Determining Which Chapter of Bankruptcy to File

Determining Which Chapter to File

National Business Institute

June  28, 2011

Alfred S. Lee
Johnson Westra Broecker et al., P.C.

1900 E. Golf Rd., Ste. 950

Schaumburg, IL 60173

847-232-9400

Al.Lee@JWBWN.COM

Determining Which Chapter To File

Determining which chapter to file for a client involves a rigorous analysis of what the client is going through or about to go through in the collection process.  In other words, I want to understand what my client is facing, and to paint a picture for the client what they will go through if they allow the creditor to pursue them and to forcibly collect the debt.

In my experience, the client often has an unreasonable fear that since they are falling behind on their debts, at anytime they could lose everything.  I want to dispel that fear by explaining to the client the collection process and how the related exemptions work.

After knowing what the worst case scenario is, only then will the client (and the attorney) understand what relief, if any, bankruptcy will provide.   Also, the attorney can work together with the client to set achievable goals to address the client’s financial problems.

I.  Exemption Analysis

Exemptions were designed to protect an individual judgment debtor and provide them with some level of property to survive on.  Determining which exemptions apply to the client will be critical in determining what may be the “pressure points” for the client – will the client lose a savings account because it has more than $4,000 in it, does the client have a home that has too much equity in it and will it be subject to a lien or worse foreclosure action, will a wage garnishment destroy the family’s budget?  (To accomplish this analysis it is critical that you get the client’s detailed information.)

1. The Illinois Exemptions  – 735 ILCS 5/12-1201

Illinois exemptions apply to almost every client since Illinois has opted out of using the federal exemptions.  735 ILCS 5/12-1201.  See also 11 U.S.C. §522.  The Illinois exemptions can be found at 735 ILCS 5/12-1001 and elsewhere in the Illinois Code.

• Alimony, support, and separate maintenance. 735 ILCS 5/12-1001((g)(4).
• Cemeteries and burial funds. 225 ILCS 45/4a; 760 ILCS 100/4; 815 ILCS 390/16.
• Claims for negligence or tortious conduct. 735 ILCS 5/12-1001. $15,000 exempt for personal bodily injury of the debtor or of a person on whom the debtor was dependent; even if the action is still pending to recover the amounts, any award is exempt for up to two years after it accrues; finally, if a claim is received and the Debtor has transferred these funds these funds are exempt for five years after accrual.
• Crime victim’s compensation. 735 ILCS 5/12-1001(h); 740 ILCS 45/18.
• Disability or illness benefit. 735 ILCS 5/12-1001(g)(3).
• Franchise, permit, and license interests. 235 ILCS 5/6-1. Most typically, this will involve valuable liquor or franchise license.
• Fraternal benefit society benefits. 215 ILCS 5/299.1a.
• Homestead on residential property. 735 ILCS 5/12-901. $15,000 exempt.  $30,000 exempt.
• Illinois College Savings Pool funds. 735 ILCS 5/12-1001(j).
• Insurance benefits. 215 ILCS 5/238; 735 ILCS 5/12-1001(f).
• Motor vehicles. 735 ILCS 5/12-1001(c). $2,400 in one motor vehicle.  In a joint case, each spouse can claim this for separate vehicles, but check the title of the vehicles.
• Partnership property. 805 ILCS 206/203.
• Pensions and retirement benefits. 40 ILCS 5/7-217; 735 ILCS 5/12-1006.
• Personal property. 625 ILCS 45/3A-7; 735 ILCS 5/12-1001(a) through 5/12-1001(e). Most notable, the “wildcard exemption” of $4,000.  In a joint case, this can be doublde to $8,000.
• Public assistance. 305 ILCS 5/11-3; 735 ILCS 5/12-1001(g)(1). 100-percent exempt.
• Social security. 735 ILCS 5/12-1001(g)(1). 100-percent exempt.
• Spendthrift trusts. 205 ILCS 665/14.
• Tenancy by the entireties. 735 ILCS 5/12-112; 750 ILCS 65/22; 765 ILCS 1005/1c. . See Judge Wedoff’s excellent article on this matter posted on the Northern District’s website.
• Trade implements. 735 ILCS 5/12-1001(d). $1,500 in trade implements, including professional books.
• Unemployment compensation. 735 ILCS 5/12-1001(g)(3); 820 ILCS 405/1300.
  100-percent, subject to certain child support claims.
• Wages. 735 ILCS 5/12-803; 740 ILCS 170/4. Exempt to the extent of 15 percent of gross wages (less child support payments).  You also have to make enough money –  earnings must exceed a certain threshold.  For the latest numbers, I check www.illinoislegalaid.org:

• $371.25 weekly
• $742.50 bi-weekly (every other week)
• $804.38 semi monthly (twice a month)
• $1,608.75 monthly.

