Updated May 12, 2016
If you file for Chapter 7 bankruptcy, the law of your state will determine whether you can keep the money from a lawsuit—but be prepared to give it up unless your state exemption law specifically says that you can keep the award. In this article, you’ll learn when you can keep your lawsuit proceeds in a Chapter 7 bankruptcy and when you might be better off exploring other options.
If you qualify to file for Chapter 7 bankruptcy, you can get rid of your nonpriority, unsecured debt, such as credit card balances, personal loans, and medical bills. You also don’t have to give up all of your property. You’re allowed to “exempt,” or keep, the property your state determines you’ll need to work and live, such as household furnishings, clothing, and an inexpensive car. Thanks to state exemption laws, most people who file for Chapter 7 bankruptcy give up little, or no, property—as long as they don’t own much in the way of valuable assets. (Learn more about how exemptions work.)
If you own something of value—such as a lawsuit award—and your state considers it “nonexempt” property (property that you aren’t allowed to keep) you might find yourself in a pickle. The bankruptcy trustee—the person assigned to manage your bankruptcy case—will sell your nonexempt property and distribute the sale proceeds to your unsecured creditors. If find out that you'll lose certain property after you file for bankruptcy, t’s unlikely that the court will let you out of the case. So, if you’re expecting to recover money from a lawsuit, or if you already have, it is important to find out whether your state will allow you to keep the money before proceeding with a Chapter 7 bankruptcy.
As soon as you file, everything you own is transferred to the bankruptcy court and is maintained by the trustee in a “bankruptcy estate” for the benefit of your creditors. In other words,you automatically lose ownership of all of your property, including a prior or future lawsuit award.
This rule doesn’t mean that you lose all of your property, however. You can reclaim the property your state allows you to exempt by doing two things: First, you must list all of your assets on official bankruptcy form Schedule A/B: Property. Because exempting property is not automatic, however, that’s not enough. You must also list the exempt property on Schedule C: The Property You Claim as Exempt. If you don’t list it on Schedule C, you stand to lose it.
The exemption status of typical lawsuits, such as personal injury suits for automobile accidents, slip and fall accidents, dog bites, employment, malpractice, or products liability cases, is different in each state. To find out about your state's exemption laws, visit our State Bankruptcy Exemptions topic page.
States that exempt lawsuit proceeds usually limit an exemption to personal injury cases (a lawsuit that you filed to recover money after you were injured due to someone else's carelessness). Of those states, some states exempt all settlement and judgment proceeds while others exempt only funds necessary for the support of the debtor and family. For example, if you receive a $500,000 settlement, some states will allow you to keep the entire amount while others will determine how much you and your family need to live. If you need $100,000, the bankruptcy trustee receives the remaining $400,000. Other states do not allow for any personal injury lawsuit exemption whatsoever.
Many states allow you to keep money from a wrongful death action, particularly if you depended on the deceased for support and you need the money for your current support.
If your award is not too large and no other exemption applies, you might be able to keep it by using what is called a “wildcard” exemption. A wildcard exemption usually allows you to exempt any property up to a designated dollar amount. So, for example, if you receive a lawsuit settlement of $5,000, and your state has a wildcard exemption of $8,000, you could use the wildcard to keep your lawsuit award. Not all states have a wildcard exemption, and for those that do, the amounts vary widely.
If you live in one of the states that allow you to choose between state and federal exemptions (Alaska, Arkansas, Connecticut, District of Columbia, Hawaii, Kentucky, Massachusetts, Michigan, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Texas, Vermont, Washington, and Wisconsin), and you choose to use the federal exemptions, here’s what you can keep:
A large settlement might prove more problematic, however, since any asset over and above the amount allowed by your state’s exemption list must be turned over to the bankruptcy trustee to liquidate and distribute to your creditors on a pro rata basis. In that case, you’d likely be better off staying away from bankruptcy altogether. For instance, it might make more financial sense to negotiate with your creditors directly rather than file for bankruptcy protection.
Example. Assume that you receive a settlement of $100,000 and that you owe your creditors $100,000. If you reach a deal with each of your creditors to cut your debt in half, the result would be that you would keep $50,000. If this is more than the amount you’d end up with if you filed bankruptcy, it may be the better route to take.
Understand, however, that you must pay income tax on forgiven debt. Additionally, if you settle a substantial amount of debt, you might be pushed into a higher tax bracket and taxes are rarely dischargeable (wiped out) in bankruptcy. If you are (or might be) the recipient of a lawsuit award, you should consult with an attorney who can advise you of your options.
When you file for bankruptcy, you must list all of your property on your bankruptcy papers that you file with the court, including awards from potential lawsuits not yet filed, proceeds that you’ve already received, or that you might get in the future. If you don’t disclose a potential or pending lawsuit, you could run into trouble in your bankruptcy.
When you fill out your petition and schedules, you’ll sign a form called the Declaration About an Individual Debtor’s Schedules that makes clear that if you commit fraud, you face up to $250,000, imprisonment for up to 20 years, or both. By signing it, you affirm that you read the warning and declare under penalty of perjury that everything in your completed bankruptcy paperwork is true and correct. (To learn more, see What Happens If I Fail to List Pending Lawsuits in My Bankruptcy Papers?)