The Main Differences Between Chapter 7 and Chapter 13 Bankruptcy

i lawssss laIn short, they are quite different. Each one has its advantages and disadvantages, so that for many people, Chapter 7 bankruptcy is a much better option, For others, Chapter 13 would be their recommended course of action. Even if you have your mind set on one or the other, it’s important to discuss both alternatives with your bankruptcy attorney in case there are significant advantages or disadvantages you didn’t know about.

The biggest difference between Chapter 7 and Chapter 13 is that Chapter 7 focuses on discharging (getting rid of) unsecured debt such as credit cards, personal loans and medical bills while Chapter 13 allows you to catch up on secured debts like your home or your car while also discharging unsecured debt.

Chapter 7 looks at the assets you own at the moment your case is filed, protects those assets which are “exempt”— generally everything you own—and discharges most or all of your debts.

Chapter 13 also looks at your financial life as of when your case is filed but focuses more on a repayment plan to deal with any secured debt (house, car etc) that you are behind on while also discharging most or all of your unsecured debts.

One thing that may be helpful is to estimate Chapter 7 qualification and a Chapter 13 monthly plan payment using a bankruptcy calculator based on the bankruptcy forms, which you can do below.

Power Over Special Unsecured Creditors

There are certain types of debt that are not discharged in bankruptcy, such as recent income taxes, all child and spousal support, student loans, and a few others. Under Chapter 7, if you have any of these debts, you need to deal with them after your case is finished.

This may be fine if the surviving debt is relatively small and discharging your other debts has made dealing with it manageable. Additionally, many types of unsecured debts are discharged under Chapter 7 bankruptcy. These include medical debt and credit card debt.  

Under Chapter 13, you can arrange to pay those kinds of special debts through a court-approved repayment plan which usually gives you more control, is based on what you can afford, and protects you from all your creditors throughout the process.

This continued protection can be especially important because otherwise, the law tends to give these kinds of creditors extraordinarily aggressive collection powers. Also, in some cases—such as income taxes—you will be able to pay less by avoiding ongoing interest and penalties.

Dealing with Secured Creditors

With Chapter 7, you are generally allowed to either keep or surrender any collateral. So you can decide that you can no longer afford your mortgage or vehicle payment and give up the house or car and discharge the remaining debt. Or you can arrange to continue making the payments and keep the collateral. If you are behind on those payments, you will have limited time to catch up, depending on the discretion of the creditor.

Contrast that with Chapter 13, under which you can usually stretch out payment of your mortgage or vehicle arrears over the entire three-to-five year repayment plan. Also, you may be able to save a tremendous amount by “cramming down” the balance on an older vehicle loan to the value of the vehicle.

Summarizing Chapter 7 vs. Chapter 13 Bankruptcy

Generally, Chapter 7 is more appropriate for simple cases while Chapter 13 for more complicated bankruptcies. Or somewhat more accurately, Chapter 13 can give you more power over and flexibility with certain kinds of creditors, and if you have non-exempt assets. However, if you do not have those kinds of debt or assets, or not much in terms of tangible assets, then Chapter 7 would likely be the faster and easier option.

Next, we’ll get into a few scenarios where knowing the difference could pivotal.

Choosing between Chapter 7 and 13 Bankruptcy if You Owe Money to Your Ex-Spouse

Spousal and child support cannot be discharged (written off) under either a Chapter 7 “straight bankruptcy” or a Chapter 13 “adjustment of debts.” However, other kinds of divorce obligations — sometimes called “property settlement” debts — can be discharged, but only under Chapter 13. If you owe a significant amount of non-support debts from your divorce, get legal advice about whether Chapter 13 would be a good option for you.

Support and Property Settlement Obligations

Separation and divorce decrees can create a number of different financial obligations. The bankruptcy law divides these obligations into:

  1. those “in the nature of alimony, maintenance, or support” (even if not specifically called that in the decree) — the support obligations, and
  2. those that settle the division of marital property and debt — the property settlement obligations.

