions are reviewed, you then look at the exclusions. For individuals, some of the most common situations that are excluded from consideration as income from the cancellation of a debt would be the following. The most common one probably involves bankruptcy – if a debt is discharged in a bankruptcy case, then it cannot be counted as income from debt forgiveness. Insolvency, which involves a situation when your assets have a fair market value that is less than the amount of all of your debts, also would exclude you from having debt forgiveness income. However, this is not easily determined so you would be wise to have a tax professional examine your financial position to determine if you are insolvent.

Another category of exclusion that is complicated and would require the help of a tax professional usually deals with certain farm debts. The IRS also has noted that non-recourse loans are not subject to debt forgiveness. These loans permit a lender to repossess the property that you financed with the unpaid debt or, if this does not apply, the property that you used as collateral in the event that you defaulted on the loan. There is no personal liability for the default on a non-recourse loan, which is why you do not gain taxable income from the debt’s cancellation. On the other hand, this type of loan still could result in a capital gain when the property is sold.

Exceptions should be applied before you apply the exclusions because their effects on “tax attributes” of yours are different. Unlike exceptions to tax forgiveness income, exclusions require you to reduce tax attributes, which include certain credits and losses as well as the basis of assets. Remember that, while income due to debt forgiveness can seem to be a relatively simple concept, there are many twists to this concept of which you must be aware, and the only way to approach this is to consult with a tax professional about all of the implications that ultimately will impact your tax bill.

There is one final word of caution when the possibility of income from debt forgiveness exists. Whether or not a Form 1099-C was received does not determine income tax implications. The IRS requires these forms only under certain circumstances. When a creditor cancels a debt of less than $600, you may not get a Form 1099-C. However, you must look at the possibility that you received income that is taxable due to debt forgiveness despite the absence of the 1099-C because the IRS would look for income in this situation and will not be do forgiving if you neglected to pay tax that you owed.

Business and Chapter 11 Bankruptcy

Business – particularly small business – forms the backbone of the U.S. economy. According to the Small Business Association website, there are 28 million small businesses in this country, and they account for 54 percent of all sales and 55 percent of all jobs. There is no good definition for “small business” because this classification differs from industry to industry. However, all businesses face an unfortunate fact of life: most that start up must wind down sooner than later. Depending on the industry, at least one half of new businesses are unlikely to survive for five years. When a business begins to fail, it may look to protections that the Bankruptcy Code can provide. This often means looking at a Chapter 11 filing in an attempt to save the business, but this is a possibility exists mainly for one established as a separate legal entity, such as a corporation (including a Limited Liability Company) or legally formed partnership (including Limited Liability Partnerships).

A sole proprietor is in a different position. If the business or the individual files for bankruptcy, the individual or the business, respectively, also files. Chapter 11 generally is not available here. However, if the debtor wants the business to survive the bankruptcy, then a filing under Chapter 7 would not be helpful since a trustee will be appointed and will control the bankruptcy estate. The trustee is likely to shut down operations and liquidate assets in order to make payments to creditors.

When a debtor who is a sole proprietor wants business to continue in business after a bankruptcy filing, the individual should consider incorporation prior to filing or, possibly, a Chapter 13 case since the debtor generally would remain in possession of the business in a filing under Chapter 13. If there was an incorporation, then Chapter 11 again can be viewed as a possibility. This article will look at separate legal entities seeking to continue operating into the future. As with General Motors during the last decade, bankruptcy under Chapter 11 can succeed, but a small business that looks to protection under this chapter must understand what it is getting into and the likelihood of getting out of it successfully.

The general purpose for filing for bankruptcy under Chapter 11 is “reorganization.” This actually amounts to a plan for the repayment of debts while the entity continues in business. As an aside, Chapter 11 can be used by certain individuals when their amount of debt prevents them from filing under Chapter 13; however, this is the exception to the usual filing under Chapter 11. There also is Chapter 11 “liquidation” for a business, but this not the usual reason for a Chapter 11 filing so it will not be discussed here.

