A new chapter in bankruptcy reform.

The number of people filing for bankruptcy relief has more than quadrupled since 1981, with over 1.35 million filings in 1997. With this dramatic increase in individuals seeking relief, it is increasingly likely that some of a CPA's clients will need to consider this option. These clients frequently look to their CPAs as the first line of advice on the process. Although CPAs ultimately will refer them to a bankruptcy attorney, it is imperative they know the fundamentals of the present bankruptcy system as well as changes being considered in Congress.

BANKRUPTCY SYSTEM OVERVIEW

The bankruptcy system has drawn widespread criticism. Credit associations believe the current laws make it too easy to file for bankruptcy. Others blame lenders for extending credit recklessly. Most agree the system needs reform. With this in mind, Congress created the National Bankruptcy Review Commission (NBRC) to study bankruptcy law and recommend improvements. In October 1997 the NBRC submitted its final report which contained 172 recommendations. Although not intended to spur radical changes, they had some controversial aspects.

The NBRC report induced Congress to give bankruptcy reform high priority in 1998. The House passed its bankruptcy reform bill (HR 3150) on June 10, 1998; the Senate followed not long after, passing its version (S 1301) on September 23. The two bills had a number of differences that a conference committee addressed, issuing a compromise bill. The House passed this final reform bill on October 9, but the session ran out of time and the bill stalled in the Senate. However, the apparent agreement between Congress and the Clinton administration on the need for bankruptcy reform makes it probable the legislation will pass this year.

The bills considered in the last Congress adopted many of the NBRC recommendations, but went much further in protecting creditor claims. To counsel clients properly, CPAs need to grasp the fundamental provisions of this legislation, with particular emphasis on consumer bankruptcy, small business and tax recommendations. Clients affected by these areas are the most likely to seek a CPA's advice.

The provision that will have the biggest impact on individual consumers is the means-testing that will determine whether an individual is eligible to file for bankruptcy under Chapter 7, which grants an immediate discharge of most debts. The proposed means-testing legislation would require debtors with income levels sufficient to repay part of their unsecured debts to file under Chapter 13--which says debtors must repay their debts over a three- to five-year period. Other significant consumer changes include revisions to property exemptions, new rules on credit card fraud and restrictions on debts that can be discharged under Chapter 13.

Proposed rules for small businesses reorganizing under a Chapter 11 bankruptcy would increase reporting requirements, heighten supervision, shorten deadlines and apply to all businesses with unsecured debts of $5 million or less. Other tax-related proposals may influence a taxpayer's decision on whether to file for bankruptcy to gain protection from the IRS.

Since bankruptcy reform is probable this year, CPAs should review the proposed rule changes carefully with financially distressed clients, as they may have a major impact on the timing of bankruptcy filings. Certain debtors may prefer to accelerate filings to avoid the rule changes, while others may elect to delay filing until the changes take effect.

CHAPTER BY CHAPTER

There are three principal chapters of bankruptcy law--Chapters 7, 11 and 13. Chapter 7 allows a discharge of debts and a fresh start for debtors who cannot turn their finances around. Chapter 11 provides for a business reorganization to let troubled business debtors develop viable recovery plans. Chapter 13 lets wage earners develop a recovery plan without discharging all debts. Individuals may file under any of the three chapters; businesses are allowed to file only under Chapters 7 and 11.

Chapter 7. The primary goal of Chapter 7 is to provide debtors with a fresh start by discharging their debts. This is justified by several arguments:

* Without a second chance, some debtors might turn to crime or even suicide because of extreme financial pressures.

* The threat of bankruptcy losses discourages merchants from letting consumers become overextended.

* Bankruptcy rules provide an orderly approach to financial problems, so creditors operate within a defined system.

Individuals may seek Chapter 7 relief every six full years. The typical Chapter 7 bankruptcy begins when a distressed debtor contacts an attorney. Assuming the attorney and debtor agree Chapter 7 is the best course of action, the attorney prepares and files a petition with the bankruptcy court listing all of the debtor's debts. The court appoints a trustee and the clerk of the bankruptcy court notifies all creditors of the Chapter 7 filing. An automatic stay rule immediately halts all collection efforts. After being notified, creditors must each file a claim with the trustee in bankruptcy indicating how much they are owed and whether the claim is secured or has priority over other claimants, based on an order of priority for unsecured claims established by the Bankruptcy Code. Claims such as trustee administrative costs, tax obligations and child support have preference over general unsecured claims. The trustee acquires the debtor's nonexempt assets and distributes them under bankruptcy priority claim rules.