• Workers’ compensation. 820 ILCS 305/21, 310/21.
• Veterans’ benefits. 735 ILCS 5/12-1001(g)(2).

B.        Using the Exemptions – Highlighting the Obvious or Maybe Not So                           Obvious

Knowing the various exemptions is helpful, but how do they actually apply.  I think it is helpful to explain to a client the actual collection process.   Some of this may be so obvious to us attorney, that we fail to realize that the client has had no experience with the collection process.  This is why clients are often intimidated by collection calls..

1. An exemption is only needed if there is a judgment.

A creditor cannot freeze an account or garnish wages without a judgment (in most instances, there are the exceptions of a wage assignment executed in a payday loan or a money attachment.)

1. Notice is provided to the client throughout the collection process.

The client will receive notice of the lawsuit via personal service.  The client will typically receive notice of a default judgment.  The client will also receive notice of a non-wage or wage garnishment.

1. Even if there may be some non-exempt assets, you have to take into account the cost and time of forcibly liquidating an asset.

Executing a judgment against property typically requires a considerable amount of expense – ie., posting a bond with the sheriff, placing an ad for a notice of public action, paying a realtor, etc.  You also have to pay prior lien holders first as well.  A judgment creditor typically does not want to go through this expense, if there is not a strong prospect of significant recovery.  The bankruptcy trustee also goes through this same analysis in determining the equity in a bankruptcy estate.

Also, in a home foreclosure situation, the lender cannot evict the homeowner until :

1. A foreclosure action has been filed:
2. After the seven (7) month redemption period has passed.
3. The sherrif’s sale has been completed an approved by the Court.

See Mortgage Timeline set forth in 735 ILCS 5/15-1101 through 1706, or more easily at :

http://www.illinoisprobono.org/index.cfm?fuseaction=home.dsp_content&contentID=4945.

If the Lender is able to time everything perfectly, this will take at least eight months from the time the foreclosure action is filed.  Practically, the typical time period where the client can stay in their home rent free is about one (1) year or more.

1. You can combine the exemptions.

You can combine the exemptions to make an asset unattractive for a creditor or bankruptcy trustee to attach.  For example, you can combine the $4,000 wildcard exemption with the $2,400 vehicle expense, or with a joint debtor with a lot of equity in their home, you can combine the $30,000 exemption with the $8,000 wildcard exemption.

1. Transferring assets to others or into non-exempt assets typically does not work.

Any transfer to another person – friend, family member – will be considered presumptively fraudulent.  Property that is purchased that is exempt and is acquired within six months of the filing of a bankruptcy petition shall be presumed to have been acquired in contemplation of bankruptcy. 735 ILCS 5/12-1001.

1. These are personal exemptions and do not apply to a business.

1. Bankruptcy  — Does it provide the relief that you are seeking?

At this point, after going through the exemptions, we should know what are the assets or income in the “line of fire”.

1. Chapter 7 – Liquidation

If after going through the above exemption analysis, the client can protect all his assets, then a Chapter 7 is an attractive option.  Chapter 7 is a liquidation of all non-exempt assets.  If there are no assets to liquidate, this is commonly referred to as a “no asset” case.  The client receives a discharge of all the debts (except for those listed below), and the client now can hopefully begin their “fresh” start.

The exemptions need to be made in the appropriate schedule.  You need to cite the statute, the amount that you are protecting, and the specific property that you are protecting.

If you are unsure whether or not a certain exemption applies, you should go ahead and apply the exemption.  First, you can amend the schedules at any time prior to the close of the case.  Second, the trustee or other interested party has to make an objection to the exemption within 30 days of the creditor’s meeting.  in applying the exemption.  See In re Yonikus, 996 F.2d 866, 868 (7th Cir. 1993) (“Failure to file a timely objection to exemptions is an absolute bar to consideration of the merit of the exemptions.”).

However, though the assets are exempt, the client still may not be a good candidate for Chapter 7.  This will be because of several factors based on the following:

1. Makes too much money and has too much cash flow. –  The Means Test and/or Abuse

1. The Means Test will covered in the separate session.  However, if the presumption of abuse cannot be overcome, Chapter 7 is not viable option.
2. An Abusive Case.  There are instances though when the client initially can pass the Means Test, however, in looking at the overall case, it just doesn’t seem appropriate that the client receive a discharge.  11 U.S.C. §707(b)(3) states that a case can be dismissed when the filing constitutes an abuse under the totality of the circumstances and filed in bad faith.Typically, the first danger sign is that the client has significant cash flow after taking out expenses.  Another danger sign is where the client has significant income, but is not paring down their expenses to make a good faith effort to pay back their debts.  For example, a client who earns a significant income, but refuses to sell a second home.

