Bankruptcy filing can be used by individuals and businesses as a way to erase unpaid debt. In short, it is a way to move forward with a clean financial slate.
There are different rules involved whether you file for personal bankruptcy or business bankruptcy so let’s explore.
We’ll start with personal bankruptcy. There are two forms of filing– Chapter 7 and 13. Chapter 7 is the more common filing when an individual is determined to just not be able to pay back the debt owed. This form is mainly used by people with very little income. Chapter 7 will completely discharge a person’s debt.
If you think you can manage and repay your debt on a multi-year payment plan, you should file for Chapter 13 bankruptcy. In this case, declaring bankruptcy has typically improved the financial situation. People in this category have some money but are struggling to pay off the debt.
With Chapter 7, you’re sending a signal that you’re basically broke and that there is no way the creditors will ever be paid. All of your assets will be liquidated to go toward the debt. Most of your debt will be wiped away, but student loans and tax debt will not—you still will have to pay that. With Chapter 13, you are able to keep many of your material possessions. Most repayment plans occur over a 3 to 5 year period.
There are also two filing chapters that pertain to corporate or business bankruptcy. Businesses can file under Chapter 7, but it means the end of the business.
Under Chapter 11, businesses can liquidate certain assets to pay off the debt, and under Chapter 11, the business is allowed to reorganize. In fact, in most cases, companies that file for Chapter 11 do indeed reorganize. Both debtors and creditors get to propose different ways for reorganizing, and creditors always get the final vote on approving the reorganization plan.
Bankruptcy is available from the government as protection for a company that is suffocating because of debt. When companies can’t meet their financial obligations, the Chapter 11 provision allows them to reorganize. When the government gets involved, there is a trade-off because trustees from equity firms are brought in to ensure the debt claims are handled. So, the equity holders do get control of the company—they make the decisions, they vote and they determine the company’s direction.
The company may even appear to operate as usual. Major companies like Kmart have successfully come out of Chapter 11. Granted, they are a much smaller company but they’re still a company. Some companies however, cannot come out of Chapter 11; they simply can’t create enough business and revenue to keep the company going.
There are other differences between personal and corporate bankruptcy. One of them is the means test that is applied. Individuals must go through a means test to determine whether they’ll file Chapter 7 or 13, but businesses have no means test for Chapter 11 since they’re reorganizing. A means test of course is required for business Chapter 7 filing.
Under individual bankruptcy, a person owes all creditors, meaning there are no mechanisms by which to cancel your debt, let’s say with a student loan or other debt. But businesses can cancel contracts with creditors if both parties agree. So if it is financially beneficial for both parties, it immediately helps the business lower their overall debt.
Most financial experts will advise to use personal bankruptcy as a last resort because it wreaks havoc on your credit rating for at least 10 years. You won’t get any slack if you try to make a large purchase like a house or car. You’ll be out of pocket more money for this purchase and you’ll likely pay a much higher interest rate (even perhaps double or triple the rate) of someone with good credit.
Personal bankruptcy also has an added piece where, basically, creditors are looking for you to do the right thing. So actions like demonstrating that you’ve cut your expenses, tightened your own budget or found a way to earn extra income—really anything that shows you’re trying to meet your responsibilities—goes a long way.
“Doing the right thing” doesn’t come into play as much in a business bankruptcy because company management is supposed to maximize shareholder money. So profitability is the focus there.
There is life after personal bankruptcy. Eventually, you can return to normal, buy a car, buy a home and all those other normal things in life. After all, personal bankruptcy is designed to give you a fresh start. Once your debt is cleared, you start over by paying bills on time going forward. Most people see a rise in credit rating in about two to three years.
Most people who file personal bankruptcy have either lost a job, gotten a divorce or have tons of medical expenses.
If all of this has your head swimming, consider talking with a licensed bankruptcy attorney before deciding on your filing mechanism. Bankruptcy law can be extremely complicated. Furthermore, the laws frequently change, so you want to be up to speed and in-the-know.