CPA REG: Bankruptcy Law - Chapters 7, 11, and 13

Bankruptcy Law for the CPA REG Exam

Federal bankruptcy law, codified in Title 11 of the United States Code, provides a legal framework for debtors to obtain relief from their debts and for the orderly distribution of assets to creditors. The REG exam tests the basic requirements and procedures of the three most commonly used chapters: Chapter 7 (liquidation), Chapter 11 (reorganization), and Chapter 13 (individual debt adjustment).

Voluntary and Involuntary Petitions

A voluntary petition may be filed by virtually any debtor under any chapter. An involuntary petition may be filed only under Chapter 7 or Chapter 11. For an involuntary petition, if the debtor has 12 or more creditors, the petition must be filed by three or more creditors whose unsecured claims aggregate at least a specified amount (adjusted periodically). If the debtor has fewer than 12 creditors, a single creditor meeting the threshold may file.

The filing of a petition creates an automatic stay under Section 362, which immediately halts virtually all collection actions, lawsuits, foreclosures, and repossessions against the debtor or the debtor's property. The automatic stay is one of the most powerful protections in bankruptcy and is frequently tested.

The Bankruptcy Estate

The filing of a petition creates a bankruptcy estate under Section 541, which includes all legal and equitable interests of the debtor in property as of the filing date. This includes real and personal property, tangible and intangible property, and causes of action. Certain property acquired after filing may also be included, such as inheritances, property settlements, and life insurance proceeds received within 180 days of filing.

Exempt property is excluded from the estate and retained by the debtor. Federal exemptions include a homestead exemption, motor vehicle exemption, household goods exemption, and a wildcard exemption. Many states have their own exemption schemes, and some states require debtors to use state exemptions rather than federal exemptions.

Chapter 7: Liquidation

Chapter 7 involves the liquidation of the debtor's nonexempt assets by a trustee, with the proceeds distributed to creditors according to priority. After distribution, the debtor receives a discharge of most remaining debts. Individuals must pass the means test to qualify for Chapter 7; if the debtor's income exceeds the state median and they have sufficient disposable income to fund a Chapter 13 plan, the case may be dismissed or converted.

Priority of distribution under Section 507 follows a specific order: secured creditors are paid from their collateral first, then unsecured claims are paid in order of priority. The order includes domestic support obligations, administrative expenses of the estate, gap claims (in involuntary cases), employee wages (up to a specified limit per employee, earned within 180 days before filing), employee benefit plan contributions, claims of grain farmers and fishermen, consumer deposits, tax claims, and claims based on commitment to maintain capital of an insured depository institution.

Non-Dischargeable Debts

Certain debts survive bankruptcy and are not discharged under Chapter 7. These include most tax debts (for returns due within three years of filing or assessed within 240 days), student loans (unless the debtor demonstrates undue hardship), debts for fraud, embezzlement, or larceny, domestic support obligations, debts for willful and malicious injury, government fines and penalties, debts arising from DUI injuries, and debts not listed in the bankruptcy schedules. The debtor may also be denied a discharge entirely for concealing assets, destroying records, making false statements, or failing to explain loss of assets.

Chapter 11: Reorganization

Chapter 11 allows businesses (and individuals with substantial debt) to reorganize while continuing operations. The debtor typically remains in possession as a debtor-in-possession (DIP) with the powers of a trustee. The debtor proposes a plan of reorganization that must be accepted by creditors and confirmed by the court.

A plan divides claims into classes and specifies the treatment of each class. For confirmation, each impaired class must accept the plan (by holders of at least two-thirds in amount and more than one-half in number of allowed claims), or the plan may be confirmed over objection through the "cramdown" provision if it is fair and equitable and does not discriminate unfairly. The plan must also be feasible, meaning the debtor is not likely to need further reorganization.

Chapter 13: Individual Debt Adjustment

Chapter 13 is available only to individuals with regular income whose unsecured debts and secured debts each fall below specified thresholds. The debtor proposes a repayment plan, typically lasting three to five years. The debtor retains all property but must commit all projected disposable income to the plan. The plan must pay priority claims in full and must provide secured creditors with at least the value of their collateral.

Chapter 13 offers broader discharge than Chapter 7, potentially discharging some debts that are nondischargeable in Chapter 7. However, domestic support obligations, certain tax debts, student loans, and debts for DUI injuries remain nondischargeable. A debtor may receive a Chapter 13 discharge even if they received a Chapter 7 discharge within the preceding four years.

Exam Strategy

• Know the distinction between voluntary and involuntary petitions
• The automatic stay halts nearly all collection activity upon filing
• Memorize the priority of distribution order for Chapter 7
• Understand which debts are nondischargeable in Chapter 7 versus Chapter 13
• Chapter 11 requires creditor acceptance or cramdown for plan confirmation
• Chapter 13 requires commitment of disposable income for three to five years