What is the Means Test?

The means test is a formula created by Congress and included in the 2005 revision to the bankruptcy law. The test is the centerpiece of the bankruptcy overhaul law and is used to calculate whether an individual filing bankruptcy has any income available to pay toward his unsecured debts. The means test is first used to determine, if an individual has enough income available to make payments on his unsecured debts, and if his income exceeds a certain amount the debtor will not be allowed to file a Chapter 7 bankruptcy, in which the court would have granted him a discharge without first requiring him to make monthly payments toward his debt. If the income is above the thresh hold for a Chapter 7 the law will only allow him to file a Chapter 13 bankruptcy in which he makes monthly payments for a five year period.

If an individual must file a Chapter 13 the means test will also be used to determine how much his plan payments will have to include to cover unsecured debts. Needless to say for a bankruptcy lawyer a thorough understanding of the means test is now a necessity.

The means test starts by taking the debtors average monthly income for the six months before filing the petition and subtracting out what the bankruptcy law allows as deductions. For most expenses such as food, clothing, personal care, transportation, utilities etc the debtor receives a standard allowance for the expenses regardless of his or her actual expenses. For certain items however such as taxes, mortgage and car payments, medical expenditures, health insurance, day care, child support and charitable contributions up to 15% of one’s income, the debtor may deduct his actual expense.


The income less the allowable expenses produces what is called current monthly income, and unless he qualifies for a Chapter 7 an individual debtor will have to pay at least 60 times the current monthly income to his unsecured creditors.

Bankruptcy and Credit Reports

A person’s credit rating  credit rating has become very important in modern society, and in the twenty-first century credit rating agencies have perhaps become the equivalent of the ever present Big Brother, who kept the entire population in a state of fear, in George Orwell’s 1984. A low credit score will increase the rate of
interest a consumer pays on a loan, or in some cases prevent a person from getting a loan altogether. Insurance companies review credit ratings as part of their underwriting process,employers check credit scores when they are hiring a new employee and sometimes before they approve a current employee's promotion, and landlords will often refuse to rent an apartment to an individual who has credit problems.

Thus it is hardly surprising that one of the questions many people ask, when they consult a bankruptcy lawyers, is how  will a bankruptcy affect my credit score.  The simple answer is that bankruptcy shows as a negative item on your credit report, and it will stay on your credit report for ten years.


 However, as a practical matter filing bankruptcy will usually improve an individual’s credit score.  This is because  in most cases by the time an individual files a bankruptcy he or she usually already has a number of negative negative items on his credit score, such as missed mortgage payments, failure to pay the minimum charge  charge on a credit card, judgements, garnishments, etc.  When an individual files a chapter 7 or chapter 13 bankruptcy this goes on the credit report, but all these other items disappear from the report, and if she pays her bills going forward her credit will start to improve.

If an individual does not file bankruptcy on the other hand the late payments, judgments and garnishments will stay on his credit report until he catches up on these debts, and the reason most people consider filing bankruptcy is because they realize they are unlikely to be able to pay off these items in the foreseeable future.

Can A Chapter 13 Bankruptcy Plan Be Amended

Individuals entering a Chapter 13 bankruptcy generally are committing to make payments out of their disposable income for a three to five year period, and as they frequently point out to their bankruptcy lawyers a lot can change in this period of time. They could lose their job, they could have medical problems or give birth to additional children, or they could get divorced and have to support two households instead of one.

If such traumatic events occur many debtors will be unable to make their Chapter 13 plan payments, and as a bankruptcy lawyer I can see why they become nervous about making this long term commitment.
The law however offers some relief in these situations. A Chapter 13 bankruptcy plan can be amended after the court confirms the plan, if a substantial change of financial circumstances has occurred. The debtor may petition the court to amend the plan, and in many cases the court will grant lower payments. Or if circumstances grow so bleak that the debtor can no longer afford to make any payments, he or she can convert the Chapter 13 bankruptcy to a Chapter 7 bankruptcy.

Unfortunately, when the payments go down it may become impossible to meet some of the debtor’s goals under the plan. In many cases the reason for choosing a Chapter 13 over a Chapter 7 is because the Chapter 13 allows a homeowner to stop a foreclosure by paying back the mortgage arrearage over a five year period. This requires the plan to pay back the entire amount of the shortage though, and while an individual will still receive his discharge after amending the plan, if there is not enough money remaining to pay-off the mortgage delinquency the foreclosure may proceed.

A similar situation can occur when the debtor was counting on paying off non-dischargeable tax debts. A Chapter 13 must pay off 100% of the non dischargeable portion of the tax liability, and while a person may be able to obtain a Chapter 7 discharge after a drop in income, if he converts he will still have to deal with the IRS after the bankruptcy is finished.

Home Mortgage Debt Forgiveness

These days approximately one quarter of the homes in America have dropped in value to levels that are less than what the home owners owe on their mortgages. This often leaves the borrower unable to keep up the payments on the loan, which in many cases leads to the loss of the residence.

And unfortunately the loss of his residence is not necessarily the end of the former home owner’s problems. If the bank forecloses on the property, because the owner cannot make the payments, the court will order the house to be sold in an auction. In many cases the auction price will be too low to pay the balance on the mortgage, and the court will enter a judgement ordering the former homeowner to pay the bank the amount of the deficiency.

In some cases for a variety of reasons mortgage companies end up accepting less than the total balance due on the home. The home owner might enter a short sale of the property in which the mortgage company agrees to accept the sales price, after expenses, even though they will end up receiving less than the total balance due on the note. The debtor might give the mortgage company a deed in lieu of foreclosure, which allows the bank to reacquire the property without going through the lengthy foreclosure, but which also cancels all debt due under the mortgage. Or the court may not enter a judgment against the homeowner for the deficiency leaving the debtor with no legal obligation to pay the funds back.

