Understanding Bankruptcy Reorganization Plans

Two bankruptcy systems exist to help individuals and businesses with overwhelming debt. The first—Chapter 7 liquidation bankruptcy—is for those who don't have money to pay creditors. The second system provides a way for individuals and businesses with some disposable income—but not enough—to restructure their debt in a manageable way. A reorganization plan is, in essence, the budget that a bankruptcy filer (debtor) proposes to pay creditors.

The Four Reorganization Bankruptcy Chapters

Debtors choose to reorganize under either Chapter 9, 11, 12, or 13, depending on the particular circumstances. An overview of each appears according to filing frequency.

Chapter 13: Individuals and Couples

This chapter allows single and married people (but not businesses, other than sole proprietors) to pay discretionary income (the amount remaining after paying living expenses) into a plan for three to five years.

If your family income is above the average for your state (called the median income), your plan will be 60 months long. When income falls below the median, 36 payments are required, but you can propose a plan that spreads out what you need to pay over 60 months, if necessary. (Your state's median income is on the U.S. Trustee website—click on Means Testing Information.)

How Debts Get Paid During the Plan Period

Bankruptcy law assigns a higher priority to some debts and requires the filer to pay them fully over the course of a three- to five-year plan. Examples of priority claims include the following:

• recent income tax debts
• past due child support and alimony payments, and
• overdue payments on secured debts like house notes (you don't have to pay off the entire mortgage within the plan, however).

Most of your other debts—like credit cards and medical bills—will fall into the category of general unsecured debts and won't necessarily be paid anything. They'll receive something only if you have disposable income after all your higher priority claims get paid. Even then, the unsecured claims might be paid pennies on the dollar. The remaining debt gets discharged at the end of the case.

Using the Plan to Make a Secured Debt More Affordable

Another interesting feature of a Chapter 13 plan is its ability to cram down (reduce) a secured debt (other than the mortgage on your residence or a recently purchased vehicle—more below). If the collateral (the property securing the debt) is worth less than what you owe, you can propose to pay just the value of the asset plus interest at one or two points above prime. For high-interest loans that are under water, this can save you thousands of dollars.

Unfortunately, not all secured loans are subject to cram down. It's not available for the mortgage on your residence or on car loans that are less than two and one-half years old when you file your case. Also, you must be able to pay off the entire cram down amount over the course of the plan, something many people aren't able to do for high-value property, such as vacation rentals.

Although you can't cram down your home mortgage, you can use a Chapter 13 plan to strip off a junior mortgage if your property value has dropped so far that it's no longer enough to cover your primary mortgage. (This was commonly used during the housing crisis; however, its availability is limited due to rising property values.)

(If you'd like more information, read An Overview of Chapter 13 Bankruptcy.)

Chapter 11: Businesses and Individuals

Chapter 11 bankruptcy is best known for helping prevent large corporations from closing their doors. Because of the expense involved in filing a Chapter 11 case, it's used by small businesses to a lesser extent, and, on a rare occasion, by individuals whose debt balances exceed the Chapter 13 debt limitations.

In many Chapter 11 cases, creditors actively work with the debtor to evaluate the debtor's financial health and determine the best way to tackle the debtor's debt. This collaboration will include more than renegotiating loan terms, although that accounts for an important part of the plan.

During the first months of a Chapter 11 case, the parties look carefully at many aspects of the business. Decisions might be made to do one or more of the following:

• change leadership
• sell underperforming assets, or
• reorganize operations to make them more efficient.

The debtor then proposes a plan for paying its debts. A Chapter 11 plan must be approved not only by the bankruptcy court but by the creditors owed the most money. If a debtor fails to propose a confirmable plan, a creditor (or the trustee, if one has been appointed), can offer a plan that will be submitted to the creditor body for a vote. Once a plan is confirmed, the debtor can spend years carrying out its terms.

(For more details, start by reading Chapter 11 Bankruptcy: An Overview.)

Chapter 12: Farms and Fishing Operations

If your primary business is farming or fishing, you'll likely choose to file for Chapter 12 bankruptcy. The procedural aspects of Chapter 12 and Chapter 13 cases are similar; however, Chapter 12 bankruptcy provides more flexibility because it allows for the seasonal nature of the farming and fishing industries.

The Chapter 12 debtor has 90 days after filing the case to propose a plan lasting from three to five years. Instead of making monthly payments as required by Chapter 13 bankruptcy, the Chapter 12 plan can allow for seasonal payments. The plan can also provide for a cram down of virtually any secured debt, including homes and farmland, and allow for the modified secured debt payments to extend beyond the five-year plan limit.

(Learn more in Chapter 12 Bankruptcy for Farmers & Fishermen.)

Chapter 9: Municipalities

Chapter 9 bankruptcy is reserved exclusively for municipalities and governmental units like utilities and taxing districts. The plan and the plan approval process in Chapter 9 bankruptcy are similar to Chapter 11 bankruptcy. Creditors in Chapter 9 are not allowed to propose a plan, but taxpayers and creditors can file a plan objection.

(If you'd like additional information, read Chapter 9 - Bankruptcy Basics on the U.S. Court's website.)