It's not mine--it was a gift!

Gifts come in many shapes and sizes and, while usually a welcome thing, can have unintended consequences in a bankruptcy case.  There’s basically two types of gifts:  Those you give, and those you receive.

Gifts Must Be Listed As Assets On the Bankruptcy Schedules

When preparing the papers to be submitted in a bankruptcy case, any competent attorney will ask their client to list all of their assets, because that is required by the Bankruptcy Code.   I’ve had many clients over the years give me their list, but omit items that were given to them as a gift.   When I am fortunate enough to avert disaster and discover this before their case is filed,  the reason clients give for omitting it is that they think since they didn’t purchase it, it isn’t an asset.   Huh?   If your rich relatives give you their $10 million dollar house, putting title into your name,  just because you didn’t purchase it, it isn’t yours?  Wrong.   Gifts are just as much of an asset as anything else.   If you own it, it’s an asset.  And if you don’t have sufficient exemptions available under applicable law to protect it, you could lose it (depending on which bankruptcy chapter you file).    Regardless, you must list it or else you could face the loss of your discharge under Section 727 of the Bankruptcy Code, and/or possible criminal sanctions.

Gift Income Counts Towards the Means Test

Another frequent scenario is family assistance.  That is, when a friend or family member gives (rather than loans) money to the debtor to help with living expenses.   Thanks to the new (as of 2005) means test created by Congress,  all income received in the six (6) calendar months prior to filing a consumer bankruptcy case counts towards one’s eligibility to file.   Thus, even if the debtor who wishes to file bankruptcy has no wage or unemployment income at the time they file, they could conceivably be ineligible to file a Chapter 7 case now because of income received as a gift from friends and family within that 6 month period.   Of course, the easy solution to this is to have those gifts be loans, or to wait more than 6 months after receiving them to file a bankruptcy case.

Gifts You Make to Others:  Fraudulent Transfers or Charity?

The other side of this coin is gifts that the person filing bankruptcy (debtor) makes.   The bankruptcy papers require disclosure of any gifts made to any entity in the 12 months prior to filing the bankruptcy case if it exceeds $200 to a family member, or $100 to a charitable organization.   It also requires disclosure of ANY transfers of assets made in the 2 years prior to filing the case, for any purpose outside of the “ordinary financial affairs” of the debtor.  Presumably this would exclude normal and regular gifts (such as the holiday or birthday variety).

The reason for these disclosures is to enable a Trustee or creditors of the debtor to determine if assets were essentially “squandered” which could otherwise have been used to pay the creditors.    If large enough and outside the ordinary financial affairs of the debtor, a Trustee can sue the recipient of the gift to recover the value thereof, and if the transfers are particularly large and obvious, it could be grounds for denial of the debtor’s entire discharge under Section 727 of the Bankruptcy Code.   Charitable organizations are usually safe from such gifts,  as are holiday and birthday gift recipients, especially if they were regular donations.

But, if you’ve been Johnny (or Judy) Generous giving out large gifts,  you better wait at least a year before filing a bankruptcy case (particularly Chapter 7).   In fact, to prevent the Trustee from recovering on a fraudulent transfer theory,  it needs to be at least 2 years, and possibly more depending on the laws of your state.

As always, it is very important to discuss all specifics of your situation with a qualified bankruptcy attorney before filing a case!  (See more on why hiring a bankruptcy attorney is so important).

This article is part of my bankruptcy alphabet series

Others playing the Bankruptcy Alphabet Game:

Jay Fleischman believes G is for Garnishment

Cathy Moran believes G is for Guaranty

Ryan Caldwell talks about G for General Unsecured Creditors

Cate Eranthe examines how G is for Gumshoe

Stuart Ing explains how G if for Garnishment

Bill Balena opines that G is for Good Manners

Christopher Carr thinks G is for Garnishment

Jenna Cho believes G is for Good to Me

Mitchell Goldstein posits G is for Good Faith

Image Courtesy of Howard Dickins

One situation that arises frequently is where a relative or friend has given the debtor money to help them with their expenses during that 6 month period.    Whether this money is a loan or a gift can make the difference between whether or not one is eligible to file Chapter 7 vs. a Chapter 13 or Chapter 11 case, as well as possibly affecting the amount needed to be paid in a Chapter 13 or Chapter 11 case).