1. Non-dischargeability – Can’t Get Rid of the Debt

There are also instances where the client’s assets are exempt, but the client cannot discharge a particular debt.  This is important because often times this means that the judgment creditor with the non-dischargeable debt can still garnish the client’s wages.  If there are not wages to garnish, the judgment creditor could also lien the exempt assets now and wait hopefully for the assets to become non-exempt – ie. a home that increases in value.

1. Marital Debt

A marital settlement agreement will typically state that one spouse or the other will be responsible for certain debts.  The underlaying debt may or may not be in the client’s name. 11 U.S.C. §523(a)(15) states that these are non-dischargeable.  The non-filing ex spouse does not have to dispute the dischargeability as well. 11 U.S.C. §523(c)(1)

1. Student Loans.

Student loans are non-dischargeable as well.  Student loans are no longer limited to federally backed loans, but also from other nonprofit lenders if the loan is determined to be a “qualified education loan as defined by Internal Revenue Code §221(d), 26 U.S.C. §221(d).

1. Fraudulent Incurred Debt

A creditor can allege that the client obtained the debt fraudulently.  11 U.S.C. §523(a)(2).  Also, there are certain debts that are presumptively considered fraudulent.

1. $500 that was incurred within 90 days prior to filing. 11 U.S.C. §523(a)(2)(C)(i)(I)
2. $750 in cash advances within the 70 days prior to filing. 11 U.S.C. §523(a)(2)(C)(i)(II).

The take away here is to make sure that you review the client’s credit card statements carefully before filing.   Flag any purchases in the amount over $500.  Ask your client about such purchases, and the circumstances around such purchases.

1. Other common exceptions (check out the complete list in 11 U.S.C. §523.)

1. Taxes (but carefully review when the taxes were incurred.)
2. Child Support, Maintenance.
3. Criminal Penalties
4. Fraud, Embezzlement, or Larceny
5. Criminal Penalties for Bad Checks.

1. Reaffirmation — Wants to keep the debt, but can’t show enough income to make payments?

A reaffirmation agreement has to be signed for debts that secure collateral assets – ie. a car loan, etc. –  that the client wants to keep.  If this agreement is not signed and approved within forty-five (45) days of the first meeting of creditors, the client runs the risk of losing the asset.  11 U.S.C. §521(a)(6)(A).

The reaffirmation agreement requires that client and attorney affirm that there is no undue hardship on the client by reaffirming the debt.  11 U.S.C. §524(k)(3)(J)(i).  If the bankruptcy schedules show a negative cash flow, the attorney has to sign stating that the client can make the payments.  In other words, the attorney has to have a good faith basis as to why the client can make the payments.   11 U.S.C. §524(k)(5)(B). Otherwise, the client runs the risk of losing the asset.

1. Prior Discharge.

1. A Chapter 7 discharge within the last eight (8) years.

A client is prohibited from obtaining another Chapter 7 discharge if a Chapter 7 discharge was obtained within the last eight (8) years.  11 U.S.C. §727(a)(8)

1. A Chapter 13 discharge.

A client is similarly prohibited if there was a Chapter 13 discharge for a petition filed within the last six (6) years.  11 U.S.C. §727(a)(9).  There are some exceptions:

1.         In the prior Chapter 13 bankruptcy, the client paid 100 percent of the unsecured claims.

2.         In the prior Chapter 13 bankruptcy, the client paid at least 70 percent of the allowed unsecured claims, and the plan was proposed in good faith and was the client’s best effort.

B.  Chapter 13

If the client is going to lose something in the liquidation, for example like a home or car, then Chapter 13 is an attractive option.  Also, Chapter 13 may also be available to those clients who would not qualify for Chapter 7.  Finally, those clients who would qualify under Chapter 7 may still seek Chapter 13 for other reasons such as protecting a co-debtor

Chapter 13 is a repayment plan.  The client will make payments over a three year period, and in some circumstances, a five year period.  In addition, the client gets to keep his/her assets, and gets the benefit of the automatic stay.  The client must pay over this period an amount that would equal the monies that unsecured creditors would receive from a Chapter 7 liquidation.  The client will receive a discharge even if only a percentage of the unsecured debts are paid back.

1. The Client Needs Sufficient Income to Keep Their Assets Not Exempt Under Chapter 7

After looking at Schedule I and J, the client must be able to show sufficient income to propose a Plan that will be approved:

1. Baseline Chapter 7 Liquidation.

There must be enough income to satisfy the baseline of whether or not the client can pay back an amount that would equal the monies that unsecured creditors would receive from a Chapter 7 liquidation.

1. The Means Test Calculation.

The client then must be able to show that they can pay back an amount calculated by the means test.  Again, this will be addressed under the Means Test Section.