The first set, of course, includes regular child and spousal support. But these can also include the decree’s order for you to pay certain ongoing expenses that are “in the nature of” support: for example, ongoing health insurance premiums, all or a portion of future medical expenses, and a child’s schooling. This can even include the obligation to pay the ex-spouse’s attorney fees for the divorce, especially if those fees were incurred in fighting about support-related issues.

The second “property settlement” set includes those obligations not “in the nature of” support. The division of “property” includes the divorce court’s division of both assets and debts. Besides stating which spouse gets which asset, the divorce decree can create equalizing obligations — a requirement for one person to pay the other a certain amount to compensate for getting more of the assets. The decree can also order one of the two to pay the entire balance of a jointly-owed debt, or to pay a debt that is owed by the other spouse.

Whether a debt referred to in a divorce decree falls in the first or second set of obligations is usually obvious from reading the separation or divorce decree. But it’s not always clear. If there is a dispute about this, it is decided by the bankruptcy court, not the divorce court.

Choosing between Chapter 7 and 13 Bankruptcy After Closing Your Business

If you’ve already closed down your business or are thinking of closing one that you are currently operating, you are no doubt wondering about the best way to deal with the debts incurred from that business. The answer depends on many factors, including the type of debts that you owe. Here are a few of the primary kinds of legally distinct business debts and how Chapter 7 and Chapter 13 bankruptcy would each deal with them.

Income and Withholding Taxes

Very often, the closing of a business leaves the owner personally liable for some or all of the business’s tax obligations. The owner often has his or her own personal tax obligations that were not paid during the months and years when the business was struggling. This usually happens when the business generates enough money for the owner to get some income from it, but not enough to meet personal living expenses, much less pay the taxes on that income.

Whether you owe back taxes, how much, and what kind are often the most important questions in deciding whether to file a “straight bankruptcy” Chapter 7 case, or an “adjustment of debts” in Chapter 13. And that’s particularly true after closing a business, because so often there are taxes owed in that situation.

When it comes to bankruptcy after closing a business, Chapter 7 may be the right choice if:

  1. the taxes owed can all be discharged (legally written off) or
  2. the taxes — or the portion still owed after discharging some — are relatively small and can be paid off through a manageable monthly payment plan with the IRS or other tax agency.

However, if the taxes that cannot be discharged are very large, and especially if they span a number of years, then Chapter 13 is often the right choice. That’s because Chapter 13 provides a number of advantages that become more worthwhile when more taxes are owed and when more help is needed.

For example, under Chapter 13, you are protected from the IRS’s collection efforts throughout the three to five years that the case lasts. You have that length of time to pay those taxes that must be paid. The payment amounts are based on what you can afford to pay, not on what the IRS or another tax entity demands. Interest and tax penalties do NOT continue to accrue in most situations.

You can often pay other personally important debts — such as a vehicle or mortgage arrearage or payment — ahead of the taxes. Also, if your circumstances change during the three-to-five-year period, adjustments can usually be made to your payment amounts, again based on what you can afford to pay.

Ultimately, if you can reasonably pay the taxes you owe as a result of your business closing after discharging all or most of your other obligations (including maybe some of the taxes), then Chapter 7 may well make more sense. Otherwise, you will probably need to file a Chapter 13 bankruptcy.

Debts Secured by Business Equipment

Most of the time, when a business has debts secured by collateral — such as business equipment, inventory or receivables — the business surrenders the collateral to the creditor when it closes, and the remaining debt is treated as a “general unsecured” debt. (See the next section.)

Keep in mind that you may want to keep certain collateral — such as a business vehicle or tools that you will need for your future livelihood. Assuming that the collateral is titled in your name (usually the case if your business was a sole proprietorship and not a corporation) and also assuming that you are personally liable for the debt, you will likely be able to keep the collateral if you are current on this debt. You simply have to agree to continue making payments and be liable on the debt. This can usually be done through a Chapter 7 case.