In short, if it is a gift received during that 6-month period, then it must be included as income for purposes of the Means Test.  If it is a loan, it does NOT get included, but in that event the party to whom the loan is owed MUST be listed as a creditor in the bankruptcy schedules (assuming the loan has not been repaid prior to filing the bankruptcy case).

If the loan has been repaid prior to filing the bankruptcy case, there may be other ramifications depending on the amount repaid and when it was repaid in relation to the bankruptcy filing.  This could be deemed a “preferential transfer” and should be discussed with your bankruptcy attorney.

Image Courtesy of:  http://www.flickr.com/photos/stevendepolo/

For the second period in a row, due to the declining economy, the median income is dropping and will go into effect for cases filed after October 31, 2010.  Thus, depending on how close you are to the limit, it may be important to file your case before November 2010.

In California, the median income for a 1-person household will be reduced to $3,936 per month; for 2-persons, $5,162 and a family of 4, $6,466.

Be sure to discuss the timing of your bankruptcy case with your attorney to maximize your chances of qualifying for Chapter 7 if possible, or reducing your obligations in a Chapter 13 case.

I was asked a question in a forum:  If a chapter 7 bankruptcy case gets dismissed for “failing” the means test, under 707(b) of the bankruptcy code (11 U.S.C. 707(b)), is there any time limit on re-filing?   The answer is, for most cases, “no.”

There are penalties for filing subsequent bankruptcy cases within one year after a prior case has been dismissed. The main penalty is that the automatic stay, which prevent creditors from commencing or continuing any legal action against the debtor, terminates 30 days after the petition is filed (and in cases of multiple dismissals, never goes into effect). However, this “penalty” is excluded from cases which are dismissed as a result of failing to “pass” the means test under 707(b) of the bankruptcy code (11 U.S.C. 707(b)).

A judge can still order a prohibition on re-filing a case for 180 days, but that is only usually done where there are harsh facts showing an abuse of the bankruptcy system.

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I have been unemployed for nearly a year now and will be running out of unemployment benefits in about 3 months which will leave me with no income at all and I am single. The prospects of finding a job in my line of work anytime soon is looking pretty grim so I am seriously considering launching another business of my own but that will take at least a year. I make about $960 a month on unemployment and have no residual savings other than my 401k and own no real property. My personal property is limited to my 13 year old car, my clothes and some minor furnishings which really aren’t worth anything. My dischargeable debts amount to about $35,000 and are comprised of strictly credit cards and medical expenses. I have never filed bankruptcy before and have spent the last 10 years rebuilding my credit after paying off debts from a business I was forced to close, so it’s heartbreaking for me to have to seriously consider bankruptcy now.

Here’s what I would like to know.

1. With little income which is on the verge of disappearing can I file directly for a Chapter 7 or do I need to file Chapter 13 first and complete the means test?

Answer: The “means test” must be completed if you are over the median income in your State, given your household size, in order to determine what you are eligible for. The so-called “means test form” must be completed in any bankruptcy case. You can file Chapter 13 first, but from the above facts it sounds like you would qualify for a Chapter 7 case, but you need to have a comprehensive consult with a bankruptcy attorney in your area to make that determination.

The Ninth Circuit Court of Appeals ruled today, in the case of In re Egebjerg, that 401k loans are not a debt as defined in the bankruptcy code and as such, the amount of any loan repayment cannot be considered in calculating a debtor’s budget/ability to repay his/her debts.

The basic rationale is that since a 401k loan is repaying funds to the owner of the 401k, it is not an actual debt, and the funds used to repay it are not a necessary living expense.

There are tax consequences for failure to repay a 401k loan, and these may be able to be argued as an offset, but the loan repayment itself cannot be used to determine eligibility to file a chapter 7 case.

