What Is Bankruptcy?

Bankruptcy is a legal proceeding involving a person or business that is unable to repay their outstanding debts.The bankruptcy process begins with a petition filed by the debtor, which is most common, or on behalf of creditors, which is less common. All of the debtor's assets are measured and evaluated, and the assets may be used to repay a portion of outstanding debt.

Bankruptcy offers an individual or business a chance to start fresh by forgiving debts that simply cannot be paid while giving creditors a chance to obtain some measure of repayment based on the individual's or business's assets available for liquidation. In theory, the ability to file for bankruptcy benefits the overall economy by allowing people and companies a second chance to gain access to credit and by providing creditors with a portion of debt repayment. Upon the successful completion of bankruptcy proceedings, the debtor is relieved of the debt obligations that were incurred prior to filing for bankruptcy.

All bankruptcy cases in the United States are handled through federal courts. Any decisions in federal bankruptcy cases are made by a bankruptcy judge, including whether a debtor is eligible to file and whether they should be discharged of their debts. Administration over bankruptcy cases is often handled by a trustee, an officer appointed by the United States Trustee Program of the Department of Justice, to represent the debtor's estate in the proceeding. There is usually very little direct contact between the debtor and the judge unless there is some objection made in the case by a creditor.

Bankruptcy filings in the United States fall under one of several chapters of the Bankruptcy Code, including Chapter 7, which involves the liquidation of assets; Chapter 11, which deals with company or individual reorganizations; and Chapter 13, which arranges for debt repayment with lowered debt covenants or specific payment plans. Bankruptcy filing costs vary, depending on the type of bankruptcy, the complexity of the case, and other factors.

Individualsand in some cases businesses, with few or no assetstypically file Chapter 7 bankruptcy. It allows them to dispose of their unsecured debts, such as credit card balances and medical bills. Those with nonexempt assets, such as family heirlooms (collections with high valuations, such as coin or stamp collections);second homes; and cash, stocks, or bonds must liquidate the property to repay some or all of their unsecured debts. A person filing Chapter 7 bankruptcy is basically selling off their assets to clear their debt. People who have no valuable assets and only exempt propertysuch as household goods, clothing, tools for their trades, and a personal vehicle worth up to a certain valuemay end up repaying no part of their unsecured debt.

Businesses often file Chapter 11 bankruptcy, the goal of which is to reorganize, remain in business, and once again become profitable. Filing Chapter 11 bankruptcy allows a company to create plans for profitability, cut costs, and find new ways to increase revenue. Their preferred stockholders, if any, may still receive payments, though common stockholders will not.

For example, a housekeeping business filing Chapter 11 bankruptcy might increase its rates slightly and offer more services to become profitable. Chapter 11 bankruptcy allows the business to continue conducting its business activities without interruption while working on a debt repayment plan under the court's supervision. In rare cases, individuals can also file Chapter 11 bankruptcy.

Individuals who make too much money to qualify for Chapter 7 bankruptcy may file under Chapter 13, also known as a wage earner's plan. It allows individualsas well as businesses, with consistent incometo create workable debt repayment plans. The repayment plans are commonly in installments over the course of a three- to five-year period. In exchange for repaying their creditors, the courts allow these debtors to keep all of their property, including otherwise nonexempt property.

While Chapter 7, Chapter 11, and Chapter 13 are the most common bankruptcy proceedings, especially as far as individuals are concerned, the law also provides for several other types:

When a debtor receives a discharge order, they are no longer legally required to pay the debts specified in the order. What's more, any creditor listed on the discharge order cannot legally undertake any type of collection activity (such as making phone calls or sending letters)against the debtor once the discharge order is in force.

However, not all debts qualify to be discharged. Some of these include tax claims, anything that was not listed by the debtor, child support or alimony payments, personal injury debts, and debts to the government. In addition, any secured creditor can still enforce a lien against property owned by the debtor, provided that the lien is still valid.

Debtors do not necessarily have the right to a discharge. When a petition for bankruptcy has been filed in court, creditors receive a notice and can object if they choose to do so. If they do, they will need to file a complaint in the court before the deadline. This leads to the filing of an adversary proceeding to recover money owed orenforce a lien.

The discharge fromChapter 7 is usually granted about four months after the debtor files to petition for bankruptcy. For any other type of bankruptcy, the discharge can occur when it becomes practical.

Declaring bankruptcy can help relieve you of your legal obligation to pay your debts and save your home, business, or ability to function financially, depending on which kind of bankruptcy petition you file. But it also can lower your credit rating, making it more difficult to get a loan, mortgage, or credit card, or to buy a home or business, or rent an apartment.

If you're trying to decide whether you should file for bankruptcy, your credit is probably already damaged. But it's worth noting that a Chapter 7 filing will stay on your credit report for 10 years, while a Chapter 13 will remain there for seven. Any creditors or lenders you apply to for new debt (such as a car loan, credit card, line of credit, or mortgage) will see the discharge on your report, which can prevent you from getting any credit.

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Bankruptcy Definition - Investopedia