When most people think of bankruptcy, they think of Chapter 7 Liquidation bankruptcy. A Chapter 7 bankruptcy involves the consumer (or “debtor”) giving up her non-exempt property in exchange for the discharge of a certain amount of her debt. Indeed, the ability to discharge debt through bankruptcy is one of the most attractive features of the bankruptcy laws. Discharging your debt is the first major step on the road to a fresh start.
However, not all consumers are eligible for Chapter 7 bankruptcy. In 2005, the bankruptcy laws were amended in response to a growing concern that consumers were abusing the system. Specifically, there were a growing number of complaints from creditors that it was too easy for consumers to file for bankruptcy, and that consumers were taking advantage of the discharge provisions. So, the creditors successfully lobbied Congress to pass what is called the “means test” for Chapter 7 Liquidation bankruptcy.
The means test is very complicated. Basically, the means test calculates the amount of income that is available to the debtor after into taking account certain expenses and the nature of the debt itself. The amount of income remaining after this calculation will determine whether the debtor is presumptively abusing the bankruptcy laws. In other words, if the debtor has more than a specified amount of income available to repay her creditors, then the law says the debtor should not obtain the discharge relief that bankruptcy provides. A simple example of the means test at work will be helpful.
Let’s say a debtor, who we will call Deborah, lives in Colorado and earns $7,000 per month in income. The means test starts by comparing Deborah’s income with the median income of debtors with the same size household in Colorado. If Deborah’s income is equal to or below Colorado’s median income, Deborah automatically “passes” the means test and further calculations are unnecessary. In this example, however, Deborah’s income is above the median income for Colorado, so we must take a closer look at the rest of her financial situation. Deborah’s monthly expenses are $6,850, and Deborah has $20,000 of debt. So, after deducting her monthly expenses from her monthly income ($7,000 minus $6,850), Deborah is left with $150 of disposable income per month and a total debt of $20,000. According to the means test, Deborah is presumed to be abusing the bankruptcy laws. Deborah’s monthly disposable income compared with her total outstanding debt makes her ineligible for the discharge provisions of Chapter 7 Liquidation bankruptcy. In other words, the law states that Deborah likely has the financial ability, or “means,” to make meaningful payments to her creditors without allowing her to discharge this debt. Here, Deborah’s case might be converted to a Chapter 13 repayment bankruptcy, or be dismissed altogether.
Now let’s say that everything is the same except for the fact that Deborah has $100,000 in outstanding debt. In this scenario, the law says that Deborah is not presumed to be abusing the system. Deborah’s $150 monthly disposable income compared to her $100,000 in total debt makes her eligible for Chapter 7 Liquidation bankruptcy. Here, the amount of Deborah’s total debt is such that she does not have the financial ability to make meaningful payments to her creditors, and therefore Deborah should be eligible to discharge some of her debt through bankruptcy.
Deborah’s example is meant only to provide a basic understanding of the means test. The actual language of the law is very technical and is frequently criticized as being needlessly confusing and complicated.[1] In any case, a consumer who is considering bankruptcy should be aware that not everyone is eligible for the discharge provisions of Chapter 7, and the bankruptcy court will look closely at the consumer’s current financial situation to determine whether Chapter 7 is appropriate or not. As always, consultation with an experienced bankruptcy lawyer is highly recommended.
[1] For the actual language of the statute, see 11 U.S.C. § 707(b).