Debtors who file for Chapter 7 relief are allowed to keep some property--called exempt property--and still obtain a discharge of their debts. The Bankruptcy Code's approach to property exemptions is one of the most heavily criticized areas of bankruptcy law. Although bankruptcy is under federal law, states can define the property exemptions for bankruptcies declared within their boundaries. The Bankruptcy Code supplies a list of uniform federal property exemptions, but states can opt out and develop their own. In those states, debtors must use the state-specified exemptions. In states that have not opted out--so-called debtor's choice states--debtors can choose between the federal property exemptions and any exemptions specified by their states.

Property exemptions vary widely. Most states have a homestead exemption that protects the individual's residence as well as an exemption for personal property. The exemption size is extremely important to both debtors and creditors. From the debtor's perspective, very broad exemptions make Chapter 7 attractive. Even individuals with slight financial problems may find bankruptcy hard to resist if they can keep significant property and still receive full discharge of their debts. Broad exemptions are disastrous for creditors because they can seize less property and debtors have less incentive to overcome their problems with better budgeting.

A majority of states have their own exemptions, and the approaches are widely divergent. Federal law suggests a $15,000 homestead exemption, but current state exemptions range from a low of $5,000 in Alabama to an unlimited amount in Florida and Texas. The huge Texas and Florida exemptions typically outrage creditors, which view them as de facto Swiss bank accounts, keeping money beyond the reach of valid creditors. Other state exemptions on items such as horses--Virginia allowed a debtor to keep a $640,000 racehorse under an exemption for horses used in agriculture--have encouraged debtors to purchase things in schemes to keep additional wealth. Debtors with similar economic situations are treated differently depending on the state of residence. The disparity in exemption levels between states sometimes leads to forum shopping and prebankruptcy exemption planning. For example, debtors in low exemption states might use a large portion of their remaining assets to buy a home in a state with an unlimited homestead exemption before filing for bankruptcy. Critics of the present system say a uniform property exemption used by every state would make bankruptcy laws more equitable.

Once the bankruptcy trustee determines the applicable property exemptions, he or she assembles the debtor's nonexempt property to pay off creditors. The trustee has the power to set aside both preferential payments to favored creditors and fraudulent conveyances that are tantamount to hiding assets. For example, assets transfers to relatives or friends immediately before bankruptcy may be voided if the transfer takes place within one year before the debtor files for bankruptcy. The trustee also can seize any inheritances the debtor becomes entitled to receive within 180 days after filing for bankruptcy.

Some debts cannot be discharged in bankruptcy and remain a debtor's binding obligation even if the court grants a bankruptcy discharge. Nondischargeable debts include alimony and child support, government fines, most student loans, judgments involving driving under the influence of alcohol, claims based on fraud or malicious activities and some tax obligations.

Chapter 11. Businesses seeking bankruptcy protection can choose between Chapter 7 liquidation and reorganization under Chapter 11, which is designed to protect viable businesses facing temporary financial problems. If creditors threaten to seize key assets, a business can file a Chapter 11 petition to stop them and buy time; after filing a petition, the business has 120 days to prepare a reorganization plan, which typically requires it to repay part of its debt and discharges the remainder. Before the bankruptcy court approves the plan, a hearing must be held during which creditor input is allowed. The court has the power to convert the bankruptcy to Chapter 7 if there is no hope of salvaging the business.

Chapter 13. Chapter 13 protects financially distressed debtors by allowing them to set up a court-supervised repayment plan. Debtors frequently are given more time to pay their debts or a discharge of certain ones. The emphasis is on repaying as much debt as possible while allowing the debtor to retain some income. The debtor is not given a complete discharge of debts as in Chapter 7. Repayment plans generally must be completed within three years but may be extended to five years with cause. Priority creditors are entitled to full payment, and the bankruptcy court must confirm the debtor's proposed repayment plan.

