With the new bankruptcy law effective October 17, 2005, there is a lot of confusion regarding the new “means test” requirement. Courts use the means test 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 by the new rules.
When most people think of bankruptcy, they think in terms of Chapter 7, where unsecured debts are typically discharged in full. Bankruptcy of any kind is a difficult ordeal at the best of times, but at least with Chapter 7, a debtor was able to fully discharge their debts and start fresh. Chapter 13, however, is another story, as the debtor must pay off a significant portion of the debt over a period of 3 to 5 years, with 5 years being the standard under the new law.
Before 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 prevent loss of value in their home or other property. And while wealth protection will continue to be a big reason people choose Chapter 13 over Chapter 7, the new rules will force many people to file Chapter 13 even if they do NOT have assets. That’s because the means test will take into account the debtor’s income level.
To apply the means test, the courts 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 worker in California is $42,012. If income is below the median, then Chapter 7 remains open as an option. If income exceeds the median, the remaining parts of the means test come into play.
This is where it gets a little more complicated. The next step in the calculation takes the income, minus the living expenses (excluding payments on debts included in the bankruptcy), and multiplies that figure by 60. This represents the amount of disposable income over a 5-year period for the payment of debt obligations. .
If the income available to pay off the debt during that 5-year period is $10,000 or more, then Chapter 13 will be required. In other words, anyone earning above the state average, and with at least $166.67 per month of disposable income, you will automatically be denied Chapter 7. So, for example, if the court determines that you have $200 per month of income in excess of support expenses, $200 times 60 is $12,000. Since $12,000 is above $10,000, you are stuck in Chapter 13.
What if you are above the median income but do NOT have at least $166.67 per month to pay your debts? Then the final part of the means test is applied. If disposable income is less than $100 per month, then Chapter 7 becomes an option again. If disposable income is between $100 and $166.66, then it is measured against 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 monthly disposable income. We take $125 for 60 months (5 years), which is $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 disposable income would exceed 25% of your debt and you would be required to file under Chapter 13.
To summarize, first find out if 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 consider your spouse’s income if you are a two-income family. Next, subtract your average monthly living expenses from your monthly income and multiply by 60. If the result is more than $10,000, you’ll stay in Chapter 13. If the result is less than $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 are surely watching Chapter 13.
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 for 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 collecting taxes.
A big problem here for most consumers is that their household budgets won’t reflect the harsh reality of the IRS-approved numbers. So even if you think you’re “safe” and can file Chapter 7 because you don’t have $100 a month to spare, the court may rule otherwise and still force you to accept Chapter 13. Some of your actual expenses may not be allowed.
What remains to be seen is how the courts will handle cases in which the cost of mortgages or home rents are inflated well above government schedules. Will debtors be expected to move to cheaper housing to meet the court-required schedule for living expenses? No one has answers to these questions yet. It will be up to the courts to interpret the new law in practice as cases move through the system.
