The most significant bankruptcy reform of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) (enacted April 20, 2005) was the imposition of a means test for those seeking Chapter 7 bankruptcy relief.
The reforms resulted from significant lobbying by the financial services industry in seeking to prevent consumers who had the financial ability to pay a significant portion of their unsecured debt, such as credit cards from discharging their financial obligations.
The BAPCPA replaced the discretion of judges to determine whether a debtor could file a Chapter 7 bankruptcy with a bright line rule that requires debtors to meet a means test to determine Chapter 7 eligibility.
Generally, the means test has two prongs:
(1) debtors may file a Chapter 7 if their income is below the state median income; or
(2) debtors income will be calculated for the six (6) months preceding a bankruptcy filing to determine if it sufficiently exceeds certain allowable expenses, as determined by an IRS tax table, such that the debtor can afford to repay a reasonable portion of his or her unsecured debt.
Chapter 7 vs. Chapter 13: Why Does the Means Test Matter?
The difference between Chapter 7 and Chapter 13 bankruptcy relief is significant if you are a debtor desperately trying to start over and obtain the “fresh start” that bankruptcy relief was intended to provide to those struggling to pay their household expenses. A Chapter 7 (sometimes called a “liquidation bankruptcy”) is a bankruptcy in the common parlance of layman’s terms. Any debtor that obtains a Chapter 7 discharge will have most unsecured debt extinguished including:
• Credit card bills (i.e. Visa, Mastercard, American Express, etc.)
• Department store charge cards
• Unsecured credit lines
• Hospital bills
• Deficiency judgments for repossessed vehicles or foreclosed property
• Home utility expenses
• Medical bills
Chapter 7 bankruptcy can provide relief from most forms of debt that are not covered by a security interest like your home or vehicle. However, there are some notable exceptions, including but not limited to certain tax obligations, family court obligations (i.e. child support, alimony), governmental fines and other types of obligations not covered by a Chapter 7 bankruptcy discharge. The key is that if you qualify for a Chapter 7 bankruptcy most forms of unsecured debt can be effectively extinguished so that you are not required to repay them at all.
If you cannot qualify under the Chapter 7 means tests, you will be forced to seek Chapter 13 bankruptcy relief. While a Chapter 13 can still result in a discharge of some unsecured debt, you may be required to make payments on your unsecured debt over a 3 or 5 year term before discharging the remaining balance of your unsecured financial obligations. Prior to the BAPCPA reforms, most people qualified for a Chapter 7 bankruptcy so Chapter 13 was mostly used by homeowners that wished to keep their home and had significant equity, or those who owned other assets with substantial value that they did not want to expose to liquidation and disbursement to creditors.
A Chapter 13 bankruptcy entails structuring a payment plan that includes not only payments to secured creditors like your mortgage company and vehicle lienholder but also the allocation of a portion of each plan payment to pay down unsecured obligations. This is why the means test is so important because it will determine whether you are obligated to commit a portion of your monthly income to unsecured creditors for several years or to have your obligations to such creditors extinguished without further payments.
Understanding the Chapter 7 Means Tests
Stage 1 of Means Test: Comparison with State Median Income
Because there may be much at stake, it is important to understand how your eligibility for a Chapter 7 bankruptcy is determined under the Chapter 7 means test. The name is really a bit of a misnomer because it is really two separate tests. The first test involves comparing your average income over the prior six (6) month period with the median income for your state. If your household income for a family your size is less than the median income for the state, you will generally qualify to file a Chapter 7 bankruptcy.
Stage 2 of Means Test: Disposable Income Evaluation
Even if your income exceeds this threshold, you may still qualify for a Chapter 7 bankruptcy based on a calculation that is designed to determine whether you have enough “disposable income” to pay a significant portion to your unsecured debts. Under this test, your income will be evaluated against certain allowable living expenses (determined by the IRS), such as rent and food, which will provide your available “disposable income.” If your projected disposable income is less than $6,000 over the next (5) years or less than $100 per month, you will “pass” the means test and generally be eligible to file a Chapter 7 bankruptcy.
