Most people wouldn’t benefit from filing for Chapter 7 bankruptcy after receiving a large lawsuit settlement because, well, bankruptcy is for people who are bankrupt. Even so, it’s possible to keep a smaller award or a lawsuit settlement needed for your support.

Your state exemption law determines whether you can protect the money from a lawsuit award or settlement. If it’s not covered by an exemption, you’ll have to give it up.

In this article, you’ll learn more about what can happen to lawsuit settlements in Chapter 7 bankruptcy and when you might be better off exploring other options.

How Chapter 7 Works

If you qualify for a Chapter 7 discharge, you can get rid of your nonpriority, unsecured debt. Some of the debt types most commonly erased include:

• credit card balances
• personal loans
• medical bills
• gym memberships
• amounts owed from rental or lease contracts, and
• home and car loan balances (as long as you return the house or vehicle serving as collateral to the lender).

Find out more about debts that get discharged in Chapter 7 bankruptcy.

Your Property in Chapter 7 Bankruptcy

Thanks to state exemption laws, most people who file for Chapter 7 give up little or no property. Property that most states will allow you to exempt include:

• household furnishings and clothing
• your retirement account
• some business tools and equipment
• an amount of equity in a home, and
• an inexpensive car.

Nonexempt property is a different matter. You’ll turn over the property you can’t exempt to the bankruptcy trustee assigned to administer your case. The trustee will sell the nonexempt property and distribute the sale proceeds to your unsecured creditors.

Disclosing Lawsuit Settlement Proceeds in Chapter 7

If you own something of value—such as a lawsuit award—and your state considers it nonexempt property you’ll lose it in Chapter 7. It’s important to know what will happen to your property before you file. If you don’t find out that you’ll lose an asset until you file for bankruptcy, it’s unlikely the court will let you out of the case.

Here’s how it works.

• You’ll list all of your property on official bankruptcy forms.
• When you file, your property will get transferred to the bankruptcy estate.
• You’ll get to keep anything you exempted properly in your bankruptcy paperwork (more below).

Keep in mind that it’s not a good idea to “forget” about an asset. When you fill out your bankruptcy paperwork, you’ll sign a form declaring that your disclosures are true and correct.

If you don’t list the lawsuit settlement, the court might believe you’re attempting to hide it and view it as bankruptcy fraud. And the consequences of bankruptcy fraud are steep—you’ll face up to $250,000, imprisonment for up to 20 years, or both.

Exempting a Lawsuit Settlement in Chapter 7

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.

• Personal injury lawsuits. States that exempt lawsuit settlement proceeds usually limit the exemption to personal injury cases (a lawsuit filed to recover money for an injury received due to someone else's carelessness). Of those states, some states exempt all lawsuit 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. Some states don’t have a personal injury lawsuit exemption.
• Wrongful death actions. Many states allow you to keep money from a wrongful death action if you depended on the deceased for support and you need the money for your current support.
• Wildcard exemption. If your award isn’t too large and no other exemption applies, you might be able to keep it by using what is called a wildcard exemption that usually allows you to exempt any property up to a designated dollar amount. For instance, 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.

Federal Bankruptcy Exemptions for Lawsuit Awards

Some states allow you to choose between state and federal exemptions—and using the federal exemption scheme might be a better bet. People who live in one of these places will have that choice:

• 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
• Wisconsin

You can find the current exemption limits in Federal Bankruptcy Exemptions.

Reasons to Talk With a Bankruptcy Lawyer

If you receive a large lawsuit settlement, you might be able to exempt it, but you might not. If you’re unsure, the best way to find out is by speaking with a local bankruptcy attorney.

A bankruptcy lawyer can review your financial situation and help you decide whether it makes more sense to:

• file for bankruptcy
• pay off your debt in full, or
• negotiate with your creditors to pay less than what you owe.

For instance, a lawyer or accountant can explain the requirement to pay income tax on forgiven debt, and that settling a substantial amount of debt for less than what you owe might push you into a higher tax bracket, leaving you with a significant tax bill.

Because taxes are rarely dischargeable in bankruptcy, if you end up filing for bankruptcy later, you could find yourself stuck with tax debt.