Surprisingly, debtors may prefer Chapter 13 to Chapter 7 despite having to repay a greater percentage of their debts. Chapter 13 is generally less complicated, since most debts are not discharged and the debtor gets to retain his or her assets rather than appointing a trustee. Chapter 13 also costs less since there is no need to appoint a trustee to administer the estate. The stigma of a Chapter 13 bankruptcy is also much less severe than Chapter 7. More important, debtors may be able to retain more property under Chapter 13. Whether a debtor can do this depends on the Chapter 7 property exemptions, the amounts of which vary greatly. States with smaller exemptions provide incentives for debtors to use Chapter 13; states with larger exemptions provide incentives for Chapter 7. The uniform property exemptions proposed by the NBRC would have a big impact on whether debtors choose Chapter 7 or Chapter 13.

PROPOSED LEGISLATION

The bankruptcy bills passed by the House and Senate in 1998 include many NBRC recommendations as well as some pro-creditor provisions. While the two bills have not yet been finalized, all parties in the process indicate they will be used as the foundation for bankruptcy legislation that is likely to be passed this year.

Consumer bankruptcy. The most significant change recommended by the House and Senate is means testing to determine whether debtors are eligible to file under Chapter 7. Under both bills, debtors with sufficient income to repay a percentage of their unsecured debts would not receive the full discharge formerly available under Chapter 7 and would be required to pay part of their debts under a Chapter 13 repayment plan. The means-testing rules are intended to prevent individual debtors from evading their debts.

The two bills use different means tests to determine when a debtor is ineligible for Chapter 7. Under the House bill, a debtor making more than the national median income for the same size household who can repay 20% of his or her unsecured debt over a five-year period would not be eligible for Chapter 7. The Senate bill allows a Chapter 7 case to be converted to a Chapter 13 case if the debtor can repay at least 20% of unsecured debts.

The primary difference between the, two approaches is their implementation. Under HR 3150, the bankruptcy trustee is required to file a report on each debtor's eligibility to file under Chapter 7. S 1301 does not require a report and converts to chapter 13 only if an interested party challenges a debtor's eligibility for Chapter 7. Both approaches differ considerably from the current system, which does not erect any significant barriers to Chapter 7 relief.

Property exemptions also will change. The NBRC report recommended uniform federal exemptions. Both bills change the property exemptions allowed in bankruptcy, although not as much as the NBRC suggested. The Senate bill puts a $100,000 cap on the homestead exemption and prevents any state from providing an unlimited exemption. The House bill does not change the amount of property exemptions but requires a debtor to live in a home for at least one year before becoming eligible for the state's homestead exemption. (Under current law, debtors can use a state's exemption if they reside in the state for at least 91 days before a bankruptcy filing.) The House bill also treats as nonexempt exempt property (such as a home) obtained with the proceeds of nonexempt property sold within one year of bankruptcy. These bills make it more difficult for debtors to shelter wealth.

Other changes in the House and Senate bills may have a significant impact on consumer bankruptcy. Both bills presume that credit card debt incurred 90 days prior to bankruptcy is fraudulent. Other proposed changes include random audits of debtor's repayment schedules, limits on repeat bankruptcy filings and new rules on reaffirmation agreements--agreements to pay a debt otherwise dischargeable in bankruptcy.

Business bankruptcy. The NBRC and Congress concluded that the current Chapter 11 business bankruptcy rules are working well in general. Despite this finding, they suggested changes in a number of areas, including partnership bankruptcy, mass tort damage claims, transnational bankruptcy and small business bankruptcies. This small business proposal was motivated by a widespread belief that Chapter 1 l does not work well for small businesses. The current system has a number of problems, most notably

* Smaller businesses with no real likelihood of rehabilitation frequently use Chapter 13 to obtain the immediate benefit of the automatic stay, while the owners retain control of the business.

* Smaller businesses do not have the proper level of supervision, resulting in debtor abuse of the system.

* Creditors have a high level of indifference to small business bankruptcies.

* Chapter 11 is not successful in getting small business cases confirmed (approved by the bankruptcy court).

To address these problems, the NBRC recommended special procedures for small business bankruptcy cases that would increase reporting requirements, heighten supervision and shorten other deadlines.

