If you want to file for bankruptcy to wipe out your credit card debt, you'll probably need to prove that you're so broke you can't pay back your creditors.
However, consumers wanting to file for Chapter 7 bankruptcy need to pass a “means test” to determine how much available cash and/or assets a person owns in order to qualify for the debt discharge.
There are two types of consumer bankruptcy available to consumers: Chapter 7 and Chapter 13. Those granted a Chapter 7 bankruptcy will be absolved of most unsecured debts (such as credit card debt), while Chapter 13 requires the debtor pay down at least some debt over three to five years (after which the remaining debt is often forgiven). There's also Chapter 11 bankruptcy, which allows businesses to restructure their debts.
Chapter 13 bankruptcy may appeal to those with assets they don't want to surrender as they may have to be in a Chapter 7 bankruptcy or to those who cannot pass the means test for a Chapter 7 bankruptcy. Plus, a Chapter 13 bankruptcy drops off credit reports slightly sooner (after seven years, as opposed to 10 years for Chapter 7).
Still, Chapter 7 bankruptcy holds appeal for those who are buried so deep in debt that even modest repayments aren't feasible — and who want a clean slate immediately. Here's how the means test works and what you can expect from the process.
What's the means test?
The means test, put in place as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, is a formula that first looks at a consumer's income. If it's below the state median income for that household size, the consumer automatically passes the test. If it's higher, expenses are subtracted from income to determine how much, if any, money could go toward debt repayment. The test is a way to prevent consumers who could repay debt from simply choosing to erase it instead.
“Before means testing, someone could be making a lot of money, living an extravagant lifestyle, and they could file for [Chapter 7] bankruptcy,” says Lauren Ross, a California bankruptcy attorney.
There is one loophole: If more than half of your debt stems from business expenses, you might be able to file Chapter 7 without going through a means test, says California bankruptcy lawyer Jeena Cho. Business debt could include a small business loan, a business line of credit or even purchases of items such as office equipment or supplies on either a business or consumer credit card, she says.
Passing the test and being deemed able to file doesn't always mean your case will go forward — for example, if the information disclosed in your means test looks suspicious or suggests you're cheating the system, a bankruptcy judge or an official from the U.S. Trustee Program, which oversees all bankruptcy cases, could challenge your case at any point along the bankruptcy process, says Irena Juras, an Arizona bankruptcy and business lawyer.
“I've seen that happen,” she says.
Going through the means test
How much do you have to reveal about your financial life in the means test? Experts explain the steps involved:
1. First, you meet with a bankruptcy lawyer. A means test is so complicated that it's smart to have a bankruptcy lawyer guide you through it. You can find a lawyer by asking for a referral from another attorney or financial professional, or you can visit the website of the National Association of Consumer Bankruptcy Attorneys. The lawyer will ask you about your income and the number of people who live with you. The lawyer will take your monthly income for the past six months, use it to calculate an annual income and check it against median income numbers for your state. If you make less than the median income for your household size, you pass the means test.
“If someone is working part-time, making minimum wage, it's not even going to be an issue,” Ross says.
2. If you make more than the median income, your lawyer will require more information. In this case, your lawyer will need to take a close look at your expenses. You'll need to gather financial records, such as mortgage statements, car loan information, court orders to pay child or spousal support, and receipts for out-of-pocket medical expenses. It can take some time to get all of the information together.
“If they're organized, it should take about a week,” Ross says. “But if they're like most people and have everything scattered around, it can take two or three weeks.”
3. Then, determine your disposable income. Once you've gathered your records, you'll probably meet with your lawyer again. To determine your disposable income, your lawyer will probably plug your financial information into a computer program that will deduct expenses from income.
“The problem is that some of the deductions are average numbers — not what you're necessarily paying,” Ross says.
For example, you would get to deduct a certain amount for rent, groceries, utilities and transportation costs such as fuel based on national averages — not on how much you actually eat, give the electric company or pay at the pump. But, for certain types of expenses — mortgages, car loans and out-of-pocket medical expenses, for example — you do get to deduct what you actually spend.
If you have no money left after your expenses are paid each month, you pass the test. If you have a small amount, say $12 a month left, you'd pass, Ross says. If you have more, whether you pass or fail could depend on the amount of your debt. In one case, Ross says, a client had $110 a month left, but still passed because that amount wasn't enough to make meaningful repayments on his $360,000 debt.
4. If the numbers aren't working, get your lawyer's advice. In some cases, a lawyer will be able to make a suggestion as to how you might still be able to qualify for Chapter 7 bankruptcy if you can't pass the means test right off the bat. For example, if you used to make $100,000 a year and you lost your job two months ago, your previous income might skew your annual income number so that you'd fail the means test. In that case, the solution could be as simple as waiting a few months. Or, maybe a child lives with you part time, and counting that child as a member of your household could help, Ross says.
“There's room to take advantage of the way the law is written — and I'm not talking about anything untruthful,” she says.
5. If you pass the means test, file for bankruptcy. If you pass the means test, your lawyer can then file your Chapter 7 bankruptcy. Officials from the U.S. Trustee Program will review the case over the next few weeks. If they have a question or if something looks odd, they probably will contact your lawyer, Ross says. If necessary, the lawyer can then turn over bills, receipts or other documentation.
“At the end of the day, you need to be able to provide proof,” Ross says.
6. If you fail the means test, have your lawyer help you make a decision. A consumer who fails the means test can opt not to file bankruptcy at all, wait to see if circumstances change and try again later, or file for Chapter 13 bankruptcy. If you don't pass the means test, your lawyer can show you what your Chapter 13 repayment plan would look like, Ross says.
Experts say many consumers get stressed out about the means test, but there's really no reason to worry.
“There's nothing to fear about a means test,” Juras says.