The New Bankruptcy Law Means Test Explained in Plain English
With the new bankruptcy law in effect
as of October 17, 2005, there is a lot of confusion
with regard to the new "means test" requirement. The
means test will be used by the courts to determine
eligibility for Chapter 7 or Chapter 13 bankruptcy.
The purpose of this article is to explain in plain
language how the means test works, so that consumers
can get a better idea of how they will be affected
under the new rules.
When most people think of bankruptcy,
they think in terms of Chapter 7, where the unsecured
debts are normally discharged in full. Bankruptcy
of any variety is a difficult ordeal at best, but
at least with Chapter 7, a debtor can wipe out the
debts in full and get a fresh start. Chapter 13, however,
is another story, since the debtor must pay back a
significant portion of the debt over a 3-5 year period,
with 5 years being the standard under the new law.
Prior to the advent of the "Bankruptcy
Abuse Prevention and Consumer Protection Act of 2005,"
the most common reason for someone to file under Chapter
13 was to avoid the loss of equity in their home or
other property. And while equity protection will continue
to be a big reason for people to choose Chapter 13
over Chapter 7, the new rules will force many people
to file under Chapter 13 even if they have NO equity.
That's because the means test will take into account
the debtor's income level.
To apply the means test, the courts
will look at the debtor's average income for the 6
months prior to filing and compare it to the median
income for that state. For example, the median annual
income for a single wage-earner in California is $42,012.
If the income is below the median, then Chapter 7
remains open as an option. If the income exceeds the
median, the remaining parts of the means test will
be applied.
This is where it gets a little bit trickier.
The next step in the calculation takes income less
living expenses (excluding payments on the debts included
in the bankruptcy), and multiplies that figure times
60. This represents the amount of income available
over a 5-year period for repayment of the debt obligations.
If the income available for debt repayment
over that 5-year period is $10,000 or more, then Chapter
13 will be required. In other words, anyone earning
above the state median, and with at least $166.67
per month of available income, will automatically
be denied Chapter 7. So for example, if the court
determines that you have $200 per month income above
living expenses, $200 times 60 is $12,000. Since $12,000
is above $10,000, you're stuck with Chapter 13.
What happens if you are above the median
income but do NOT have at least $166.67 per month
to pay toward your debts? Then the final part of the
means test is applied. If the available income is
less than $100 per month, then Chapter 7 again becomes
an option. If the available income is between $100
and $166.66, then it is measured against the debt
as a percentage, with 25% being the benchmark.
In other words, let's say your income
is above the median, your debt is $50,000, and you
only have $125 of available monthly income. We take
$125 times 60 months (5 years), which equals $7,500
total. Since $7,500 is less than 25% of your $50,000
debt, Chapter 7 is still a possible option for you.
If your debt was only $25,000, then your $7,500 of
available income would exceed 25% of your debt and
you would be required to file under Chapter 13.
To sum up, first figure out whether
you are above or below the median income for your
state (median income figures are available at http://www.new-bankruptcy-law-info.com).
Be sure to account for your spouse's income if you
are a two-income family. Next, deduct your average
monthly living expenses from your monthly income and
multiply by 60. If the result is above $10,000, you're
stuck with Chapter 13. If the result is below $6,000,
you may still be able to file Chapter 7. If the result
is between $6,000 and $10,000, compare it to 25% of
your debt. Above 25%, you're looking at Chapter 13
for sure.
Now, in these examples, I have ignored
a very important aspect of the new bankruptcy law.
As stated above, the amount of monthly income available
toward debt repayment is determined by subtracting
living expenses from income. However, the figures
used by the court for living expenses are NOT your
actual documented living expenses, but rather the
schedules used by the IRS in the collection of taxes.
A big problem here for most consumers is that their
household budgets will not reflect the harsh reality
of the IRS approved numbers. So even if you think
you are "safe," and will be able to file Chapter 7
because you don't have $100 per month to spare, the
court may rule otherwise and still force you into
Chapter 13. Some of your actual expenses may be disallowed.
What remains to be seen is how the courts will handle
cases where the cost of mortgages or home rentals
are inflated well above the government schedules.
Will debtors be expected to move into cheaper housing
to meet the court's required schedule for living expenses?
No one has any answers to these questions yet. It
will be up to the courts to interpret the new law
in practice as cases proceed through the system.
Charles J. Phelan has been helping consumers
become debt-free without bankruptcy since 1997. A
former senior executive with one of the nation's largest
debt settlement firms, he is the author of the Debt
Elimination Success Seminar, a five-hour audio-CD
course that teaches consumers how to choose between
debt program options based on their financial situation.
The course focuses on comprehensive instruction in
do-it-yourself debt negotiation & settlement designed
to save $1,000s. Personal coaching and follow-up support
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