WHAT IS A CHAPTER 13 PLAN AND HOW DOES IT WORK?

Most people looking into filing a bankruptcy understand that a chapter 7 bankruptcy wipes out all the debts you want to get rid of, while allowing you to keep certain exempt assets. If you file under chapter 7 and have assets that are not protected by exemptions, then those assets are “liquidated” (sold) by the chapter 7 Trustee and the proceeds are divided among your creditors. That is why chapter 7 is known as the Liquidation chapter.

Chapter 13 bankruptcy is a bit more complicated for people to understand. It is known as the Individual’s Debt Adjustment chapter. There are times when a chapter 7 bankruptcy doesn’t serve your purposes. Although you need to deal with your debts to get them under control, there is some obstacle in your way, such as a paid-off vehicle that you need to keep to get you to work. That is a situation where a chapter 13 bankruptcy could be more beneficial to you than filing a chapter 7 where you would lose the vehicle to the Trustee/creditors. Another instance where a chapter 13 is helpful is if you’ve fallen several months behind in your mortgage payments, and need time to bring them current. A chapter 7 will not give you that time, but a chapter 13 will.   Further, if your income is over the median amount for your state, as set up by the Census Bureau, current bankruptcy law compels you to file under chapter 13 rather than 7.

In a chapter 13, the debtor typically keeps his assets, even if their value is over the amount of the state exemption. In return for this, the creditors look toward the debtor’s future disposable income to ensure that they will eventually receive at least as much as they would receive under a chapter 7. In addition, a chapter 13 debtor has greater rights in dealing with secured creditors and receives a broader discharge than a chapter 7 debtor.

Said another way, liquidation cases under chapter 7 and debt adjustment cases under chapter 13 use different approaches to accomplish the similar goal of giving the debtor a fresh start. A chapter 7 case offers the debtor an opportunity to protect his future income stream and exempt assets from creditor collection efforts in return for the debtor surrendering his nonexempt assets for distribution among the creditors. On the other hand, a chapter 13 is designed to adjust debts of individuals with regular income through the use of the debtor’s future income, under the protection of the Bankruptcy Court. A chapter 13 debtor can keep all or some of his nonexempt assets and modify the rights of secured creditors in return for relinquishing a portion of his future income stream.

The means for dealing with debts in a chapter 13 case is the debtor’s chapter 13 plan. The plan itself is a court-approved form, which sets out the number of months that the bankruptcy is expected to last (usually 60 months), the percentage of the creditors’ debts that will be paid, and the amount of the monthly payments. It also states the amount of monthly payments on secured claims, such as car loans and mortgages, as well as other pertinent terms. The plan is served on the chapter 13 Trustee and all creditors, who do have the right to file an objection if they feel that the debtor has not presented it in good faith. Once any objections have been resolved, the plan is then confirmed by the bankruptcy judge.

Of most concern to debtors is the amount of the monthly payment they will be required to make under the plan. Current bankruptcy law applies a formula known as the “means test” to make sure that debtors who can pay their creditors do pay them. The means test requires a debtor to determine his disposable income (what is left over when subtracting his reasonable living expenses from his “current monthly income”). His current monthly income, in turn, is determined as the average of his gross monthly income for the six full months before filing. Certain expenses for basic necessities are calculated based upon IRS National Standards and Local Standards, while certain others encompass the debtor’s actual monthly expenses. Secured payments are also accounted for in the test. The amount left over is what the debtor is expected to pay.

Thus, the purpose of the means test is to ensure that the debtor pays his creditors the maximum he can afford and still be able to meet his monthly living expenses. If the debtor pays his creditors according to the court-approved plan, he will be granted a discharge of his debts when he completes the plan. The means test works fairly well if the debtor continues to earn the same income in the future as he has in the past six months. If his gross income is substantially certain to diminish in the future, the means test will indicate a monthly payment that will not be feasible for the completion of the plan. In that situation, the more accurate income and expense schedules must be reviewed, as they will more accurately take that situation into account. Thus, while the bankruptcy laws attempt to ensure that the debtor pays his creditors all he can afford, this must also be balanced to make sure the debtor is not coerced into paying more than he can afford. The debtor’s income and living costs must be realistically estimated so that the plan has some likelihood of succeeding.

Similarly, in the event that a decrease in income is not anticipated when bankruptcy is filed, but does occur later on, the debtor retains the right to modify his plan in the future. The creditors are bound by the plan once confirmed, but the debtor is not.   Furthermore, the creditors have no right to “opt out” of the plan.

Once the amount of disposable income that will paid to the general unsecured creditors over the length of the plan is calculated, the percentage that creditors will receive of their balances will be determined. The debtor’s attorney will start with the amount dedicated for the unsecured claims (for example, $20,000 over the life of the bankruptcy), and then attempt to estimate the total amount of unsecured claims that will be filed (say $40,000). By dividing the amount to be disbursed by the total balance owed to the unsecured creditors, the attorney arrives at a specified percentage for the plan ($20,000 $40,000 = 50%). In this example, then, the plan would indicated that the unsecured creditors would be receiving 50% of their balances as of the date of filing, dependent upon their filing a proof of claim.[i]

To complete the plan, there are actually two factors to be considered:

  1. you must be in the bankruptcy for a stated period of time. If you are under the median income for your state, you must be in the bankruptcy for 36 months unless you pay your unsecured debts at 100% before then. If you are over median income, the proscribed length of the bankruptcy is 60 months, unless again you pay the unsecured at 100%.
  2. you must meet the percentage to the unsecured creditors as set out in your plan. There are times when despite the best efforts of your attorney and the trustee, your 60 months of payments falls short of providing the unsecureds with their percentage. In that case, the case can extend out for a month or two until the shortfall is made up.

This is just a simple explanation as to what a chapter 13 plan is and the considerations in drafting it. Your bankruptcy attorney should go into a more detailed explanation, based upon your individual needs to be met in the plan. In summary, however, you must have sufficient income to make the monthly payments on your secured debts (car loans, mortgage), priority debts (such as taxes), and unsecured debts as set out in the plan, plus the Trustee’s commission for disbursing the funds to the creditors. The percentage specified in the plan establishes that each general unsecured creditor will receive a certain percentage of its claim. It is based on a reasonable estimation as to the total amount of the claims that will be filed, which may or may not be accurate, since the plan is filed before the creditors submit proof of their claims. In the event that a claims come in significantly higher than expected, the debtor has the right to modify the plan either before or after confirmation if it turns out that he cannot feasibly make the plan payments.

[i] It is possible, if the debtor receives some unexpected windfall during the pendency of the bankruptcy, that the creditors could receive a bonus in addition to the plan percentage.

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