Friday, August 12, 2011

Chapter 7 Bankruptcy, Taxes, and the IRS: The Means Test

In this post, I will cover one of the more complicated aspects of a Chapter 7 bankruptcy in general and its application to tax debt. 

What is the Means Test?

The “means test” was an addition to the bankruptcy code in 2005 designed to prevent abuse of bankruptcy by debtors who could afford to pay their debts in full.  This test marks a major attitude shift in bankruptcy philosophy.  Prior to 2005, there was a presumption that consumer debtors were entitled to relief under Chapter 7; the presumption now is that they are not.  If the debtor flunks this test, there is a presumption of abuse.  I believe that the law hurts debtors more than it helps them.  The amendment is mostly a benefit for large consumer lenders (e.g. – credit card companies).
If the debtor cannot pass the means test, his Chapter 7 petition may be dismissed, or the case can be converted to a filing under Chapter 11 or 13, if the debtor consents.  

The Three Steps to the Means Test

  1. Median Income Test: The means test requires the court to look at your average monthly income.  This average income is then compared to the median income for a family of the same size in your state.  If your income does not exceed the median Income, you will automatically pass the means test.  However, if  your average income exceeds the median income, then other parts of the means test must be applied.  Nationally, fewer than 20% of all debtors earn more than the median income. 

  1. Disposable Income Test: The next part of the test is take the your “current monthly income" and subtract living expenses (please be aware that calculating the “current monthly income” and “necessary living expenses” can be a complicated process if you have many sources of income and expenses; you should contact an attorney if this is the case).  This new number (let’s call this new number the “trigger number”) is then multiplied by 60 (the number of months in a 5 year period of time).  This trigger number is what the law considers the amount of money you have as income available for repaying debt obligations. 
If the trigger number is less than $6,000 (monthly income minus expenses is less than $100), you pass the test.  If it is greater than $10,000 (monthly income minus expenses greater than $166.67), you fail the test.  If the trigger number is between $6,000 and $10,000, then you apply the next test (another one!?)

  1. 25 Percent Test: So, you are above the state median income and your trigger number is between $6,000 and $10,000.  What now?  Now you need to look at the total amount of your debt.  If your trigger number is less than 25% of your debt, you pass this last test; naturally, if it is greater than 25%, you fail.  
Example: If your trigger number is $9,000 ($150 per month), you will pass the means test if your debt is over $36,000 (since $9k/$36k equal 25%).  The following chart gives examples of the application of this test.

CMI less Expenses
"Trigger" Number (x 60)
Pass Means Test?
Less than $100
Less than $6,000
Pass Means Test
Pass Means Test if debt $24,000 or less
Pass Means Test if debt $30,000 or less
Pass Means Test if debt $36,000 or less
More than $166.67
More than $10,000
Fail Means Test

For simplicity, Nolo has a calculator that you can use to make this entire explanation unnecessary.  

Do you have questions about this topic? Email or call me for a free consultation and we can discuss your situation. (760) 990-1632.

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