However, if you are not current on the secured debt and can’t get current quickly, you may need Chapter 13 to hang onto the collateral. This option will almost always give you more time to catch up. Or in some situations, you may not even need to catch up on the payments and may even be able to keep the collateral for much less than what you owe on it.

So, in some situations, you can keep the collateral under Chapter 7. But if not, then you would likely benefit from the extra tools that Chapter 13 provides.

“General Unsecured” Debts

This last category is made up of debts that have no collateral and also do not fit within any categories of “priority” debts (such as recent income taxes) that must be treated in special ways. General unsecured debts are usually discharged both in Chapter 7 or Chapter 13, so they do not generally drive the decision either way.

There IS a limit on how much general unsecured debt you can have in a Chapter 13 case — a maximum of $383,175 as of April 1, 2013. Also, general unsecured debts are generally discharged under Chapter 7 without you having to repay them. In a Chapter 13 case, most people will be able to discharge all unsecured debts, however, higher income earners may have to pay a portion of the general unsecured debts depending on their income. This depends on your budget and how many other more important debts have to be paid ahead of the general unsecured debts.

In general, if all you have are business and personal general unsecured debts, and they don’t total more than the maximum stated above, you probably need a Chapter 7 case. Chapter 13 cases are filed if your relatively high income disqualifies you from Chapter 7 or you have other debts, like the taxes and secured debts referred to above, that can be handled advantageously under Chapter 13.

Why Would You Convert from Chapter 7 to Chapter 13?

In bankruptcy, “conversion” means switching from one chapter of bankruptcy to another before the first one is completed. This blog is about going from Chapter 7 to 13. These two options are quite different, so why would a person make that switch?

For two sets of reasons: because 1) changed circumstances make Chapter 13 the better option, and 2) you are induced to convert to Chapter 13 even if you would have rather just finished the Chapter 7 case.

Voluntary Conversion to Chapter 13

The opportunity to change your case to a Chapter 13 one is one that is not often used but can be a valuable one for dealing with unexpected changes in circumstances. For example, you may sensibly decide to file a Chapter 7 case because you are just too far behind on your home mortgage payments, and your income is too low, even with the benefits of Chapter 13, to justify trying to save the home. However, if just a month or two afterward, you unexpectedly get a much better paying job, making a Chapter 13 payment plan feasible after all, there could be the possibility of converting your Chapter 7 case into 13 in order to keep the home.

Induced Conversion to Chapter 13

Although it happens quite rarely, you can be effectively required to convert from Chapter 7 to Chapter 13, although at least theoretically you can’t be forced to do so. Section 706 (c) specifically states that the bankruptcy “court may not convert a case under this chapter [7] to a case under chapter . . . 13 . . . unless the debtor requests or consents to such conversion.”

Either under Sections 706 or 707, the court can dismiss, or throw out, your Chapter 7 case under certain circumstances, and in those situations, it is usually better to convert to Chapter 13 as a fall-back option instead of being without any protection from your creditors.

These situations are relatively rare—the vast majority of Chapter 7 cases finish successfully without conversion. And conversions which occur are usually voluntary, resulting from a change in circumstances.

However, one area where induced conversions occasionally happen is when a debtor (often one not represented by an attorney) has too much income and/or insufficient allowed expenses so that the debtor fails the “means test,” causing a “presumption of abuse” under Section 707(b)(2).

If the debtor does not succeed in “rebutting this presumption with special circumstances,” the court can dismiss the Chapter 7 case. In the alternative, the debtor can avoid the dismissal by filing a motion to convert to Chapter 13, which is almost always granted.

Conversion to Chapter 13 can be a smart offensive or defensive tactical move. Many cases don’t involve such technical procedures, but it sure makes sense to know you have someone in your corner if it becomes necessary.

Debating Between Chapter 7 or Chapter 13 Bankruptcy? Let Leinart Law Firm Help

If you’re trying to decide between Chapter 7 and Chapter 13, the bankruptcy lawyers at Leinart Law Firm can consult with you on your financial situation to help you make an informed decision. Alternatively, we also specialize in other debt relief solutions if bankruptcy isn’t your best option.

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