How Bankruptcy Exemptions Affect Chapter 13 and Chapter 11 Cases
The three most used types of bankruptcy protection, Chapter 7, Chapter 11 and Chapter 13, work in fundamentally different ways to eliminate or reorganize debt and allow the filer, also known as a debtor, a chance to get back on firm financial footing.
One of those fundamental differences can be seen in the way the each chapter uses property exemptions, the parts of state and federal law that allows an individual debtor (as opposed to a corporation or partnership) to protect certain property from the reach of creditors or the bankruptcy court.
For a primer on how exemptions work in general, see Understanding Bankruptcy Exemptions.
Chapter 7 cases are also called straight bankruptcy cases. In exchange for a discharge of debt, the debtor agrees to give up all of the property except for a certain amount that we call exempt property. A trustee appointed by the bankruptcy court is charged with the duty to take that property, liquidate it (turn it into cash) and distribute the cash to the debtor’s creditors. If the debtor is a corporation, there are no exemptions. Instead, all of the debtor’s property is liquidated and used to benefit the creditors.
Chapter 11 cases are known as reorganization cases. Instead of the debtor giving up property, the debtor is allowed to keep the property, continue operating a business (most Chapter 11 debtors are businesses, although some individuals file also, especially if they have a lot of debt or a lot of assets), while it negotiates new terms on its debt.
Chapter 13 cases are also reorganization cases. In a Chapter 13 case, the debtor (always an individual, never a corporation) also holds onto his property and instead uses future income to make payments over a period of three to five years. Those payments are used to pay down or pay off debt.
These future payments take the place of the surrender of assets that might happen in a Chapter 7 straight bankruptcy case. In fact, some debtors will choose to file a Chapter 13 case, even though they might qualify for a Chapter 7 straight bankruptcy, just so that they can protect assets they own that they might otherwise have to turn over to a Chapter 7 trustee to sell. Many times these assets will include property that the debtor believes will someday increase in value, like shares of a corporation or real estate. Instead of giving it up to a Chapter 7 trustee and eventually to the creditors, the debtor will choose to make payments over three to five years to pay down the debt.
The "Best Interest of Creditors" Test
In both Chapter 11 and Chapter 13 cases, the debtor proposes a payment plan to adjust, pay down or pay off creditors. For a Chapter 11 or Chapter 13 case to be successful, the debtor must propose a payment plan that will leave his unsecured creditors better off than if he filed a Chapter 7 case. This is called the "Best Interest of Creditors" Test.
Remember that unsecured creditors are creditors that have no collateral they could sell and apply to the debt if the debtor fails to pay.
It includes general purpose credit cards, medical bills, personal loans and others. It even includes that $20 you haven’t paid back to Uncle Phil.
Example: Applying Exemptions in Chapter 13
Here’s an example of how the "Best Interest of Creditors" Test works, comparing a Chapter 7 and a Chapter 13 case.
Don Debtor files a Chapter 7 case. After he applies all the exemptions to which he is entitled, he still has a coin collection worth $10,000 and an oil painting worth $5.000. The Chapter 7 trustee could take possession of the coin collection and the oil painting, sell them and use the proceeds (after the cost of the sale and his own commission) to pay part of the debt Don owes to unsecured creditors.
Let’s say that the costs of sale and the trustee’s commission would total $3,000. That would leave $12,000 available to pay creditors.
If Don wants to preserve the coin collection and the oil painting, presumably because they have sentimental value or because he believes that they will go up in monetary value in the future, he must propose a plan that will pay the unsecured creditors at least $12,000, the amount they would receive had he filed a Chapter 7 case. If he cannot show that his Chapter 13 plan will pay his creditors at least that much, the plan will not be approved.
Even though debtors do not actually turn over their property in a Chapter 11 or a Chapter 13 case, exemptions are still just as important as as they are in a Chapter 7 case in valuing and distributing assets to creditors to satisfy debt.
For more on Bankruptcy Exemptions, see
Updated by Carron Nicks August 2017