A business that continues to operate as it pursues bankruptcy under Chapter 11 is a “debtor-in-possession,” which essentially places it in the position that an appointed trustee usually occupies. The trustee is supposed to manage the bankruptcy estate and to sell off its assets in order to pay creditors when possible, but, with an ongoing business, its assets remain in the hands of the entity to provide an opportunity to continue operating. This also means that the business has fiduciary responsibilities and must act in the best interests of its creditors, which may be contrary to its own best interests.

While the business faces obstacles due to fiduciary responsibilities to creditors, Chapter 11 does give it various powers that can increase the chances of success. These include is ability to object to creditors’ claims, avoid liens, reject leases and contracts without penalty, extend the time to repay to current creditors and potentially reduce the amount owed to them.

Although having the potential to use these powers is beneficial, there also are realities that reduce the chance of emerging from Chapter 11 successfully. There tends to be more litigation involved in these bankruptcies – creditors suing the business, and vis-a-versa. Even if the litigation ends favorably, the cost to finance it can be considerable.

There are other practical problems when a business files under Chapter 11. It not only involves a time-consuming process (which could take years to resolve), but it also entails the likelihood of considerable costs beyond those already mentioned. As of February, 2016, the filing fee to begin the process is $1,717. However, there are additional costs that can be much higher. For example, attorney’s fees and related costs can begin in excess of $10,000 and may increase considerably depending on the case’s complexity and amount of work that is likely. Also, attorneys and any other professionals usually need to be paid prior to filing since any further payments require authorization by the Bankruptcy Court. There also are numerous administrative burdens along the way – there are reports that must be filed regularly with the Court as well as the Office of the United States Trustee, along with additional fees to be paid.

With so many difficulties facing a business that already is failing, one should not rush to file under Chapter 11. If there will be any chance of success, there must be significant planning in advance. Of course, this really applies to all bankruptcies – a successful outcome is unlikely when a debtor pushes to file right after meeting with the attorney. However, this is even more applicable to Chapter 11 filings, which have the additional financial burdens and administrative requirements that cannot be avoided. Therefore, anyone who would consider such a filing must plan well in advance of an attorney’s involvement in the case, producing as much relevant documentation as possible for the attorney to review before any decision is made.

With all of the requirements during the process itself, it must be remembered that the fundamental purpose here is to prepare a viable Plan of Reorganization that the Bankruptcy Court will confirm. This essentially becomes a contract with creditors, with details about how debts will be repaid as well as the source for payments. Before seeking court approval, creditors generally vote on the plan. They do so by particular creditor classes (secured, unsecured, etc.) that are established. If a creditor class does not approve the plan, the class members still may have to accept it, although this also may force the business to relinquish some assets as a result.

To improve the likelihood of a plan’s approval, a business should attempt to negotiate agreements with creditors for the payment of its debts. A skilled attorney who can craft a proposal that is acceptable to creditors and provides the business with an opportunity to attempt to move forward in a stronger, more stable position is essential.

In the end, all of these efforts may serve simply to forestall the inevitable – a business filing a Chapter 11 case may intend to continue operating after the bankruptcy, but most that file under Chapter 11 will not survive. This must be realized before filing, and other options must be reviewed, including filing a Chapter 7 case.

This is a quick primer on business reorganization under Chapter 11. Any entity that is considering this possibility needs to explore all of the details and implications involved before deciding to pursue this option.

Abandonment of Property

At the start of a bankruptcy filed under Chapter 7, a debtor creates a bankruptcy estate that includes all interests in property in which you, as the debtor, hold any legal title or equitable. To show why abandonment occurs, if you gave a security interest in property, such as a house with a mortgage, in exchange for a loan, you agreed to a lien on that property created by agreement. A lien is an interest in the property that gives the creditor security for payment of a debt or performance of an obligation. This can create difficulties for the bankruptcy estate’s trustee, who looks for estate property to sell to generate funds to pay creditors some amount of money for what you owe them since the security interest must be paid first, leaving a smaller pot left to divided among other creditors.

