Article: Bankruptcy Protection Restricted in the Post-Reform Era

June 2005

Bankruptcy protection restricted in the post-reform era

The new creditor-friendly law significantly limits debtors’ ability to discharge their financial obligations via Chapter 7 of the Bankruptcy Code

Under the new bankruptcy reform law, which takes effect October 17, 2005, thousands of debtors who under current law would be allowed to cancel many of their debts by filing for Chapter 7 bankruptcy protection will instead be required to work out a Chapter 13 plan to repay their creditors.

The American Bankruptcy Institute estimates that between 30,000 and 210,000 people — from 3.5% to 20% of those who dissolve their debts in bankruptcy each year in exchange for forfeiting some assets — will now be disqualified from doing so.

The law’s overriding purpose appears to be to reduce the attractiveness of bankruptcy and to restore its historic reputation as an option of last resort. This is accomplished in many ways, most notably these two:

Prior to filing for bankruptcy, debtors are required to submit to credit counseling and meet other obligations intended to dissuade them from seeking bankruptcy protection.
There is now a “means” test that limits access to a straight liquidation of debts under Chapter 7.

Means test. Those with income above the state’s median income who can pay at least $6,000 over five years — an average of $100 a month — would be forced into Chapter 13, where a judge would order a repayment plan. (The means test can help a credit counselor or attorney assess the debtor’s options before a bankruptcy petition is filed, thereby reducing the flood of Chapter 7 filings by debtors who would end up with a Chapter 13 repayment plan anyway.)

If a debtor earns less than the median income in the state where he lives, then his case will generally remain in Chapter 7, where, after he gives up certain property that he owned when he filed for bankruptcy, his debts will be cancelled. The law will also make a debtor wait eight years, rather than the current six years, before filing a new petition to erase future debts.

The new law also provides for the following:

Child support. The law gives top priority to a spouse’s claims for child support among creditors’ claims on a debtor in bankruptcy.
Homestead exemption. The law restricts the homestead exemption in states to $125,000 if the person in bankruptcy bought his or her residence less than three years and four months before filing.
Credit counseling. People filing for bankruptcy will be required to pay for credit counseling.
Military accommodations. The law makes special accommodations for active-duty service members, low-income veterans, and veterans with serious medical conditions.

Overview. The news is not all bad for debtors. The new law increases the exemption for retirement funds, exempts personal residences owned for at least 40 months, and protects unlimited funds in state-sponsored asset protection trusts. There is also a mild incentive for creditors to work out repayment plans outside of bankruptcy. A court may reduce an unsecured consumer debt claim by up to 20% if the claim was filed by a creditor who unreasonably refused a reasonable alternative repayment schedule proposed by an approved credit counseling agency on the debtor’s behalf.

On the other hand, the new law discourages “forum shopping” – the practice of filing for bankruptcy in a state with the most beneficial rules for the debtor – by increasing the required domicile period for purposes of determining which state law governs the debtor’s selection of property exempt from the bankrupt estate. Under the new law a debtor must reside in a state for 730 days – up from 180 days – to receive the benefit of that state’s exemptions.

Retirement plans. Retirement plans that are generally exempted from taxation are not property of the bankruptcy estate. (This includes qualified plans as well as traditional, Roth, SEP, and SIMPLE IRAs.) Rollover distributions from such plans, and direct transfers between such plans, will also be exempt.

The new law places a limit of $1 million on the exemption for traditional and Roth IRAs; conversely, qualified plans aren’t subject to this limit. Also, SEPs and SIMPLE IRAs are treated like qualified plans for this purpose and are not subject to the limitation.

Conclusion. Clearly, the availability of a fresh start under Chapter 7 of the Bankruptcy Code will be severely limited when the new law goes into effect. Many debtors who currently qualify for a liquidation of their debts under Chapter 7 will be forced into Chapter 13 (or Chapter 11 in the case of business debtors), where they will be expected to devise and adhere to a repayment plan. However, substantial protection will still be available for homesteads, retirement plans, and other traditionally exempt assets. Some of the rules have changed, but nevertheless, planning opportunities exist for individuals who can anticipate the possibility of a bankruptcy filing and plan accordingly.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.