C.        Payback Certain Debts – Mortgage Arrears, Auto Loans (even if repossessed), and Taxes and Other Priority Debts.

The client must finally have enough income to pay back certain debts such as mortgage arrears, repossessed vehicle, and taxes.

1. Mortgage Arrears – Foreclosure or Impending Foreclosure

If the client is in foreclosure or about to be in foreclosure, and a sale of the property has not yet occurred, a Chapter 13 is available as long as the plan provides for a cure of the mortgage arrears.  11 U.S.C. §1322(c)(1). See also Colon v. Option One Mortgage Corp., 319 F.3d 912 (7th Cir. 2003).

1. Auto Loan Arrearages

If the value of the vehicle is less than the loan, the client must pay an amount equal to the fair market value of the car over the plan.  11 U.S.C. §1325(a)(9).  (“Cramdown”).

If the value of the vehicle is more than the loan, the client must propose a plan to pay the arrearage over the life of the plan.

1. Priority Debts Such as Income Taxes (which are nondischargeable).

If the client owes certain priority debts such as income taxes, these amounts must be paid in full by the proposed plan.

2.         Chapter 7 is not an available option for other reasons than the possibility of losing non-exempt assets.

a.  Too Much Cash Flow  –.

1.  Failed the Means Test.

2.  Possible Abuse Motion in Chapter 7. 11 U.S.C.                                  §707(b)(3)

b.  Debts Dischargeable in 13 But not in 7.

11 U.S.C. §§523(a)(1)(B), 523(a)(1)(C), 523(a)(2) – 523(a)(4), and 507(a)(8)(C) lists the debts that are non-dischargeable in Chapter 13.  The debts that are dischargeable in Chapter 13 and that are not dischargeable in Chapter 7 are not as “super” as they were before the 2005 Act.   Congress has whittled down the differences between the two discharges.

A Chapter 13 is still an attractive option when a Chapter 7 will not discharge certain debts.  This seems to be most commonly applicable with marital debts.

c.  Prior Discharge in Chapter 7

Here a client has filed a prior Chapter 7 bankruptcy within the prior eight (8) years, and thus is ineligible to file another Chapter 7 bankruptcy.  If the prior Chapter 7 Bankruptcy was filed more than four (4) years ago, a client still has the option to file Chapter 13.  A client can file Chapter 13 and receive a discharge, if a Chapter 7 has been filed more than four (4) years prior.  11 U.S.C. §1328(f)(1).

Interestingly, a client may still consider filing Chapter 13 even if a Chapter 13 discharge is not available.  The client may use the Chapter 13 to keep an asset such as a home or vehicle, and pay back arrearages on debts securing such assets.   In other words, if the client is not eligible for a Chapter 13 discharge due to prior filings, Chapter 13 is still a valuable tool for stopping foreclosures and other actions against the client.

3.         Filing Chapter 13 even when Chapter 7 is available.

Finally, the client still may want to consider filing Chapter 13 when Chapter 7 is available.

1. Reaffirmation Agreement Can’t Be Worked Out.

In the event, a reaffirmation agreement cannot be worked out in time with the particular creditor/lender, the client may consider filing Chapter 13.

1. Protection of Co-Debtor.

The automatic stay of the Chapter 13 extends  to co-debtors of the Debtor. See 11 U.S.C. §1301(a). However, a creditor may request the Court to modify the stay if:

1. The debt is not a consumer debt;
   1. The co-debtor solely received the consideration for the claim  (ie., the cosigner is the person driving the vehicle that serves as collateral for the loan)
   2. The Chapter 13 Plan does not propose to pay the claim.
   3. The creditor’s interest would be irreparably harmed by continuation of the stay.  (ie. no insurance on vehicle, etc.)

See. 11 U.S.C. §1301(c).

1. Client Wants to Pay Back Debts –

There are rare circumstances when the client has some ability to pay, and the client wants to make payments back to his creditors.

III. Conclusion

By understanding what is at risk if the client is to face the collection process, the attorney can pin point what is at stake.  Is the client going to face a garnishment of their wages that will destroy the client’s family’s budget though all the assets are exempt from non-wage garnishment?  Is the client going to lose a home because s/he have fallen behind in payments?  Is there too much equity in the home and the client would lose the home in liquidation?

The attorney then can see if a Chapter 7 or Chapter 13 would provide some relief to the client.  A Chapter 7 is ideal in providing a fresh start when the client’s assets are exempt.  However, if a Chapter 7 is not available because of the client wants to keep an asset, or other reason – clients has too much free cash flow, or has a certain non-dischargeable debt, etc. – a Chapter 13 and its benefits should be considered.  A Chapter 13 allows the client to keep its assets as long as s/he has