The security interest also makes the use of exemptions more likely to succeed in protecting property from being lost during a bankruptcy – if the value of the lien and the amount of any exemptions cover your property’s total value, then a trustee could not generate funds for other creditors by selling the property since the secured creditor must be paid while you are entitled to receive the amount of your exemption. However, if you have a considerable amount of property that you want to keep but lack exemptions to cover all of it, you would need to consider Chapter 13 of the Bankruptcy Code, as Chapter 7 would leave at least some of the property unprotected. Meanwhile, in Chapter 13, plan confirmation regarding debt payments vests property interests in the debtor so the trustee doesn’t have to deal with the issue of abandonment.

Any nonexempt property creates an issue for a Chapter 7 trustee, though. It often will be “abandoned” or may be sold back to the debtor. These options arise because the trustee would have to liquidate the property – this involves converting it into cash and paying creditors of the estate. However, the costs of liquidation would include any liens and taxes that exist as well as costs of handling the sale. Often, this leaves little for distribution. This is why abandonment commonly occurs. The trustee decides how much of a burden the asset is when the estate is being administered or deciding that the asset is of inconsequential value and benefit to the estate. The value and benefit to the estate usually are the deciding factors. If the effort and obligations involved in getting rid of an asset outweigh the benefit that the estate would receive, the trustee has no reason to do anything with it. As a result, abandonment of this property occurs, which often puts the asset back in the debtor’s possession.

 Abandonment may happen during or after the administration of the bankruptcy estate, at some point following the meeting of the creditors when the nonexempt assets are turned over to the trustee’s control. Commonly, the debtor schedules the property when filing for bankruptcy, but it is not administered by the trustee through the closing of the estate. The presumption of abandonment will arise and, if no court order states otherwise, the property remains with the debtor by operation of law. Also, a trustee may pursue abandonment prior to the closing of a case after deciding that the property is too burdensome to administer or, more commonly, determining its value is inconsequential and retention does not benefit the bankruptcy estate, as mentioned earlier. This type of abandonment generally requires notice from the trustee to parties that might have an interest in the property followed by a court hearing if a party objects to abandonment.

 

A party in interest regarding specific property also could file a motion requesting abandonment. The Court would have to sign an order for the property to be abandoned here. While the party bringing the motion usually would be a creditor, the motion could be brought by the debtor who might think that the trustee is waiting for any nonexempt equity to increase in value before finishing the administration of the property, which often is real estate in this situation.

 The Bankruptcy Code does prevent the abandonment of property at times. Property could remain in the bankruptcy estate because it has not been administered or abandoned by the time that the case closes, which could occur when the property that doesn’t appear in the bankruptcy schedules. The trustee cannot administer or abandon unknown property. A debtor might need to reopen the case to attempt to get an order for the abandonment of the property. The cost and the time to do this is a reason for being thorough and forthcoming when you originally decide to file for bankruptcy.

While abandonment can occur at various times and in various ways under the Bankruptcy Code, its impact is what really matters. At the point that abandonment occurs, possession generally remains with the party having possession. Often, the debtor is this person when no security interest exists. However, with property that is used as collateral for a debt, the result could be different. For example, property that was repossessed and remains with the creditor at the time of abandonment may remain with the secured creditor. Often, secured property is under the debtor’s control and will remain there when it is abandoned by the trustee. Since abandonment doesn’t affect the automatic stay’s status, the secured creditor cannot take action to get property returned (for example, via lien enforcement through the legal system).

 

When the automatic stay ends, a secured party can look to non-bankruptcy laws to see what to do to get the property. With real property, this would involve following the foreclosure procedure under state law; if successful, the creditor eventually could have a sale scheduled.

 

Abandoned property and unsecured debts lead to a straightforward result since these debts are discharged and the property is not used as security for any debt – the property remains with the debtor. When secured interests are involved, the ultimate disposition of property becomes less predictable. In Chapter 7, the discharge eliminates personal liability for the amount owed so you can’t be sued for any deficiency, such as when property is sold but the proceeds are less than the debt. (You may have to worry about the IRS, though, because you had a debt obligation of which some portion never has to be repaid – this often is considered income to a person who no longer needs to worry about repayment of the entire debt. The IRS does have an exception regarding primary residences and discharge of indebtedness, though.)

