Overview of Chapter 13 Bankruptcy

Chapter 13 is known as a plan of reorganization which in which you must submit a plan to the Court and to creditors that must be confirmed by the Judge.

Chapter 13 is useful for people who are behind on certain secured items, behind on the IRS, or who make too much money to file Chapter 7.

In order to be confirmed a plan must be feasible, must pass the disposable income test, and must pass the best interest test.

Chapter 13 provides more flexibility than Chapter 7 in the way that attorney fees work and for avoiding the risk of potential issues in a Chapter 7.

Chapter 13 is still very common, accounting for about 25% of all Bankruptcy cases filed.  The debtor must submit a plan to the Court and serve that plan on the creditors.  The plan must be at least 36 months and at most 60 months.  Most plans are 60 months because it provides the most flexibility for the debtor in keeping their plan payments as low as possible.  In this Chapter 13 plan you tell the Court how you will treat certain types of debt:  Secured, Priority, and General Unsecured.

Secured:  with secured debt you must show to a given secured creditor that you will continue to make all your post-petition payments while providing for any arrears (if any) through the plan OR show that you will pay the entire of the claim inside the Chapter 13 plan.  

Priority:  Priority debt must be paid through your plan.  The most common example of priority debt are tax payments to the IRS.  

Unsecured:  Unsecured debt is treated as one class of debt inside your plan.  Your plan will show how much (if any) of your unsecured debt will be paid as whole in your plan.

Practical Point

Most cases that deal with secured debt will not have to pay anything to unsecured creditors (or least very little).   This is because of the debtor is already having trouble paying their secured debt then most likely their budget will show that they can’t also afford to pay unsecured creditors.

The opposite is also true.  If the plan does not need to reorganize any secured debt (the debtor being current) then most likely they an afford to pay something back to unsecured creditors.  The payment to creditors will establish an overall lower amount or at least eliminate the interest.   

These scenarios are interrelated to the tests for confirmation discussed below.

Test for Confirmation 

In order for your plan to be confirmed by the Court it must be feasible, pass the disposable income test, and pass the best interest test. 

Feasibility – this deals with the ability to make the Chapter 13 plan payment.  You must be able to submit a budget that shows you have the ability to make your Chapter 13 plan payment.  The Court does not want to confirm plans where the debtor(s) has no realistic shot of making the plan work.  Feasibility comes into play mostly with people who are behind on their mortgage or their car payment.  If the situation that got them behind hasn’t changed, or if the plan doesn’t save any money, then most likely their plan isn’t feasible.  

Disposable Income Test – the disposable income test is the main issue in most Chapter 13 cases.   This test is similar to the “means test” in Chapter 7.   This test operates much like an income and expense statement.  It starts out with what comes into the household (income) and then deducts all eligible expenses to determine whether there is anything left over.

One important thing to note with the test is that some of the expense items are set by the Court.  Those would include things such as:  food, clothing, personal care, out of pocket health care, and transportation.  These “set” expense items are based on IRS standards based on where you live and your household size.

Other expenses will differ by individual (car payment, mortgage payment, tax liability, health insurance deduction, flexible spending deduction, child support, child care, etc).  

The idea behind the test is that you live under a court mandated budget committing what is left over (your savings) to the Chapter 13 plan.  After living under this budget for 5 years you get a discharge of any remaining unsecured debt.  

Practical Point

The disposable income test is almost identical to the Chapter 7 “Means Test.”  It does however differ in a very meaningful way.  It allows you to take into account your 401k deductions.  Thus, a debtor should make sure to set this up before filing as 5 years worth of 401k contributions is way better than 5 years of a higher Chapter 13 plan payment.  

Best Interest Test—This test makes sure that the Chapter 13 is in the “best interest of the creditors.”  The test looks at how much money the unsecured creditors would have gotten in a hypothetical Chapter 7 liquidation case and compares that to how much the unsecured creditors are getting in the Chapter 13 case.   The distribution to unsecured creditors in their Chapter 13 plan must be the same or greater than that of a Chapter 7.  For example, if a debtor has a non -exempt boat worth $10,000 then the debtor must propose a plan that at least gives his unsecured creditors $10,000.

Practical Point

Nothing is sold in a Chapter 13.   The debtor keeps everything but operates under this Best Interest Test.  This is useful for people who don’t want to deal with the possibility of losing something to a Chapter 7 trustee.  It also useful for people who want to operate with a cushion in their bank account.  For example, in a Chapter 13 a debtor could keep $10,000 in non exempt money in their bank account without it being touched so long as they commit at least that amount in their Chapter 13 plan.  That could work out to as little as $167 per month ($10,000 divided by 60).  This concept is part of the flexibility aspect of the Chapter 13 discussed below.

Flexibility of Chapter 13

Chapter 13 is more flexible than Chapter 7 and can offer less risk for more complex cases. Some examples of the flexibility are:

Attorney Fees – the majority of your attorney fees are paid through your Chapter 13 plan.  The attorney is allowed to be paid to detriment of your unsecured creditors.  In other words your plan payment would essentially be the same even if the attorney got no money.   This is important because Chapter 13 cases are more complex than 7 and cost more.   

727 Action – this is an adversary proceeding brought by a creditor or the US Trustee seeking to prevent the discharge.  A 727 cannot be brought in a Chapter 13 case.  (Please note that a 727 action is also one of the most rare events in a Chapter 7).  

Variable payment terms – the disposable income test establishes a monthly number per month and then extrapolates that to an overall number to unsecured creditors over a 60 month period.  You don’t have to follow that monthly number exactly.  For example, we often make the plan payment lower for the first couple of months to get the debtor on their feet.  We also will make the payment lower and then increase later down the road when something pays off (like a car).  

Chapter 13 Trustee – the Chapter 13 trustee focuses on income and not assets.  So a Chapter 13 is essentially a way to buy a back non-exempt asset from the trustee over a long period time (See Best Interest Test Above).  Many times the Best Interest Test doesn’t come into play as the Disposable Income Test shows a higher amount to unsecured creditors. 

Dismissal or Conversion – because the plan is voluntary you can dismiss your case or convert your case to a Chapter 7 (if eligible for conversion based on income).