9.1 Bankruptcy Types and Discharge

9.1 Bankruptcy Types and Discharge

The AICPA REG blueprint (Area II, Group D) asks candidates to recall the types of bankruptcy and the requirements for discharge of indebtedness. Area II, Group C also asks how property is distributed in a bankruptcy proceeding. The statute is the Bankruptcy Code, Title 11 of the United States Code, as amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) — a named Blueprint reference. REG tests structure: which chapter, who may be a debtor, how a case starts, what the estate and the automatic stay do, who is paid in what order, which transfers the trustee can pull back, and which debts survive a discharge.

Indexed dollar amounts — the involuntary-petition threshold, the wage-priority cap, Chapter 13 debt limits, luxury-goods and cash-advance presumptions — are adjusted under 11 U.S.C. §104 every three years. AICPA does not treat a particular year's dollar as the tested fact. It does expect the three-versus-one creditor rule, the 90-day versus one-year preference windows, and the distribution waterfall. The Judicial Conference's April 1, 2025 adjustment (90 Fed. Reg. 8941) set the §303 unsecured-claim aggregate at $21,050; that figure will move again at the next triennial adjustment. Know that a threshold exists and is indexed. Do not build the answer around a remembered number.

The three chapters REG names

A Chapter 7 individual whose debts are primarily consumer debts must pass the means test BAPCPA added to §707(b). Current monthly income — a six-month average — is annualized and compared with the Census median for the debtor's state and household size. If income is above median, allowed IRS-standard and actual expenses are subtracted. If remaining disposable income over 60 months exceeds the Code's indexed thresholds, a presumption of abuse arises and the case may be dismissed or converted unless the debtor rebuts with special circumstances. Below-median debtors generally remain in Chapter 7. The exam tests the concept — median comparison, then a disposable-income screen — not a particular year's median table.

Voluntary versus involuntary

A voluntary case begins when the debtor files a petition. An involuntary case may be commenced only under Chapter 7 or 11, and only against a person who may be a debtor under that chapter. Farmers and nonprofit corporations are protected from involuntary petitions. Section 303 sets the petitioning-creditor structure:

• If the debtor has 12 or more qualifying creditors, three or more holders of claims that are not contingent as to liability and not the subject of a bona fide dispute as to liability or amount must join. Their unsecured claims (claims in excess of any lien on the debtor's property) must aggregate at least the statutory dollar threshold.
• If the debtor has fewer than 12 such holders — the count excludes employees, insiders, and transferees of avoidable transfers — one qualifying creditor holding unsecured claims totaling at least that same threshold may file.

A two-creditor petition against a company with 15 outside trade creditors fails even if those two are owed far more than the indexed threshold. A single creditor with a large, undisputed, unsecured claim can force Chapter 7 against a debtor who has only eight qualifying creditors.

If the alleged debtor timely contests, the court enters an order for relief only if the debtor is generally not paying undisputed debts as they become due, or if a custodian was appointed within 120 days before the petition. A petition filed in bad faith can expose the petitioners to costs, attorney's fees, and damages. The gap period between an involuntary filing and the order for relief produces the §507 gap-priority claims listed below.

Guarantors and sureties of the debtor may hold contingent claims; a claim in bona fide dispute does not count toward the petitioning total. Those relationships are developed in /study-guides/cpa-reg/debtor-creditor/suretyship-guarantors.

Automatic stay and the estate

Filing the petition — voluntary or involuntary — operates as a stay under §362 of most collection: lawsuits, foreclosures, repossessions, garnishments, and dunning. The stay is automatic; no separate injunction motion is required. Statutory exceptions include criminal prosecutions, certain tax audits and assessments, and collection of domestic support from non-estate property. A willful stay violation can yield actual damages, costs, and, in individual cases, punitive damages.

The estate under §541 is all legal and equitable interests of the debtor in property as of commencement, wherever located and by whomever held, plus certain after-acquired items (for example, inheritances, life-insurance proceeds, and property-settlement payments the debtor becomes entitled to within 180 days). Exempt property (homestead, tools, specified personal property under §522) is still estate property until the exemption is allowed; REG will not make you memorize a state's exemption table.

Secured creditors' liens generally ride through to the extent of the collateral. Article 9 attachment, perfection, and priority — covered in /study-guides/cpa-reg/debtor-creditor/ucc-article-9 — decide who is secured before the bankruptcy waterfall starts. An undersecured creditor's deficiency is a general unsecured claim.

Priority of distribution in Chapter 7

Teach the order. Caps are indexed; do not treat a wage dollar as the tested fact.

