Very little in bankruptcy causes more confusion and anxiety than the Chapter 7 means test. Many people assume that the means test will automatically force them into a Chapter 13 payment plan or prevent them from filing for bankruptcy at all. Although these assumptions are not true in most cases, the confusion is understandable. The means is unnecessarily complicated and not entirely rational. Yet despite its complexity, a basic understanding of the test can maximize your chances of passing it or avoiding it altogether.
The Chapter 7 means test is a case study in unintended consequences. In theory, it requires people who can afford to pay at least part of their debts to enter into a Chapter 13 payment arrangement, rather than discharging their debts in Chapter 7. The driving force behind the enactment of means test was the banking and credit card lobby, which sold the test to Congress in 2005 as a tool to prevent bankruptcy abuse. In practice the means test does little to stop bankruptcy abuse. Instead, by setting arbitrary income caps and failing to take into account the debtor’s actual ability to pay, it forces some struggling middle-income debtors into pointless or unworkable five-year Chapter 13 plans. Often these plans are exercises in futility, paying back unsecured creditors only a nominal amount.
Certainly, some debtors with significant disposable income should be in Chapter 13. For others, such as those who are seriously behind on a mortgage or auto loan, Chapter 13 offers the option to keep their home or car. However, for many people who would be better served by Chapter 7, the means test can be a trap. Therefore, it is important to understand how the test impacts your options under the Bankruptcy Code.
The Means Test By the Numbers.
It is generally not a good idea to tackle the highly complex means test without the advice of an experienced bankruptcy attorney. However, the best way to show how the means test works is to go through the process step-by-step with examples, as we have done below.
First Step: Calculate your current monthly income. The first step in completing the means test is determining your “Current Monthly Income” or “CMI.” CMI is not the same as your actual current income or what you are making right now. Rather, it is an average of your income over a specific period of time.
To obtain your CMI, you must average your monthly gross income (your income before taxes and other deductions) for the six months prior to the month in which you will file for bankruptcy. In other words, add up all of your gross income for the previous six months and divide by six. The resulting figure is your CMI. It is important to keep in mind that in calculating your CMI, you do not include the month that you file. Thus, if you file in October, you would average your income for the months of April through September.
Seniors with SSI and individuals on SSD should note that Social Security income does not count towards your CMI and should not be include in your calculations.
Because CMI is an average, the resulting figure may be significantly more or less than your actual current income. Thus, an unemployed debtor may still have a relatively high CMI, if the unemployment was very recent. (For that reason, bankruptcy attorneys sometimes advise clients to wait to file.) Likewise, if you received little income for several of these months but now have a steady salary, your CMI may be lower than your current income.
Example: Let’s consider Jane who made $4000 per month from January through April, then lost her job and had no income in May and June. If she files for bankruptcy in July, her CMI will be based on the months from January through June (the six months prior to the month in which she filed). An easy way to visualize this is through the use of a table:
To determine her CMI, Jane would add up all the income she made in the previous six months ($16,000) and divide it by six to give her a CMI of $2667. ($16,000 / 6 = $2667)
Example 1: Bob and Mary are a husband, wife with two kids. They have a CMI of $6250 per month ($75,000 per year). If, the Pennsylvania state median income for a family of four is $6390 per month ($76,682 per year), Bob and Mary’s income falls below the median. Therefore, they could file under Chapter 7 (assuming they meet the other requirements) without taking the means test.
On the other hand, if your income is over the state median, you must take the test, unless you fall under an exception.
Example 2: Bill and Ann, a couple with no minor children, have a CMI of $5000 per month ($60,000 per year). If the Pennsylvania State Median income for a family of two is $4424.25 per month ($53,091 per year), Bill and Ann are over the median and must take the means test.
Note that not everyone with a CMI over the state median has to take the means test. Some common exceptions to the means test include active duty service with the National Guard and Reserve and debtors with primarily business debts. (We will look at these exceptions in a later post.)
Third Step: Subtract your expenses to get your “disposable income.” If you must take the means test, begin by listing your allowable expenses. The means test permits you to deduct certain standard expenses such as housing, food, clothing, medical care, transportation, etc. based upon IRS averages for your area. (As a bankruptcy lawyer with a practice covering Philadelphia, Montgomery, Delaware, Berks, and Bucks counties in Pennsylvania, I can attest that the IRS housing and transportation allowances do reflect the actual cost of living in this region.) In addition to the standard expenses, you can deduct some actual expenses, such as debt payments (primarily mortgage and auto loans), as well as taxes, and charitable donations. Your income minus these allowable expenses is your “disposable income.”
Example 1: Bill and Ann from above have a CMI of $5000 per month and allowable expenses (taxes, mortgage, car payment, etc.) of $4900. If they subtract their allowable expenses from their CMI, they will show disposable income of $100 per month.
Example 2: Bob and Mary, also from above, have a CMI of $6250 per month and allowable expenses of $5750, giving them disposable income is $500 per month.
Fourth Step: Calculate. There are three possible outcomes under the means test: (A) you pass and can file under Chapter 7; (B) you fail and must file under Chapter 13; or (C) you can file under Chapter 7, if you can jump one more hurdle pertaining to the amount of your debt.
A. Disposable income less than certain amount. If your disposable income averages less than a certain amount (currently around $117 per month or $7025 over 60 months), you may file under Chapter 7. Thus, Bill and Ann in the example above, who have disposable income of $100 per month, fall below the $117 cutoff for Chapter 7. Therefore, they can file under Chapter 7.
B. Disposable income more than a certain amount. If your disposable income is over a certain amount (currently around $195 per month or $11,725 over 60 months ), you must file under Chapter 13. In the example of Bob and Mary, their disposable income of $500 is well above the $195 cutoff for Chapter 7. Therefore, they would be required to file under Chapter 13.
C. Disposable income between set amounts. This one may make your head hurt. In cases where your disposable income is between the amounts set forth above ($117 and $195), and you could pay back at least 25% of your non-priority unsecured debts (such as credit cards or personal loans) over 60 months, you must file under Chapter 13. In other words, if your disposable income over the next 60 month is enough to pay at least 25% of your debts, you cannot file under Chapter 7.
Example 1: If Karen’s disposable income is $150, she is caught in between. Let’s assume she has unsecured debt of $30,000. If we take 25% of this debt, we get $7500. If Karen paid all of her disposable income of $150 towards those debts, at the end of 60 months Karen would have paid $9000. Because $9000 is more than 25% of her debt, she must file under Chapter 13.
Example 2: If Karen had $40,000 in debt, that same $9000 would be less that 25% of her debt ($10,000). Therefore, she could file under Chapter 7.
I hope this article helps to clear up some of the mystery surrounding the means test. In the rest of this series, I will discuss avoiding the means test, passing the means test, and special circumstances that may allow you to file under Chapter 7, even if you fail the means test.
If you would like to speak to an experienced Philadelphia bankruptcy attorney about the Chapter 7 means test or any other aspect of bankruptcy law, call Dan Mueller at 215-248-0089.