Bankruptcy is a term that describes the situation in which debtors find themselves unable to repay what they owe to creditors. Individuals and businesses can be considered bankrupt if they are unable to pay their debts.
Definition and Examples of Bankruptcy
Bankruptcy refers to situations where a debtor cannot repay the debts they owe. For example, a business may become bankrupt if it is unable to make loan payments or pay amounts due to supplier invoices.
The IRS provides another definition of bankruptcy: “A taxpayer is bankrupt when their total liabilities exceed their total assets.” The IRS uses this definition to determine whether canceled debts should be reported as income on your taxes. Thus, if you owe $100,000 in credit card debt, but you have negative net worth, you may likely be considered bankrupt under the IRS definition.
Different things can cause a person or business entity to become bankrupt. There are various ways to deal with it as well, including reaching repayment agreements with creditors or, in the worst cases, filing for bankruptcy.
How Bankruptcy Works
Bankruptcy is not a process in itself. Instead, there are different factors that can lead to a person, company, or other entity becoming bankrupt.
Here is an example. You might decide to start a food truck business. You obtain a startup loan of $100,000 to purchase a truck, equipment, supplies, and other necessary items.
The initial plan is to use your savings to pay off the loan installments until the business starts generating profits. But after a year, you are still not making a profit and can no longer pay the loan, nor can you pay the other bills needed to keep the business running. At this point, the business can be considered bankrupt.
Legally, there are some federal laws that define bankruptcy. Under the Uniform Commercial Code, for example, a business is considered bankrupt if:
- It has stopped regularly paying debts in the ordinary course of business, except for genuine disputes.
- It is unable to pay debts when they are due.
- It meets the definition of bankruptcy under federal bankruptcy law.
It is worth noting that bankruptcy is a financial condition, while bankruptcy is a legal procedure that allows debtors to reach a resolution with creditors.
In addition to businesses or individuals, governments can also become bankrupt. The Greek debt crisis is an example of a governmental system that faced bankruptcy in recent years. The crisis was triggered by the country’s inability to pay the debts owed to the European Union. Thanks to the restructuring of loan agreements, default was avoided, which would have threatened the financial stability of the entire Eurozone.
Types of Bankruptcy
There are various ways to measure bankruptcy. First, balanced bankruptcy is examined to see whether assets exceed liabilities. If you have more debts than assets, you are typically considered bankrupt according to the balance sheet rule.
This type of bankruptcy can be used in bankruptcy proceedings to determine whether a person or company has assets that can be liquidated and used to pay creditors. The court uses fair value to assess the value of assets.
Financial bankruptcy tests the ability to repay the debts owed. This is also referred to as “solvency.” This test looks ahead to see whether the person or company is likely to have sufficient liquidity in the future to fulfill their obligations.
It is important to understand that a company or person may meet one bankruptcy test definition but not another. For example, it is possible in the previous food truck example to have more debts than assets, making you bankrupt according to the balance sheet rule. However, if you are still able to pay current bills, you may not be considered bankrupt in terms of financial liquidity.
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In Chapter 7 bankruptcy, debts are discharged or eliminated, while filings for Chapter 11 and Chapter 13 bankruptcy allow for debt restructuring and repayment over time.
Key Takeaways
Bankruptcy is a term used to describe a situation in which an individual or company finds itself unable to repay their debts. The Internal Revenue Service provides a distinct definition of bankruptcy to determine when debt forgiveness should be included in taxable income. Bankruptcy can occur for various reasons, including poor business management and financial situations beyond your control. There are different types of bankruptcy tests that can be used to assess the financial condition of an individual or a company. Bankruptcy can precede the filing of a bankruptcy petition, although they are two separate matters.
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Sources:
Internal Revenue Service. “What If I Am Insolvent?” Accessed June 29, 2021.
Source: https://www.thebalancemoney.com/what-is-insolvency-5190931
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