Altneratives to bankruptcy

Here at Shenwick & Associates, we keep a close eye on the news related to bankruptcy, and one news story that caught our eye was about the recent drop in bankruptcy filings. In New York and New Jersey, bankruptcy filings were down by 5 percent from May 2011 to June 2011.

Although filing for Chapter 7 or Chapter 13 bankruptcy is usually the best solution for our clients, there are two alternatives to bankruptcy for debtors:

1. Do nothing. Although this isn’t really a viable solution, it’s a path commonly taken by debtors who think that inaction and time will make their debt magically disappear. In actuality, what will likely happen is that the creditor will commence an action against the debtor in civil court. If the action is not answered, a default judgment will be entered against the debtor. In New York State, a judgment is valid for 10 years (which can be renewed once for another 10 years), and can be enforced against a judgment debtor’s income and assets.

2. An out–of–court workout with the creditor. An out–of–court workout is a voluntary or consensual negotiation with the creditor to reduce the amount of debt the debtor owes to the creditor. In our experience, the biggest discounts can be gained by agreeing to pay the creditor a lump sum, rather than making monthly payments over a year to 18 months. The agreement between the creditor and the debtor should always be memorialized in writing, and should always provide fixed terms for payments (i.e. twelve payments of $500 made each month by the debtor to the creditor), rather than requiring payments in perpetuity from the debtor to the creditor.

There are a number of pros and cons to attempting an out–of–court workout:

Pros:

• The debtor can save the legal fees in filing a bankruptcy petition (which could range from $2,000-$4,000) and the Bankruptcy Court filing fees ($299 for a Chapter 7 case).

• A workout may be a less negative factor on the debtor’s credit report and lower their FICO score less than filing for bankruptcy would.

• A workout provides psychological relief to the debtor in not filing for bankruptcy and lessens the “embarrassment or failure” factor.

Cons:

• Bankruptcy provides a solution for all of a debtor’s creditors, but in an out–of–court workout, each creditor has to be negotiated with individually-what if an agreement can’t be reached with all creditors?

• Who will do the negotiating with the creditor-the debtor, a CPA or an attorney? (CPAs and attorneys will charge a fee for this work)

• It takes substantial time and effort to draft, review and revise and file the documents needed to expedite a workout: a settlement agreement, a release, a satisfaction of judgment and a stipulation of settlement or stipulation of discontinuance of the action (if the creditor has commenced litigation).

• Under § 108 of the Internal Revenue Code, debt relief is considered income and is taxable. This is “phantom income,” for which the creditor will have to file a Form 1099-R with taxing authorities. For example, if a debtor owes $10,000, and reaches an out–of–court workout with a creditor for $4,000. The $6,000 difference between the original debt and the settlement is taxable debt relief income, which must be included in the Debtor’s tax return for the year in question.

To discuss the best strategies for dealing with your personal and business debt and to avoid judgments that will encumber your income and assets, please contact Jim Shenwick.