1. Secured creditors, to the extent of their collateral. Any unsecured deficiency drops to general unsecured.
2. Priority unsecured claims under §507, in rank: domestic support obligations; administrative expenses of the estate (trustee fees, postpetition goods and services needed to preserve the estate); involuntary-gap claims; wages, salaries, and commissions earned within 180 days before the filing or the cessation of business, up to an indexed cap per employee; employee-benefit-plan contributions tied to that wage period; specified grain-producer and fisherman claims; consumer deposits for undelivered purchases, up to an indexed cap; certain taxes; death or personal-injury claims caused by DUI.
3. General unsecured creditors, pro rata.
4. Equity / surplus back to the debtor, which in a true liquidation of an insolvent entity is usually nothing.

A wage claimant is not paid ahead of a perfected secured lender's collateral. A general trade creditor does not share the §507 rank of domestic support or administrative expenses. Administrative expenses of the Chapter 7 case itself outrank most prepetition unsecured claims, which is why a trustee who sells collateral may take costs of sale off the top of that collateral under the Code's secured-claim rules.

Preferential and fraudulent transfers

Preferences (§547). The trustee may avoid a transfer of an interest of the debtor in property (i) to or for the benefit of a creditor, (ii) for or on account of an antecedent debt, (iii) made while the debtor was insolvent (presumed during the 90 days before filing), (iv) made on or within 90 days before the petition, or within one year if the creditor was an insider, (v) that enables the creditor to receive more than it would in a Chapter 7 liquidation. Ordinary-course payments, contemporaneous exchanges for new value, and later new-value offsets are defenses. Paying a longtime supplier 60 days before filing on an old invoice is the classic 90-day preference. Paying an officer-shareholder 10 months before filing sits inside the one-year insider window.

Fraudulent transfers (§548, and §544 using state law). Actual fraud is a transfer made with intent to hinder, delay, or defraud creditors. Constructive fraud is a transfer for less than reasonably equivalent value while the debtor was insolvent or was left with unreasonably small capital. The Code lookback is two years; state fraudulent-transfer law, reachable through §544, is often longer. Gifting a truck to a relative for no value is a fraudulent-transfer fact pattern. Paying a genuine insider loan is a preference analysis, not a "no value" analysis, because satisfaction of a real debt is reasonably equivalent value.

Discharge and debts that survive

A discharge enjoins personal collection of discharged debts; valid liens may still be enforced against collateral. Nondischargeable debts under §523 that REG actually uses include:

• Certain taxes (recent income taxes for which a return was due within three years, many unfiled or late-filed returns, and tax debts tied to a fraudulent return).
• Debts obtained by false pretenses, false representations, or actual fraud, including certain false written financial statements.
• Domestic support obligations.
• Debts for willful and malicious injury (a negligent tort is not enough).
• Student loans generally, unless the debtor proves undue hardship — the exam's default is nondischargeable.
• Government fines, penalties, and forfeitures, and many criminal restitution obligations.
• Consumer debts for luxury goods or services incurred shortly before filing, and cash advances shortly before filing, above indexed amounts — the Code creates a presumption of nondischargeability, not an automatic dollar trivia item.

A corporate Chapter 7 debtor is not "discharged"; it is liquidated. An individual who hides assets, destroys records, or fails a §727 denial-of-discharge test loses the discharge entirely, which is a different result from a particular debt being excepted under §523.

Worked scenario: involuntary petition with two creditors

Facts. Apex Tooling, Inc. has 15 unpaid outside trade creditors (none of the 15 is an employee or insider). It is missing vendor payments and is generally not paying debts as they come due. Creditor Park holds a $40,000 undisputed unsecured claim. Creditor Quinn holds a $25,000 undisputed unsecured claim. Together they file an involuntary Chapter 7 petition. No other creditor joins. Separately, consider the same dollar claims against Lane Studio, a sole proprietor with only eight qualifying creditors.

Analysis.

1. Chapter 7 is a permitted involuntary chapter. Creditors cannot force Chapter 13, and they cannot force Chapter 7 against a farmer or a nonprofit.
2. Apex has 12 or more qualifying creditors, so three or more holders of noncontingent, undisputed unsecured claims must join. Park and Quinn are only two. Their combined dollars, even though well above the indexed §303 threshold, do not cure a missing third petitioner. The petition is defective.
3. If a third qualifying creditor joined, the aggregate unsecured claims would be measured against the current indexed threshold, and Apex's general nonpayment of debts would support an order for relief.
4. Lane Studio has fewer than 12 qualifying creditors, so one petitioner suffices. Either Park or Quinn, standing alone with an undisputed unsecured claim above the indexed threshold, could commence the case.
5. Employees and insider-shareholders, had they been in Apex's creditor list, would have been dropped from the count used to decide whether the debtor is in the 12-or-more bucket. That exclusion cannot be used to manufacture a one-creditor case if 12 outside trade creditors remain.

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