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Bankruptcy offers a way for struggling borrowers to shed some or all of their debt and start afresh. But before debtors can get that far, they have to clear several hurdles – starting with the insolvency needs test.
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Means test basics
The means test is a formula that determines whether a borrower can apply for bankruptcy protection under Chapter 7 of the Bankruptcy Act.
Chapter 7 bankruptcy, also known as a liquidation bankruptcy, lets a borrower keep a tax-free property — like a car — while everything else is to be sold to pay off unsecured debt. After going through the process, which takes four to six months, the applicant can come out of most types of debt, including credit card balances, personal loans, and unpaid medical bills, with fewer assets but a clean slate.
There is another Chapter 13 means test, the other type of individual bankruptcy. Chapter 13 is called a reorganization bankruptcy because the debtor must make payments on unsecured debt for three to five years. Most bankruptcy filings choose Chapter 7. But if they can’t pass the means test, Chapter 13 is the only option.
Bankruptcy Means Test: Some Background
The means test was created as part of the Abuse of Bankruptcy and Consumer Protection Act, a major overhaul of the personal bankruptcy process that went into effect in 2005. The means test was created to prevent people from applying for Chapter 7 if they can afford to pay off debt.
The means test is required for individual bankruptcies who have primarily consumer debt. If you are seeking bankruptcy protection primarily for tax debts, business debts, investments, mortgages, or damages in a court proceeding, you can skip straight to Chapter 7. The same applies if you are a disabled veteran.
According to a report by the US Trustee Program, the federal agency that monitors bankruptcies, 94% of people who take the means test pass it. The report shows that the trustees even allow some debtors they identify as “abusive” to file under Chapter 7. In that sense, the means test isn’t too mean.
This is how the insolvency test works
The means test can be quite confusing as Congress left many aspects open to interpretation.
In the simplest case, the means test consists of two steps. The first checks the applicant’s income; The second is more complicated and involves checking the debtor’s income and expenses.
Step One: Compare Income to Median
You begin the means test by completing Form 122A-1, Chapter 7 Statement of Your Current Monthly Income. The form is available for download from the United States Courts website.
After entering your marital status, enter details about the average monthly income you received over the past six months, including:
- Wages, salaries, tips, bonuses, overtime pay and commissions before wage deductions
- Any monies regularly received from roommates for expenses such as child support or rent payments
- Income from self-employment after taxes and duties
- Capital gains such as dividends, interest and royalties
- unemployment benefit
- pension benefits
Applicants are not required to provide information about Social Security benefits they receive or government payments for a military disability.
Once you have your typical monthly income, multiply it by 12 to get an annual income number. Then compare that to the median income in your state, which you can find on the means testing portal on the Justice Department’s website. Locate the field labeled “Dates required to complete Forms 122A and Forms 122C”, select the current date range and click Go.
You’ll land on a page with a link labeled “Median Family Income Based on State/Territory and Family Size.” This link provides a table of median incomes for different size households in each state and four US territories.
If your income is below the relevant median, you pass the means test and can file for Chapter 7 bankruptcy. If not, you can either give up and opt for a Chapter 13 filing, or you can proceed to step two.
Step Two: Means test calculation
The second part of the Chapter 7 means test uses Form 122A-2, the Chapter 7 Means Test Calculation. You determine your eligible expenses and then subtract them from your average monthly income from step one. If the result shows that you would not be able to pay off at least 25% of your unsecured debt over five years, you can apply for Chapter 7.
While it may sound simple, part two of the test has limitations. “Reimbursable expenses” include rent, groceries and medical expenses, but other expenses are considered expendable – meaning the bankruptcy system thinks you could take that money and use it to pay down debt instead.
But both expenditure and revenue are open to interpretation, making the second phase of the means test arguably beyond the abilities of almost any layperson. For this reason, even fans of DIY legal solutions recommend speaking with an experienced bankruptcy attorney before attempting step two.
Of course, hiring a lawyer increases the price considerably. However, other approaches such as B. free online test calculators, probably not that good. And the risks are significant.
You could end the Chapter 7 filing incorrectly and cause the court to convert your case into a Chapter 13 filing. Or you may come to the conclusion that you cannot file a Chapter 7 application even though you qualify.
The bankruptcy funds test separates people who can legally afford to pay their debts from those who cannot. Applicants who pass the first part of the test can go directly to Chapter 7 and work to eliminate debt through the bankruptcy process. Some applicants must take the second, more complicated part of the test to qualify for liquidation bankruptcy. Those who fail altogether must submit under Chapter 13 or find an alternate route.
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