Although you aren’t liable for the debt after abandonment of a secured property interest, the lien that attached to the property itself remains if you did not take care of this issue during the bankruptcy. This is why a secured creditor can take steps to sell the property after obtaining relief from the automatic stay or after the bankruptcy court issues the discharge order in your case. If there is no sale, the debt remains attached to the property. As long as a valid lien under state law exists, a secured creditor has a right to payment from the disposition of this property, although you, as the debtor, have been relieved of personal liability through the Chapter 7 bankruptcy.

 

The Value of Valuing Personal Property in Bankruptcy

If you file for bankruptcy, you also must file a Schedule B, listing all personal property in which you have any legal or equitable interest. This is important because you cannot protect what is not listed in this schedule. The description must contain sufficient detail so that the trustee and creditors have a good idea regarding what the property is, what its condition is, and so forth – this will help to determine what could happen to it prior to the bankruptcy discharge. You also need to make clear about your interest in the property since this will impact the value included in Schedule B, which leads to the point of this schedule: it must provide the current value of your interest in the property, without adjustment for secured claims or exemptions.

You must include all property, even if it would not be in the bankruptcy estate (which places it under the trustee’s control). The list includes causes of action for which you can sue, government grants for which you are eligible, security deposits, earned income tax credits as well as tax refunds that you will receive, and support obligations payable to you.

Property has to be listed so you can protect it. You will exempt the property using available exemptions — not doing so allows the trustee to sell it to pay creditors whom you owe. Without a listing and a description that is detailed, an exemption could be denied because the trustee cannot get a good idea of the property’s value – again, the potential for a sale exists. If you forget to list something, you may be able to amend the schedule to include it, but you should take care to have a complete inventory as of the date of filing. Scheduled property that the trustee has not administered by the end of the bankruptcy is abandoned to the debtor so you will not lose it, but unlisted property can cause you many problems, including losing it.

After you have the list of personal property, you need to review it and place values on items in the list. This doesn’t mean that each item has to be valued. Some things that would have an individual value below $575 and would be considered household goods can be combined into one category – for example, you could value pots and pans or silverware or your clothing in groups (although you should give some idea of how much is in these groups since details matter here). With property such as furniture, appliances, and clothing, remember that they tend to lose value quickly, and the value to list is the current fair market value, not replacement values. Basically, you look at the price that they reasonably could bring at a garage sale. Since they wouldn’t raise much money, a trustee – who seeks to raise funds to distribute among creditors – is unlikely to go to the expense of, essentially, holding this garage sale.

Personal property of greater value (such as expensive jewelry or artwork) could be worth more than the value that you can exempt. Property in these categories might be sold during a bankruptcy, which is a consideration before filing but cannot be “forgotten” in Schedule B if you do file. Also, you might want to have these appraised before they’re listed since they are not common, ordinary items like the property mentioned in the preceding paragraph.

A few other categories of personal property merit some mention here. One consists of your financial account, including checking accounts. The value as of the date of filing is needed. If you have written checks that have not been cashed yet, this is not a problem. You simply would exempt the higher value. However, never add funds after the account is valued on the date of filing because you don’t want to list a value that is too low on Schedule B.

Additionally, intangible personal property must appear on the schedule. You need to pay attention to detail in your description of this type of property because valuation often is difficult. As an example, if you have a cause of action against someone and seek a monetary award, the value to include is not the amount that you are seeking because you may not receive this. You have to adjust the value based on the odds that you will win and be awarded that amount – in law, there is no such thing as a sure thing. Beyond this reality is the possibility that, while you may be awarded monetary damages, you could have trouble collecting the judgment. The value in Schedule B should be reduced to reflect such reasonable possibilities. If the value is too hard to estimate with any accuracy, you might list it as “unknown” while providing an accurate description so that you can attempt to exempt it while the trustee has an opportunity to try to place a value on it.

The last category, for now, consists of property that is not part of the bankruptcy estate, which only includes non-exempted items and is under the control of the trustee. Because Schedule B requires the inclusion of all your personal property, everything appears in it. A common example is an interest in an ERISA-qualified pension. Generally, this is not part of the bankruptcy estate, but, if you take this position, you should include a reference to a statute that protects it in the schedule. Meanwhile, just in case the trustee doesn’t agree with your interpretation, you could claim an exemption in Schedule C “in the alternative” for additional protection.