In these case however the borrower may still not be out of the woods, because Section 108 of the Internal Revenue Code provides that cancelled indebtedness is taxable income for the debtor.

With the wave of foreclosures foreclosures  created by the recent meltdown in the housing market Congress granted some relief for mortgage debt discharged through 2012, and a homeowner who meets the qualifications of the temporary law can avoid paying tax on a forgiven mortgage debt.

The first qualification is that the mortgage must be on the taxpayer’s principal residence. A debtor cannot claim this exception for investment property or for a vacation home. In addition the exception is limited to home acquisition indebtedness up to $2,000,000 (or $1,000,000 in the case of a married individual filing separately). Acquisition indebtedness includes refinancing of home acquisition indebtedness to the extent the refinanced amount does not exceed the original indebtedness.

Example


Herman Highflyer buys a house in Libertyville, Illinois for $450.000 in 2000 putting $50,000.00 down. During the next few years the house appreciates in value, and in 2005 he takes out a home equity loan for an additional $400,000. In 2010 Herman loses his job and when he is unable to pay his mortgage the bank agrees to allow a short sale in which they accept $600,000 in settlement of the outstanding note. The $200,000 debt forgiveness will not qualify for the special rule on discharge of mortgage debt, because it exceeds Herman’s acquisition indebtedness.
There are other exceptions to the cancellation of indebtedness income though, most notable bankruptcy and insolvency, and with luck Herman will qualify for one of these exceptions and will still be able to avoid adding $200,000 to his taxable income.

Does Bankruptcy Create Taxable Income

Section 108 of the Internal Revenue Code provides that as a general rule the cancellation of indebtedness creates taxable income.

Example

 Holly Hamilton has missed a number of payments on her credit card issued by the Thirteenth National Bank of Mundelein Illinois. With the higher interest rates that kick in, when one fails to make minimum credit card payments, she soon has rolled her debt up to $20,000. When the credit card company offers to settle for half this amount, Holly quickly borrows $10,000 from her mother and pays off her debt. She assumes this is the end of the matter and is quite pleased with the result. However, at the end of the year the Thirteenth National Bank sends a 1099 form to the Internal Revenue Service reporting that Holly has $10,000 of cancellation of indebtedness income, and though the bank also sends her a copy of the 1099, she does not understand the document and ignores it when she prepares her annual tax return. Later that year Holly receives a letter from the Internal Revenue Service demanding several thousand dollars of taxes and penalties.

There are however several exceptions to this general rule, and one of these exceptions is  bankruptcy.  If Holly had gone to a bankruptcy lawyer and had received a discharge of the $20,000 debt in a Chapter 7 bankruptcy she would have no tax liability on the transaction.

Another exception provides that the taxpayer will not recognize taxable income on cancellation of indebtedness to the extent he or she was insolvent at the time of the cancellation of indebtedness. A person is insolvent if immediately before the cancellation of the debt the person’s liabilities exceeded the fair market value of his property. In Holly Hamilton’s case the fact that she had to borrow the money from her mother to settle her credit card debt for fifty cents on the dollar is a strong indication that she was insolvent, and she may well be able to avoid the tax liability, even if she does not file bankruptcy.

One thing to keep in mind is that, since the bank reported the income to the Internal Revenue Service, the government will still demand the tax unless Holly claims the insolvency exception on her tax return. She does this by completing form 982 and submitting it with her 1040. Creditors should not report the taxable income to the government in the case of bankruptcy discharge; however, sometimes they do, in which case the debtor also needs to claim the exception when she files her tax return. :

Are Income Taxes Dischargeable in Bankruptcy

Individuals with financial problems frequently fall behind in paying their income taxes for a number of reasons. People, who are self employed, may be short on funds, when their estimated tax payments are due. Or if they are subject to wage withholding, they may be unable to pay any additional balance due, when they file their annual tax returns. One mistake individuals sometimes make, which compounds this problem, is withdrawing funds from retirement accounts in an effort to catch up on their late bills. Unfortunately withdrawing from retirement accounts creates taxable income, and if the debtor is under the age of fifty-nine and a half he or she will probably also be subject to a ten percent penalty for premature withdrawal.
A bankruptcy can discharge income tax liability, but there are a number of circumstances which will prevent the taxpayer from receiving a discharge, and if you owe income taxes you need to discuss the problem with your bankruptcy attorney, so he or she can properly advise you how the rules apply in your case.
The general rule is that income taxes will be discharged, if they are more than three years old provided the tax return was timely filed. The three year period is counted from the due date of the tax return.
Example: Orrin Oxford from Libertyville, Illinois decides to file a bankruptcy on April 1, 2011, and among his debts is $5,000.00 of unpaid Federal Income Taxes for the year 2007. He may assume that 2011 is four years after 2007, and he will receive a discharge for the taxes. However, the due date for his 2007 tax return was April 15, 2008, and his filing date for the bankruptcy, April 1, 2011, is less than three years later. His bankruptcy attorney will no doubt advise Orrin to postpone filing until the second half of the month, so he can obtain relief from the Internal Revenue Service along with the rest of his creditors.
The above example assumes that the debtor filed his 1040 on time. If a taxpayer fails to file a tax return, the taxes will not be discharged in bankruptcy, even if they are more than three years old. If the tax returns are filed late, the bankruptcy must occur at least two years after the taxpayer filed the return to allow a discharge.
Even if the taxpayer files taxes on a timely basis, the taxes will be nondischargeable, if fraud was involved, and the Internal Revenue Service sometimes takes an unreasonably aggressive approach in opposing the discharge on the ground of fraud. The government does not do particularly well in court, when debtors challenge such claims, but unfortunately many people in bankruptcy cannot afford to take the issue to court.