Bankruptcy Is Divided Into Two Common Types: Liquidation vs. Rehabilitation

Bankruptcy is a legal process for individuals and businesses struggling with overwhelming debt. It provides a structured way to eliminate debts or establish a repayment plan under court supervision. The two most common types are liquidation and rehabilitation, each with distinct rules and outcomes.

Understanding these differences is essential for making informed financial decisions.

Eligibility Factors

Qualifying for bankruptcy depends on financial circumstances, income levels, and legal requirements under federal law. The U.S. Bankruptcy Code outlines criteria determining whether an individual or business can file under a particular chapter. Courts review financial records, outstanding obligations, and repayment capacity before granting approval.

Income plays a major role. For individuals, the means test compares earnings to the median income in their state. If income falls below this threshold, filing is generally allowed. Those earning above the limit must show they lack sufficient disposable income to repay debts. Businesses must submit financial statements proving insolvency, meaning liabilities exceed assets or they cannot meet obligations as they come due.

Debt limits also affect eligibility. Some bankruptcy types impose caps on secured and unsecured debts. As of 2024, individuals filing under certain chapters must have unsecured debts below $465,275 and secured debts under $1,395,875. These limits adjust periodically for inflation. Businesses face different requirements, often needing to demonstrate ongoing operations or a structured recovery plan.

Distinct Features of Liquidation

Liquidation bankruptcy, commonly filed under Chapter 7, involves selling non-exempt assets to repay creditors. A court-appointed trustee oversees the process, ensuring fair distribution of available property. Unlike other bankruptcy types, Chapter 7 does not require a repayment plan, making it the fastest route to debt discharge.

Assets subject to liquidation depend on federal and state exemption laws. Some possessions, such as primary residences, retirement accounts, and essential personal belongings, may be protected. Exemptions vary by state, with some allowing debtors to choose between federal and state exemption lists. Under federal law in 2024, individuals can shield up to $27,900 in home equity through the homestead exemption, while states like Texas offer unlimited protection for primary residences.

Unsecured creditors, such as credit card companies and medical providers, are typically paid first from liquidated assets, followed by secured creditors if collateral is insufficient to cover outstanding balances. Any remaining eligible debts are discharged, meaning the debtor is no longer legally required to pay them. However, certain obligations, including student loans (unless undue hardship is proven), child support, and most tax debts, remain enforceable.

Rehabilitation Framework

Rehabilitation bankruptcy restructures debt rather than eliminating it through asset sales, allowing individuals and businesses to retain assets while following a court-approved repayment plan.

A key component is the structured repayment plan, typically lasting three to five years. Debtors propose a schedule for allocating disposable income toward obligations. The court and creditors review this plan to ensure feasibility before granting approval. Payments go to a trustee, who distributes funds based on priority. Secured debts, such as mortgages and car loans, are prioritized, while unsecured debts may receive only partial repayment before discharge.

Upon filing, an automatic stay halts collection efforts, foreclosures, and wage garnishments, giving debtors time to reorganize finances. Certain debts may also be restructured with extended repayment periods or reduced interest rates, making long-term recovery more manageable.

Asset Management and Liabilities

Managing assets during bankruptcy requires careful planning to preserve value while complying with legal obligations. Debtors must provide a full accounting of all assets, including real estate, investments, business interests, and intellectual property. Courts scrutinize these disclosures to ensure accuracy, and failure to report assets can result in case dismissal or legal penalties under federal bankruptcy fraud statutes.

For businesses seeking debt reorganization, asset valuation is critical. Under Generally Accepted Accounting Principles (GAAP), assets should be recorded at fair market value, but bankruptcy may require impairment testing to determine if assets should be written down due to diminished economic utility. Lease obligations must also be evaluated, as restructuring may involve renegotiating terms or rejecting burdensome agreements.

Liability management is equally important. Debtors must classify obligations as secured, unsecured, priority, or contingent to determine repayment structure. Tax liabilities require special attention, as certain obligations—such as payroll taxes—cannot be discharged. Businesses may need to negotiate installment agreements with the IRS or seek Offer in Compromise settlements to resolve outstanding balances while maintaining operations.

Credit Effects

Bankruptcy affects creditworthiness, influencing borrowing capacity, interest rates, and financial opportunities. Credit reporting agencies document filings, with Chapter 7 remaining on reports for ten years and Chapter 13 for seven. Lenders consider these records when assessing risk, often leading to higher borrowing costs or loan denials.

Rebuilding credit requires strategic financial management. Secured credit cards, which require a deposit as collateral, provide a controlled way to demonstrate responsible usage. On-time payments and low credit utilization gradually improve credit scores. Some lenders offer credit-builder loans, where payments are held in a savings account until the loan is repaid, helping establish a positive payment history. Monitoring credit reports for inaccuracies is also important, as errors can further hinder recovery. Under the Fair Credit Reporting Act (FCRA), individuals can dispute incorrect information to ensure their financial records accurately reflect post-bankruptcy progress.

Selecting an Appropriate Option

Choosing between liquidation and rehabilitation depends on financial goals, asset retention priorities, and repayment ability. Those with minimal assets and overwhelming unsecured debt may find Chapter 7 more suitable, as it provides a swift resolution. In contrast, individuals or businesses with steady income and valuable assets often benefit from Chapter 13 or Chapter 11, which allow structured repayment while preserving ownership.

Legal and financial consultation is essential before making a decision. Bankruptcy attorneys assess eligibility, exemptions, and repayment plan feasibility, while financial advisors help evaluate alternative debt relief strategies, such as negotiation or consolidation. Courts also consider prior bankruptcy filings, as restrictions exist on how frequently individuals can seek relief. Those who previously filed Chapter 7 must wait eight years before filing again under the same chapter, while Chapter 13 filers face a two-year waiting period for subsequent filings.