With all personal property in Schedule B, you want to be as thorough and accurate as possible with descriptions and valuations. You don’t want to face the possible loss of property because you neglected to list it, and you also want to exempt as much of the listed value from the bankruptcy estate so that the property can remain yours after the bankruptcy has ended.

Chapter 7 Bankruptcy and the Means Test

When the Bankruptcy Code is changed in 2005, the idea that this would force people to file under Chapter 13, which requires a plan to repay as much of your debt as possible, instead of using Chapter 7 to get a “fresh start” by discharging most debts and allowing you to keep most (if not all) of your possessions was a commonly held belief. The new law did have a bias against Chapter 7 bankruptcies, but the reality is that most people still can file under the chapter that gives them their best options.

The means test, which can be used to force you pursue a Chapter 13 bankruptcy, has “safe harbors” that protects the average filer’s choice of which bankruptcy to pursue. For this reason, you need some understanding of this test and when the safe harbor based on income will allow you to consider a range of possibilities, including those under the Bankruptcy Code if necessary, to handle your financial struggles.

Due to the formula involved, we will take a greatly simplified journey through the means test. Its starting point is “current monthly income,” which actually looks at the average income from the previous six months to find a monthly average. Also, the focus is on income from all sources used to pay household expenses of the debtor and the debtor’s dependents on a regular basis during this period. The bankruptcy law provides for various deductions from the total and also excludes some sources of funds from being counted. The most prominent of these would be any benefit received under the Social Security Act. However, not everything paid under this Act is not counted necessarily – for example, the Advisory Committee on Bankruptcy Rules did not include Unemployment Compensation as being excluded. Also, we will see some other sources that are omitted due to the use of data regarding income from the Census Bureau.

“Current monthly income” must be calculated, after which it is multiplied by 12 to turn it into a yearly amount. The new total then can be compared to the median income in your state; the median income is the amount at which half of the households fall below it while the other half will be above it. As mentioned previously, the source of this data is the Census Bureau. For this reason, we have to be aware of various items that it leaves out of its income calculations, including Food Stamps, public-housing benefits, and lump-sum inheritances, so that the comparison is based on the same information. Meanwhile, in addition to income, your household size is important for establishing the median income level, as reported by the Census Bureau, that you would use for the means test. Unfortunately, this is another case in which the bankruptcy law does not provide clear guidance, which has made the definition of the size of any particular household an issue of contention at times.

However, despite the problems with ambiguity with the additions to the bankruptcy law in 2005, the means test eventually does produce an income figure to be compared to the median income borrowed from the Census Bureau. As of May 1, 2014, in Pennsylvania, the median income for a one-person household has been $47,809 while, for a household of two, this rises to $56,690. It continues to increase as the household size increases. The issue now becomes what all of this means to you.

Essentially, it means that the means test will be meaningless to you as long as your household income falls below the median level for a household of the same size in Pennsylvania (or the level for whatever state you live in). You would be in one of the safe harbors that Congress built into the means test. In turn, this means that the “presumption of abuse” (which focuses on a debtor’s ability to repay creditors) does not apply to you so that, if you decide to file for bankruptcy, you should be able to choose the chapter that would be most beneficial in meeting your goals for filing.

Most people who pursue a bankruptcy tend to be under the median income figure that applies to them, which means that the means test that can seem so intimidating due to its complexities actually has no effect on them. For those above the median income, the test will have implications, which can be explored at another time. What matters here is that you generally will not have to worry about the means test with its presumption of abuse preventing you from considering all of your options, including a possible Chapter 7 bankruptcy as a last resort, as you begin rebuilding your financial world.