The House bill adopts most of the NBRC's small business recommendations, which apply to all businesses with unsecured debts of $5 million or less. A business meeting that definition would have increased reporting requirements, such as filing a balance sheet, a statement of operations, a cash flow statement and the most recent tax return within three days of filing for bankruptcy. Small business debtors would be subject to heightened supervision, with new rules permitting on-site inspection by the bankruptcy trustee of the business premises, books and records. In addition, small businesses would have only 10 days to establish separate deposit and tax accounts and would be limited to 30 days to file all schedules and statements of financial affairs with the bankruptcy court. The rule changes are designed to make Chapter 11 bankruptcy less hospitable for small businesses. Small businesses doomed to failure would move more quickly to liquidation under Chapter 7. This unfriendly attitude is reflected in the rule disallowing small businesses automatic protection from creditors the second time they file for bankruptcy within a two-year period.

Tax-related recommendations. The House bill adopts most of the NBRC's tax-related recommendations. However, several provisions included in HR 3150 contradict the NBKC. One of the most significant alters the types of tax liabilities that can be discharged under Chapter 13, eliminating a debtor's ability to discharge taxes from years in which he or she did not file a return and taxes due from fraudulent returns--referred to as the superdischarge of Chapter 13. This proposal may provide an incentive for debtors to forgo Chapter 13 and instead file under Chapter 7. Another proposal specifies the IRS is entitled to interest on tax claims at the fixed federal deficiency rate under IRC section 6621 (a)(2).

Other notable tax recommendations include

* Debts incurred to pay for nondischargeable federal taxes no longer would be dischargeable.

* Income tax returns prepared by the IRS would not be considered filed income tax returns for purposes of the Bankruptcy Code.

* Bankruptcy trustees and Chapter 11 debtors in possession of their indebted property would have to pay tax obligations in the course of the debtor's business.

ANOTHER RECORD YEAR

Bankruptcy statistics compiled for the first three quarters of 1998 indicated that last year was on its way to setting another record for the number of bankruptcies filed. According to Samuel J. Gerdano, executive director of the American Bankruptcy Institute, this "ensures that Congress will continue to take a hard look at the Bankruptcy Code." Congress appears motivated to act on a reform package early this year. With significant changes imminent, it is imperative that CPAs keep up with the developments in Washington that will have an impact on how both businesses and individuals use bankruptcy protection. Businesses interested in influencing the likely congressional reforms in this area still have some time left to lobby their representatives for favorable changes before the legislation is finalized later this year.

RELATED ARTICLE: EXECUTIVE SUMMARY

* AS THE NUMBER OF BANKRUPTCY FILINGS grows, CPAs are likely to find an increasing number of clients involved in the process. To provide timely advice, CPAs should be familiar with the current bankruptcy system as well as reforms being considered by Congress.

* CONGRESS CREATED THE NATIONAL BANKRUPTCY Review Commission to recommend improvements to the bankruptcy system. Many of the consumer, small business and tax recommendations in the commission's October 1997 report were included in bankruptcy reform bills passed by the House and Senate last year. Since no final bill was approved by both houses, bankruptcy reform is high on the congressional agenda for this year.

* INDIVIDUALS CAN FILE FOR BANKRUPTCY under Chapters 7, 11 or 13. Businesses are allowed to file only under Chapters 7 and 11. New uniform property exemptions proposed by the NBRC will have a big impact on whether debtors choose Chapter 7 or Chapter 13 bankruptcies.

* THE REFORM BILLS PASSED BY THE HOUSE and Senate in 1998 include a number of changes, the most significant of which is means testing to determine whether a debtor is eligible to file under Chapter 7. Debtors with sufficient income to repay a certain percentage of their unsecured debts cannot use Chapter 7 but must, instead, file under Chapter 13.

* OTHER SIGNIFICANT CONSUMER BANKRUPTCY changes include a crackdown on fraud that presumes credit card debt incurred within 90 days of a filing is fraudulent, random audits of debtors' repayment schedules and limits on repeat filings.

RANDALL K. HANSON, JD, LLM, is professor of business law at the University of North Carolina at Wilmington.

JAMES K. SMITH, CPA, PhD, JD, LLM, is assistant professor of accounting at the University of North Carolina at Wilmington.