Many Consumer Bankruptcies Do More Harm Than Good

By Stephen J. Dunn

A theme that returns to me again and again is that consumer bankruptcies do more harm than good.

In a chapter 7 bankruptcy case, the debtor’s nonexempt assets are marshaled and sold, and the proceeds net of administrative expenses are applied against the debtor’s debts.  The debtor is discharged of his or her debts.  Chapter 7 cases are also called “liquidations.”

A chapter 7 case is distinguished from a chapter 13 bankruptcy case.  In a chapter 13 case, the debtor proposes a plan to pay off a portion of his or her debts over five years.  The debtor remains in possession or his or her assets.  The debtor is discharged of debts remaining at completion of the plan.  Chapter 13 cases are also called “reorganizations.”

Bankruptcy-minded consumers generally prefer the immediate discharge of a chapter 7 liquidation to a protracted chapter 13 reorganization.

By “consumer bankruptcy” I mean a chapter 7 case for an individual.

I am not a bankruptcy lawyer.  But the case against consumer bankruptcies is compelling:

Most consumer bankruptcies are pointless.  Consumer bankruptcy petitioners want to get rid of debt.  But why not just leave the debt there?  Under the Fair Debt Collection Practices Act, a  third party debt collector must, at the request of a consumer, stop contacting the consumer about a debt.  Under the Fair Credit Reporting  Act, the placement of a consumer debt for collection, or the filing of a suit to collect such a debt, or the entry of a judgment in such a suit, can remain on the debtor’s credit report for seven years, whereas the filing of a bankruptcy case can remain on the debtor’s credit report for ten years.  Creditors rarely sue consumers over debts.  If a creditor does threaten to sue, the consumer should threaten back to assert his defenses, such as breach of contract or fraud.  The consumer can also threaten to file bankruptcy.  Chances are the creditor will back off.  If the debtor is unable to reach a satisfactory resolution of the matter with the creditor, perhaps bankruptcy will be an option.

The bankruptcy petition and schedules are signed under oath.  The debtor is subject to criminal prosecution for willfully false statements made therein.

The filing of a consumer bankruptcy case can have unexpected consequences.  For example, consumers often place low values upon property in their bankruptcy schedules, seeking to bring the property within an allowed exemption.  If the trustee thinks the value is too low, he can object to the exemption, and offer the property for sale.  If the property brings more than the exempt value claimed by the debtor, the trustee can pay the debtor and/or lenders secured by the property the exempt value claimed, and retain the balance for the bankruptcy estate.  Debtors commonly lose their house this way.

A creditor can challenge the dischargeablity of a debt.  This is called an “adversary proceeding.”  Adversary proceedings are tried to a judge sitting without a jury.  If a creditor brings an adversary proceeding and wins, the court affirmatively enters a judgment against the debtor and in favor of the creditor for the amount of the debt, and that judgment is forever nondischargeable in bankruptcy.

My son handled such an adversary proceeding for a bank.  The bank had made a loan to a company.  To induce the bank to make the loan, the president of the company had personally guaranteed the loan.  After the company defaulted on the loan, the president sought to avoid his personal guarantee by filing a chapter 7 bankruptcy case.  In its adversary proceeding, the bank proved that the president had omitted certain of his debts, including gambling debts, from the loan application. The bankruptcy court held the president’s personal guarantee nondischargeable, and entered a judgment of nearly $3,000,000 against the president and in favor the bank.  What is the president of the company doing now?  He is living outside the United States, in a country where the bank’s judgment cannot reach him.  He is paying a high price indeed for having filed a chapter 7 case.  My son, Stephen Paul Dunn, is a litigator and a shareholder at Howard & Howard, based in Royal Oak, MI.

In another case, a woman taxpayer owed a balance to the IRS.  The IRS investigated the woman’s finances, determined that she was impecunious, and closed her case as currently not collectible (“CNC”).  After awhile, the IRS retrieved her case from CNC status and assigned it to a new investigator, the first one having retired.  The new investigator researched in the register of deeds office and found a quit claim deed issued by the taxpayer to her son with respect to a house owned by the son.  The son had paid the entire purchase price of the house, but the mother had served as the son’s real estate agent in the purchase, and had the title company issue the deed to the her and the son as joint tenants.  When the son realized this, he had his mother issue a quit claim deed to him with respect to the house.  But the mother owed a substantial balance to the IRS when she issued the quit claim deed, and new IRS investigator assigned to her case asserted that the quit claim deed was a fraudulent conveyance—a conveyance without fair consideration in return.  As a result, the IRS claimed a “nominee lien” in the house for the mother’s tax liability.  What prompted the IRS to retrieve the woman’s case from CNC status and investigate her finances anew?  A chapter 7 bankruptcy case filed by the woman.

Taxes are especially problematic in bankruptcy.  Nondischargeable taxes include the following:

(1)          A tax for which a return was due but not filed.

(2)          A tax for which a return was filed after its due date and less than two days before the filing of the bankruptcy petition.

(3)          A tax with respect to which the taxpayer made a fraudulent return or willfully attempted in any manner to evade or defeat the tax.

(4)          A tax for which a return was last due, including extensions, less than three years before the filing of the bankruptcy petition.

(5)          A tax assessed less than 240 days before the filing of the bankruptcy petition.

(6)          A tax required to be collected or withheld and for which the debtor is liable in whatever capacity.

The purpose of (1), (2), and (4) is to afford the taxing authority a reasonable opportunity to collect the tax.  (3) encompasses evasion of assessment of tax, as well as evasion of collection of tax.[1] (5) requires the taxpayer to obtain and review the actual tax assessment documents from the taxing authority—assessment can occur long after a tax return is filed. (6) refers to employment and sales taxes withheld by a business but not remitted to the taxing authority.  These can be assessed against individual responsible persons at the business, and when they are assessed they are not dischargeable by such persons in bankruptcy.

Even if a tax obligation manages to run this tortuous gauntlet, if a lien for the tax arises against the debtor’s property before the filing of the bankruptcy petition, the lien survives the bankruptcy discharge.

I am not saying that bankruptcy never makes sense for a consumer.  For example, I recently submitted an offer in compromise to the IRS.  I rarely submit OICs, as they usually do more harm to the taxpayer than good (I will explain in a separate post).  But this client subsists on a fixed, limited income and is permanently disabled from working.   He is a good candidate for an OIC if there ever was one.  We carefully prepared his OIC and submitted it.  We provided the IRS with additional information they requested.  Then the IRS rejected his OIC.  The IRS failed to consider facts we had submitted, and fabricated other facts.  Meanwhile, the taxes have become dischargeable.  The client qualifies for a chapter 7 bankruptcy.  Further process is available from the IRS, including an appeal, for which the client could pay me $5,000.  Or the client could pay $2,000-$3,000 for a chapter 7 bankruptcy.  Bankruptcy is looking pretty good to the client.

Before filing a bankruptcy case, a consumer needs to determine whether it is truly in his or her best interests.   In this regard the consumer should seek the advice of legal counsel independent of that recommending the filing of a bankruptcy case.  Standing and dealing with your debts may be wiser than trying to run from them.


[1] S.J. Dunn, Evasion of Payment as Evasion of Tax Under 26 USC § 7201 and 11 USC § 523(a)(1)(c), 8 Journal of Tax Practice & Procedure 19 (2006).

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