Protecting Retirement Funds in Bankruptcy

When you file for bankruptcy for consumer debt, everything that you own generally becomes part of your bankruptcy estate. The bankruptcy trustee in charge of the estate could sell these assets to raise funds to pay debts. However, most debtors will find exemptions under the Bankruptcy Code that will protect all, or at least most, of the property in their estate. Property that could not be exempted may remain in the estate because the trustee will look at the cost of selling it versus the amount that a sale would bring and decide to abandon or sell the property back to the debtor. On the other hand, the status of pensions, retirement funds, and similar accounts still is somewhat ambiguous in bankruptcy law.

Looking at the Bankruptcy Code, Section 541(c)(2) states that restrictions on transferring a debtor’s beneficial interest in a trust which are enforceable under applicable nonbankruptcy law will remain enforceable in a bankruptcy case. If the law shields a beneficiary’s interest in a trust from creditors, then the same protection applies during a bankruptcy.

In 1992, the U.S. Supreme Court decided the language in this  section applied to certain types of pensions. ERISA-qualified pension plans were found to be excluded from the bankruptcy estate because this federal law had an “anti-alienation” provision that protected pensions that are covered by ERISA.

Then, in 2005, the Bankruptcy Code was amended. Section 522 was revised to allow the debtor an exemption, usually without limitation, in most types of retirement funds. With this change, whether or not a pension is part of the bankruptcy estate ceased to be an important issue when attempting to protect such plans after a bankruptcy filing. Congress also added provisions stating that any amount withheld or received by an employee in retirement funds or employee benefit plans are not property of the bankruptcy estate.

This does not protect everything, however. If you file for bankruptcy while you are in the process of rolling over your pension funds into another plan, you leave yourself open to the claim that these funds were not in an ERISA-qualified plan when the bankruptcy was filed. Therefore, as the argument goes, your retirement funds should not be  excluded from your bankruptcy estate. This also shows the importance of timing when you decide to file for bankruptcy. Under this scenario, to avoid a possible problem, you could wait to file your bankruptcy case or undertake the rollover. By doing so, the bankruptcy case will be filed while retirement funds are in a qualified plan.

Non-ERISA plans face other issues. For example, the Supreme Court’s 1992 decision pointed to retirement funds that do not qualify under ERISA, determining that they are not entitled to its protection as a result.

Individual retirement accounts (IRAs) would be an example here. However, IRAs now qualify as exempt under subsections 522(b)(3)(C) and (d)(12) (with a $1,245,475 waivable cap for funds that were never rolled over from another plan) and may also be protected from alienation under state law. In addition, if a debtor cannot reach funds in a plan, the bankruptcy estate has the same limitation – it cannot have greater rights than the debtor. Therefore, with the already existing protections plus the expanded ones for retirement savings, a debtor will rarely lose retirement funds in a bankruptcy case.

Other types of plans may be considered spendthrift trusts, with the beneficiary having no right to access the funds whenever the individual so desires. Under the laws of most states, due to this limitation, the beneficiary’s interest in such a trust is protected from the person’s creditors. These trusts are excluded from the debtor’s estate under Section 541(c)(2). However, it should be noted that not all spendthrift trusts are protected under state laws – an example is the “self-settled” spendthrift trust created by its own beneficiary, which most states do not protect from this person’s creditors.

Finally, when possible, the debtor also must remember to list retirement funds, pensions, and similar trust interests in Schedule B of the bankruptcy schedules, even if they do not come into the estate. Any argument that the interest is outside the estate should be noted on Schedule B with a reference to subsections 541(c)(2) or 541(b)(7) of the Bankruptcy Code. In addition, nothing prevents a debtor from claiming on Schedule B that property is outside the estate but listing an applicable exemption on Schedule C in the alternative as a backup.

A Fresh Start: The Bankruptcy Estate in Chapter 7

Most individuals who file for bankruptcy do so under Chapter 7 or Chapter 13 of the Bankruptcy Code. Chapter 13 can be very powerful when a person falls behind in payments on secured loans, such as mortgages or car loans, because it permits you to set up a plan up to five years in length to pay off those missed payments. However, you still need enough income for your necessary expenses, which include current payments of the debts on which you had fallen behind and are included in the Chapter 13 plan. Meanwhile, a Chapter 7 bankruptcy generally focuses on discharging debts that are not secured by any specific property, with a goal of giving you a “fresh” start by getting rid of these debts while keeping as much property as possible. The process of defining what is in your “bankruptcy estate” is crucial in Chapter 7. A brief look at how this means follows.

