How are Creditors Paid in Bankruptcy?

Bankruptcy refers to the process in which a debtor is no longer held liable for repaying their creditors. Thus, bankruptcy is the legal procedure wherein certain debts that belong to a debtor are either discharged or refinanced. Creditors are the people or entities who have a legal right to payment from the debtor.

Obviously, when a debtor files for bankruptcy, a secured creditor will attempt to obtain repayment for their financing. Secured creditors are discussed in more detail below. When a debtor files for bankruptcy, there is an established order of priority among the creditors who are owed money by the debtor.

To put it simply, some creditors will have a right to be repaid before others, if they are paid at all. Creditors are divided into classes, with each class of creditor being paid in full before the next class is paid what is available. If there are not enough funds to pay each person included in the class in full, each class member will receive an even percentage of what they are owed.

An example of this would be how domestic support is to be paid out before employee benefits. If the debtor has $5,000 in their estate and owes $4,000 in domestic support, employees of the debtor will receive $1,000 each. Should the employees be owed more than $1,000, the $1,000 will be evenly distributed among the employees.

This system remains in place regardless of the type of bankruptcy. Meaning, this order of priority is followed whether the debtor is filing for Chapter 7 bankruptcy or Chapter 13 bankruptcy. However, exact priority can differ based on the type of bankruptcy.

Does the Priority of Distribution Apply to All Types of Bankruptcy?

To build upon what was just discussed, the priority of distribution applies to all types of bankruptcy, of which there are several. In order to better understand how creditors are paid in bankruptcy, it is helpful to discuss some of the more common types of bankruptcy and how they differ from each other.

A Chapter 7 bankruptcy is the most popular form of bankruptcy for those debtors who do not have many assets. As a form of consumer bankruptcy, it is ideal for debtors with low income and high amounts of unsecured debt. It is intended to provide a quick form of financial relief. It is known as liquidation bankruptcy, due to the fact that the debtor’s possessions and assets are sold in order to repay creditors. Most debts may be discharged under Chapter 7, although there are some exceptions.

Another common example of consumer bankruptcy would be Chapter 13. Under Chapter 13, the debtor’s debts are reorganized so that they may make more affordable payments. It is generally ideal for debtors who have higher income, as well as property that they would like to protect from creditors who may wish to levy those assets in order to be repaid. No property is liquidated.

Two other repayment chapters are Chapter 11 and Chapter 12. However, Chapter 11 is utilized by large corporations facing bankruptcy, and Chapter 12 is reserved for debtors who are farmers and/or fisherfolk.

Under Chapter 7, nonexempt property is sold and creditors are paid from the proceeds according to priority of distribution. Under Chapters 11 or 13, creditors are repaid according to their approved repayment plan. This plan must conform to the priority rules, generally established by state statute.

Why Do Some Creditors Receive Priority Over Others? Which Creditors Generally Have Priority?

The intent behind the priority of distribution is to protect the types of creditors that society collectively believes should be protected. Bankruptcy administrators are always paid out first, due to the fact that the law requires administrators in order for the bankruptcy system as a whole to function. Domestic support is protected as a priority because of the importance of protecting the families dependent on that support.

Keeping this in mind, the priority of distribution is generally as follows:

1. United States Bankruptcy Court: This is the court in which the bankruptcy is filed and the process is initiated. This court will charge filing fees;
2. Secured Creditors: These are creditors who hold a lien on some piece of property possessed by the debtor. An example of this would be mortgages on a home, or unpaid balances on vehicles. Secured creditors are always paid due to the fact that the collateral property claimed by the creditor legally belongs to the creditor, unless the debtor has paid off the loan;
3. Unsecured Creditors: In this class, no property is involved that the creditors could legally repossess. The first debt included in the class to be paid would be domestic support, such as child support or alimony. Next would be the costs of bankruptcy administration. These costs likely would include witness fees, accountant’s fees, etc. Additionally, administration costs include “one reasonable attorney’s fee,” so long as the services rendered are specifically for and directly related to the bankruptcy;
4. Employees: This includes employee wages, salaries, commissions, and benefits plans. However, employees have a payment cap, as well as a time cap. What this means is that each employee may only collect up to $11,752. And, they may only collect if the compensation was earned 180 days prior to their employer filing for bankruptcy; and
5. Government Taxes: Here, taxes include income, property, employment, and any tax the debtor is liable for in whatever capacity. However, it is important to note that each individual tax could be subject to differing time caps. An example of this would be how a property tax can only be collected if the tax was incurred one year prior to the initiation of the bankruptcy process.

Do I Need a Bankruptcy Attorney?

If you are considering filing for bankruptcy, you should consult with an experienced and local bankruptcy attorney before doing so. Although filing for bankruptcy can provide some relief and a financial clean slate, it is not without consequence. One example would be how the bankruptcy could remain on your credit report for up to ten years.

Additionally, other creditors may cancel their accounts with you when they are notified of the filing. Future creditors may refuse to work with you until the bankruptcy has been removed from your report. Bankruptcy is generally reserved as a last resort effort to resolve debt. An attorney can help determine whether there are any alternatives to bankruptcy that would be available to you.

As you can see, the bankruptcy process can quickly become quite complex, and varies from state to state. While bankruptcy is a federally-regulated process, state statutes frequently differ in terms of exemptions and filing periods. Should you choose to file for bankruptcy, it is imperative that you consult with a local attorney. They will be most knowledgeable in terms of your state’s specific statutes governing bankruptcy, and how those laws will affect your options moving forward.

A bankruptcy attorney can help you determine which chapter of bankruptcy you should file for, and will ensure all paperwork is filed by deadline. They can communicate with creditors on your behalf. Your attorney will also represent you in court as needed, and may be able to provide you with contacts for services such as credit counseling to help you repair your credit post bankruptcy.