One of the most frequent questions bankruptcy attorneys are asked by potential clients is whether they should file bankruptcy, or use a debt consolidation company to make payments towards their debts.   For those lucky debtors who qualify for Chapter 7 (which requires no repayment of debts but allows in most cases for discharge of all dischargeable debts), the decision is markedly easier to make.

But what about those who have the ability to make some monthly payments to their creditors and don’t qualify for chapter 7?   Their primary bankruptcy option in many cases is Chapter 13, which allows for, usually, a partial repayment of the debt.   Armed with this choice, most people decide that debt consolidation, rather than filing a Chapter 13 bankruptcy case, is their optimal solution.   However, this is almost never true.

In Chapter 13, the amount you have to repay to your creditors will almost always be less than (or, at worst, equal) to what you will have to repay outside of bankruptcy.    This is true even if you are required to repay 100% of your debts in a Chapter 13 case.  Depending on various factors–primarily your income and expense– you can get a discharge of your debts in a Chapter 13 case repaying anywhere from 0% to 100% of your unsecured debts for 36-60 months.

Why is it better to repay 100% in a Chapter 13 rather than doing debt consolidation?  Because you do not have to pay for interest accrual on unsecured debts in a Chapter 13.   Even under the best consolidation deal outside of bankruptcy there is going to be interest paid.  Also, in Chapter 13 your repayment plan will be for a maximum of 60 months (and in many cases can be as little as 36 months).   This can result in significantly less paid out over time than one would have to pay in a debt consolidation arrangement.

So if you are in a position where you may have too many assets or income to qualify for a Chapter 7 case, but are having trouble managing your monthly payments on your credit cards or other unsecured debts, you should consult with a bankruptcy attorney about the possibility of filing a Chapter 13 case.   You very well may be able to pay off all your unsecured debts with affordable monthly payments in less than 5 years!

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This is not a means test

The means test in bankruptcy is not a test like you take in school based on your memory.   The means test is a budget analysis created by Congress to supposedly determine whether one has the ability (i.e. the means) to repay all or a portion of their debts, which determines whether one  is ineligible to file for bankruptcy relief under Chapter 7, as opposed to  Chapter 11 or Chapter 13.

I say “ineligible” as opposed to “eligible” because in most court districts,  even if you “pass” the means test it does not automatically mean you qualify to file a Chapter 7 case.   There are other eligibility factors that come into play even if the presumption of abuse does not arise on the means test.  This will be discussed more below.

The Means Test Only Applies to Consumer Debt Cases

The means test only applies if one’s debts are primarily (i.e. more than 50%) consumer debts.   Consumer debts include secured mortgage debt obligations on a personal residence, as well as most credit card-type debts. The means-test also only applies if the total income received in the 6 calendar months prior to filing the bankruptcy case (explained more fully below) is above the median income for your state, given your household size. See the means test flow chart created by Judge Maureen Tighe of the United States Bankruptcy Court, Central District of California, as presented in the informative blog of the Moran Law Group.

So, What is the Means Test Exactly?

The analysis for the means test is extremely complex and requires an experienced bankruptcy attorney to properly calculate.  The basic definition can be seen here.

The more detailed and technical answer is:   The means test takes all income received (and this means ANY income, regardless of whether it’s taxable income, so that includes gifts, withdrawals from a 401k, and almost any other type of income EXCEPT social security income) in the 6 calendar months prior to filing the bankruptcy case–including that of your spouse, if any (see why this gets included)– and subtracting out certain allowed expenses.  These “allowed expenses” are mostly IRS-based allowances for living expenses, food, clothing, shelter, etc. and have little connection with reality.  There are specific allowances for secured debt payments, such as mortgages and car payments, but almost every aspect of the means test has been, is being, or will be challenged in the courts, because it is frequently nonsensical, internally inconsistent, and confusing.