A fresh start can have no beginning if you are not honest about what you own. All of your property must be disclosed, with exemptions (with amounts and categories defined by the bankruptcy laws) applied to as much of this property as possible. Any property that can’t be exempted or isn’t excluded by law becomes part of the bankruptcy estate, which a bankruptcy “trustee” controls until the bankruptcy ends.

A major part of the trustee’s job is to sell as much of the bankruptcy  estate as possible in order to pay off as much of your debt as possible. Due to the ability to exempt certain amounts of various categories of property, hiding property is not the answer to protecting what you own in order to have an opportunity to make a fresh start after a Chapter 7 bankruptcy. If and when hidden assets are discovered, this property will end up in the bankruptcy estate, and you may face more serious consequences that can include the loss of the property to creditors, the denial of a discharge of your debts, or even criminal penalties.

As you prepare to file under Chapter 7, you begin the process of defining the bankruptcy estate. This starts with making an inventory of all of the things that you own – this means that you have to list everything to which you have some ownership right. Some property that you receive after filing also would have to be included once a right to it exists. For example, property that you inherit within 180 days after filing must be listed in the appropriate schedule.

After an thorough inventory has been completed, you will have an idea of what might be in your bankruptcy estate. To further define your bankruptcy estate, you need to place realistic values on your ownership rights in this property. Sometimes, this may not be possible due to the type of property involved. A good example of this problem is a potential lawsuit that you might be able to bring against another party because you need to consider what the potential award would be if you win, the likelihood of success (which impacts the value of the estimated award), and even the likely ability to collect any judgment that you might be awarded (because a judgment that can’t be collected won’t have much value). In a situation like this, your best approach may be to describe what your cause of action in the lawsuit would be and list its value as “unknown” when you file.

You usually will be able to place a reasonable value on your property, though. This can seem difficult, but an experienced attorney can help you as you work through the list of property that will comprise your bankruptcy estate, unless the property is exempted or, possibly, excluded by law. However, before you can exempt property, you have to make a good-faith effort to value so you can use the exemptions, which are capped at certain dollar amounts.

Individuals often have trouble with this. Sometimes, they may tend to overvalue some property — for example, many things do not retain much value once they have been used. Clothing and furniture fall into this category, but people often tend to value these items closer to the prices at which they were purchased. One approach to start this process is to consider what you might ask for, and be able to get, for something at a garage sale or on eBay. There also are resources that can be used to value an older car while a house may need to be appraised in order to satisfy a trustee and the court. Once you have an inventory of property in which you have rights and have made a good-faith effort at valuing it, you are at the point in which your actual bankruptcy estate will be defined.

First, you look for property is not part of the bankruptcy estate. An ERISA-qualified pension, by statutory definition, never is part of the estate. Next, you consider possible exemptions, which could be state or federal exemptions in Pennsylvania (with the choice depending on which protects your property to a greater extent). This step essentially removes some property from a bankruptcy estate, depending on the property’s value and the amount of the exemption available. For instance, a vehicle with a market value of less than $3675 currently could be exempted from the bankruptcy estate so the trustee handling your property cannot touch it. It should be noted that federal exemptions are adjusted every 3 years — the next adjustment would occur on April 1, 2016.

Eventually, as you move through the steps in this process, what remains is the property that makes up the bankruptcy estate. In many cases, all property will be exempted – this is a “no asset” bankruptcy in which a trustee has no assets to administer to pay any of your debts; in these situations, there basically is no bankruptcy estate. You also could have a “nominal asset” case in which the bankruptcy estate’s value, at best, is little more than the cost of trustee’s administration of it; you may be able to get the trustee to abandon the property that remains because it can be seen as more trouble to sell it than it is worth. If abandoned, the property would return to you.

On the other hand, if your bankruptcy estate has assets that have more than a nominal value, you might be able to pay the value of the bankruptcy estate to the trustee in order to keep your property or the trustee may sell these items to third parties. In either situation, the trustee would use the proceeds to make payments to your creditors.

