Chapter 7 Bankruptcy: Definition & Process

Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define Chapter 7 bankruptcy. You'll learn about the filing requirements and what happens before and after you file. We'll also discuss which property you can retain and which property you must return.

What is Chapter 7 Bankruptcy?

Morgan's family has owned a pharmacy in a small town for over 50 years. After Morgan graduated from Medi's School of Pharmacy, she bought the business from her grandfather. Sales soared for the first few years under her management, until Morgan overheard a popular store was breaking ground on a huge 50,000 square foot grocery and retail operation that included a pharmacy.

Several months later, the store was built and the new pharmacy's prices were 50% cheaper than Morgan's. Soon Morgan's sales dropped, the rent on the pharmacy was past due, and suppliers were calling threatening to sue her. Just as disconcerting, Morgan couldn't pay herself a salary. The bank was in the process of taking her home and car.

Morgan met with her attorney, Kent, who informed her she needed to file bankruptcy, Chapter 7 specifically. Chapter 7 bankruptcy relieves an individual of all debt or bills.

Filing Eligibility

Kent started asking Morgan if the pharmacy was formed as a sole proprietorship or corporation. He explained a sole proprietorship means she personally owns the business, and while she can take home all of the profit, she is also held liable for all of the debt. If the pharmacy is a corporation however, it is considered a separate entity, filed with the state in which she lives, and she would not be responsible for its debt.

Morgan tells Kent that her grandfather started the business, by himself, and when she purchased the pharmacy, she did not file incorporation papers, so it is considered a sole proprietorship.

Since the pharmacy is a sole proprietorship, the business assets, property, and inventory will be sold and the monies received from the liquidation will be given to satisfy the rent, suppliers, and other expenses. According to Kent, that is the simple part. Now, they have to look at Morgan's personal responsibility.

Kent tells Morgan he reviewed and calculated her income and expenses, and it appears she doesn't have enough money to pay her bills. This analysis is called the means test. (It's important to use a calculator since different areas of the U.S. have different income requirements.) The means test essentially determines your disposable income or, how much money you have left over after you pay your expenses. Based on where you live, if your disposable income is over a certain amount, you may not be allowed to file Chapter 7 bankruptcy. However, you may be eligible for Chapter 13 bankruptcy, which is essentially a repayment plan.

Filing Process

Kent tells Morgan he will take her case and gives her an agreement to sign which shows his fees, when payments are due, and her responsibilities as well as his. After she signs the agreement, he gives her several forms to complete. The forms are very detailed and ask her to list information about all of her personal, and business, assets and expenses. The bankruptcy courts also want to know if she's sold, or given away, any assets. It's very important that all of the information is accurate and intentionally lying could result in imprisonment.

After the forms are complete, Kent files them with the bankruptcy court and the creditors are notified by mail that Morgan, the debtor, has filed Chapter 7. Once they receive notification, creditors must stop all collection activity which is called an automatic stay.

The automatic stay stops the bank from taking her home, car, and seizing inventory from the pharmacy. Suppliers and other creditors cannot call her during this time either.

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