It is not as simple as determining that your income is below or above the median income for your area and household size (and determining your household size is another hotly contested issue).  You need a qualified bankruptcy attorney familiar with the court decisions in your area, to properly evaluate your eligibility for bankruptcy.  (For example, self-employment income is not analyzed exactly the same way as wage-earner income from a job)

Passing the Means Test is Just the First Step

Which brings me back to the point of eligibility.   Passing the means test is just the first step. It is possible to pass the means test but still be showing–for example–a surplus in your current monthly income and expenses.   For example, let’s say you were unemployed for the 6 months prior to filing your bankruptcy case, but you just landed a new job that pays you $100,000 per year. In that instance, you would likely pass the means test and show you are eligible to possibly file a Chapter 7 case. However, you would most certainly draw an objection (via a Motion to Dismiss your case) from the US Trustee’s Office as having too much income.

Please Don’t Try This At Home!

The means test and assessing eligibility to file bankruptcy is a field of land mines and evolving interpretations of law.  As they say on television ad disclaimers, “We are trained professionals. Don’t try this at home”

Image Courtesy of JamesNaruke

There is an epidemic of people defaulting on their mortgage payments, as everyone knows. Real estate brokers are pushing hard to have people do “short sales” on their properties, instead of allowing them to go to foreclosure. In most circumstances, this is a very bad idea.

What is a short sale? A short sale occurs when you want to sell your property, but owe more to the lienholders (mortgages) on your property than a buyer is willing to pay to purchase the property. As a result, one (or more) of the lienholders secured by your property must agree to accept less than 100% of what is owed to them, in order to allow the sale to proceed. But who does this benefit? Certainly the mortgage broker, because he/she gets their commission.

Historically, a short sale was used in these circumstances in return for an elimination of any obligation that the seller has and an agreement that no negative marks will appear on their credit report as a result. NEITHER of these is true today. I am seeing increasing numbers of people who do these short sales, and then the lienholder who didn’t get paid in full seeks to collect from the seller for the deficiency amount. On top of that, the short sale appears on the credit report in the form of a negative defaulted loan mark.

Furthermore, doing a short sale can sometimes affect the ability to relieve the seller of certain tax burdens if they subsequently file a bankruptcy case.

Compare this with the foreclosure process. You end up with the same liabilities and negative credit marks, but you can usually live rent-free in your home for months, if not years, while the lenders go through the foreclosure process. Most lenders will wait as long as possible to foreclose in today’s market.

This is an extremely complicated area of law involving both tax and bankruptcy law, but suffice it to say that the optimal strategy is that if you are going to file a bankruptcy, it is usually best to allow your property to go to foreclosure, and file your case before the foreclosure sale takes place (and, even better, have the foreclosure sale occur DURING the bankruptcy, but this is difficult to achieve).

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The fact that a non-filing spouse’s income must be included in the bankruptcy case of the other spouse is one of the most difficult concepts for my clients to grasp. The common scenario is this:

Both Spouse’s Incomes Must Be “Included”

One spouse has certain debts which are only in that spouse’s name and may have even been incurred entirely prior to the marriage. He (or she) wants to file a bankruptcy to deal with those debts without involving their spouse. That is no problem. A bankruptcy case can always be filed by one spouse without the other.

However, when determining eligibility for bankruptcy, which includes the ability to repay debts, the other spouse’s income MUST, by law,  be included in the analysis.

This has always been the case in community property states, such as California. But with the changes in the bankruptcy laws which became effective in October 2005 (see new bankruptcy laws) Congress stated specifically that unless the spouses are legally separated or living apart (and not just for the purpose of evading the bankruptcy laws) or have a valid prenuptial agreement, then the non-filing spouse’s income must be included in the means test analysis (which is one of the several eligibility tests now required). [11 U.S.C. 707(b)(7)(B)].

The reason for this in community property states is that every spouse has a community property interest in the income earned by their spouse (and vice versa).

These requirements have absolutely nothing to do with which spouse owes the debt, whose name is on the debts/accounts, or which spouse is filing the bankruptcy case.

Will My Spouse Be Affected By My Bankruptcy Filing?

This also does NOT mean that the non-filing spouse will be “affected” by filing the bankruptcy case.   It merely means that their income must be factored into the eligibility analysis and may result in a Chapter 13 repayment plan needing to be filed instead of just a straight chapter 7 liquidation case.

Whether or not to include a non-filing spouse’s debts in the bankruptcy of the spouse that files is partially dependent on state law and is the topic for another discussion.

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