In the end, this is why the bankruptcy estate in Chapter 7 is of such importance. You want to retain as much property as possible in order to get a fresh start after going through bankruptcy. This requires that, prior to filing, you to pay attention to property that might be lost if it would be turned over to a trustee as part of your bankruptcy estate.

Diligent Preparation Is Essential When Filing for Bankruptcy

Preparation is necessary in any area of law, but even the simplest of bankruptcy cases involves a tremendous amount of collaborative preparation between clients and attorneys. A client must provide detailed and extensive information that the attorney must review thoroughly in order to discuss the client’s options, including non-bankruptcy debt relief. Without this, the attorney cannot understand a person’s financial situation and give advice on the range of options to be considered prior to any work in preparation of a bankruptcy filing, if this action would be the best way to achieve a client’s reasonable objectives.

When bankruptcy appears to be the best choice after a thorough assessment of all possibilities, even more preparation and collaboration is required to successfully navigate this process. At its most basic level, bankruptcy involves the interplay among a person’s debts, assets, and budget. A bankruptcy should not be filed unless there is sufficient debt that can be handled through one of the various types of bankruptcy. This amount of debt is somewhat relative as it would depend on your financial situation viewed as a whole because, for example, the less income that you receive in an average month, the fewer non-bankruptcy options that will be available at any level of debt.

Meanwhile, your necessary monthly expenses (such as shelter, utilities, and food) also must be examined closely because, if these expenses generally are larger than income on average during the prior six months or more, then you need to address this problem prior to pursuing a bankruptcy. Again, this means preparation by you to provide all of the information about these financial matters so that the attorney can prepare an accurate analysis of what benefits and problems are likely if you file for bankruptcy.

As for assets, most people want to protect what they have. The attorney needs full disclosure in order to determine what might be lost if you seek the protection under a particular bankruptcy chapter. For example, a basic objective of a Chapter 7 bankruptcy is to discharge debt while protecting property through the use of exemptions. The other common type of bankruptcy for individuals involves Chapter 13 of the Bankruptcy Code. You may have fallen behind on payments of a debt for which specific property of yours acts as collateral, essentially. This could be mortgage debt that is secured by your home. What can you do? It depends on the facts of your situation. Your preparation of these facts for the attorney’s review must be thoroughly for the attorney to be able to present the realistic options that are available to you.

There is a reason that detailed preparation by both you and the attorney is emphasized here. At the beginning of any discussion of a person’s financial problems, the attorney has to see various documents to have solid foundation for developing the set of possible actions that you need to consider. Meanwhile, the attorney has to help you with this preparation by requesting the necessary information. Billing statements, loan documentation, tax returns, paystubs, bank statements, and credit reports are some of the pieces that are required to understand the situation. You and your attorney must work together to put all of the necessary pieces together.

The attorney must take the time to be sure that you are aware of the need for full and accurate disclosure. Debts owed to friends and family are debts that have to be included in a bankruptcy. The inventory of assets has to be complete so that your property can be protected to the greatest degree possible, and the attorney needs to explain how you should go about the process of placing value on all of these items, including clothing and worn-out furniture. Here, the preparation begins with the attorney and ends with you in order to get a complete picture before various schedules and forms that are included in a bankruptcy filing can be drafted. Accuracy and attention to detail are crucial during this collaborative process. Your property may be exempted, allowing you to protect it in a Chapter 7 bankruptcy. However, the attorney has to emphasize the importance of including everything that you own because anything that is not listed generally is not exempted, which means that you may lose it if you decide to file. The attorney has to be observant that things that might be overlooked are included here. Again, preparation is responsibility that falls to both you and your attorney.

In addition to information supplied by the client, the attorney has to look at outside sources, such as public records, to verify and supplement as much as possible. Also, while reviewing the provided information, the attorney must be able to spot inconsistencies in order to know what questions to ask to clarify this situation. For the attorney, preparation goes beyond filling out the forms – finding information, obtaining additional information, and explaining why this is so important are responsibilities that the attorney owes to you as the client as well as to the court. It takes a collaborative effort for end result to be successful.