If you have been considering filing for bankruptcy, you’ve probably heard about the “means test,” a requirement for filing Chapter 7 Bankruptcy in US courts.
Bankruptcy, by definition, depends on not having enough money to pay off one’s debts, let alone money to save or spend. Therefore it is a function of total net income, disposable income, and discretionary income, such that the total of one’s bills is greater than their disposable income, the amount that they receive in paychecks after tax withholding. If the remaining amount, the discretionary income, is zero or negative then you are, in fact, bankrupt.
The means test, specified by the Bankruptcy Protection Act of 2005, is an added eligibility requirement to file for bankruptcy, introduced by the Bush administration to make it more difficult for higher-income households to declare bankruptcy and have their debts discharged. Previously, the only requirement was to have negative discretionary income, i.e., more bills than earnings, especially when these bills are related to servicing debts such as mortgage and credit cards.
For anyone making less than their state’s median income, the means test is very simple: you are assumed to be automatically eligible to file for Chapter 7. However, there is a catch here – your bankruptcy trustee can still order a more in-depth means test if they have reason to suspect that you have enough discretionary income to pay some or all of your creditors in a Chapter 13 bankruptcy.
If you make more than your state’s median income, you must then complete form 122A, a nine-page breakdown of your income, debts, and spending to determine whether you are eligible for Chapter 7 (liquidation) or Chapter 13 (reorganization of debts), or perhaps both, in which case your financial adviser and bankruptcy lawyer can help you select which is optimal.
This more detailed means test uses IRS national standard estimates (not your actual spending) to determine how much you should be spending on food, clothing, health care, housing, utilities and transportation. In certain cases, other actual expenses such as education, insurance and donations to church or charity will also be allowed.
If the remaining discretionary income for the past five years is negative, or under $7700, you have passed the means test and are eligible to file for Chapter 7 bankruptcy. If it is over $12850, or over $7700 with a relatively small amount of debt, this situation is called “presumption of abuse,” which is a rather harsh way of saying that there is enough money remaining to pay at least some of the debt back.
Even in this situation, which often still constitutes significant financial hardship (remember, this is just $200 per month in money to spend on anything other than bills), Chapter 13 bankruptcy, which improves the terms of your debt and may result in the discharge of some delinquent debts, is still an option.
Regardless of the outcome of the means test, a financial advisor can still make your situation better, whether through filing for bankruptcy, credit counseling, debt consolidation and renegotiation, or downsizing and improved budgeting.