If your projected disposable income exceeds $10,000 over the next five (5) years, you will face a rebuttable presumption that you can pay a significant portion of your unsecured debts and must show special circumstances to qualify for a Chapter 7, which is extremely difficult to accomplish. The process becomes more complicated when you fall in the grey area of income between $6,000-10,000, which requires an additional calculation to determine eligibility for Chapter 7. This calculation involves comparing your projected disposable income during the next five (5) year period to a percentage of your unsecured debt (i.e. credit card type debt) to determine if you have enough disposable income to pay a significant portion of your unsecured debt.
This calculation requires an understanding of the difference between priority and non-priority unsecured debts. Priority unsecured debts are debts that must be paid fully in a Chapter 13 bankruptcy and are given priority in terms of repayment in a Chapter 7 where there are assets to be disbursed to creditors. Examples of priority unsecured debts include the following:
• Certain types of recent unpaid tax obligations
• Family court obligations (child support/spousal support)
• Court ordered fines and restitution
• Contribution to employee benefits plans
• Personal injury or wrongful death claims created by drunk driving
• Unpaid wages or commission
Stage 3 of Means Test: Unsecured Non-Priority Debt Comparison
The distinction between priority and non-priority unsecured debts is important because it factors directly into the formula for determining Chapter 7 means testing eligibility for those with disposable income between $6,000-10,000. If your projected disposable income over a five (5) year period exceeds your unsecured non-priority debts by more than 25 percent, you generally will be required to pursue a Chapter 13 repayment plan rather than obtain a Chapter 7 bankruptcy discharge. If your disposable income during this period does not exceed your unsecured non-priority debts by 25 percent, you will “pass” the means test and generally be permitted to file for a Chapter 7 bankruptcy discharge.
Important Tips in Qualifying under Chapter 7 Means Test
While the Chapter 7 means test has made it more challenging for some debtors to qualify for a Chapter 7 discharge, many consumers still qualify under the means test, especially if they understand bankruptcy law or have sound legal advice from a qualified bankruptcy attorney. A bankruptcy attorney can provide estate planning strategies that may impact your disposable income calculations and make it easier to “pass” the Chapter 7 means test. However, it is important to obtain legal advice when engaging in this process because a trustee may determine that certain transactions constitute “fraudulent transactions” and deny bankruptcy relief. A knowledgeable bankruptcy professional often can advise a debtor on how to manipulate the timing of the receipt of income in the six (6) months prior to filing or adjusting certain expenses and family sizes.
There also are certain exceptions to the Chapter 7 means test that may impact many people forced to seek a Chapter 7 discharge in a struggling economy. The number of seniors over the age of 65 has surged during a recent six (6) year period by 150 percent according to AARP data. As seniors grow older, the problem is even more pronounced as there has been over a 430 percent increase in requests for bankruptcy relief among those ages 75-84. What seniors need to keep in mind is that social security benefits are not considered “income” for Chapter 7 means testing purposes. This means that many seniors for whom social security is there primary source of income will “pass” the Chapter 7 means test.
Another important exception to the Chapter 7 means test applies to debtors who have primarily non-consumer debts. This means that if you are a small business owner overwhelmed with business debt, the Chapter 7 means test does not apply. A business owner who is generating revenue of $200,000 per month but with the bulk of his or her debt in the form of financial obligations for the business will be exempt from the Chapter 7 means test and remain eligible to a Chapter 7 discharge.
A final exception to Chapter 7 means testing applies to those who serve in the Armed Service Reserves or National Guard. If you serve a minimum of ninety (90) days active service you will receive a temporary reprieve from establishing eligibility under the Chapter 7 means test during the time you are on active duty and an additional 540 days following active service. Ironically, this exception to the Chapter 7 means test requirement does not apply to those enlisted for active duty in the Armed Services.
The implementation of a means test to determine eligibility for a Chapter 7 discharge is purportedly designed to ensure that those most in need of having their unsecured debts eliminated receive a Chapter 7 bankruptcy discharge. In reality, the requirement was really a nod to financial institutions to provide protection when they extend credit at higher interest rates to those who may not be sound credit risks. While the means test has significantly undermined the ability of many people drowning in debt to obtain the “fresh start” envisioned by this country’s Founding Fathers, many people can “pass” the Chapter 7 means test, particularly when armed with sound legal advice. Successful qualification under the Chapter 7 means test can make an enormous difference in your financial foundation as you rebuild for the future.