What Is Insolvency Law: Chapters, Discharge, and Exemptions

Insolvency law is the body of federal and state rules that governs what happens when a person or business can no longer pay their debts. In the United States, it runs primarily through the Bankruptcy Code (Title 11 of the U.S. Code), which gives debtors a structured path to either wipe out qualifying debts or reorganize them into a manageable repayment plan. At the same time, it protects creditors by making sure whatever money or property is available gets divided fairly rather than grabbed by whoever moves fastest.

The Two Kinds of Insolvency

Insolvency shows up in two forms, and the difference affects which legal tools make sense.

Cash-flow insolvency means you have assets on paper but cannot convert them to cash quickly enough to pay bills as they come due. A small business that owns $500,000 in real estate but cannot cover next Friday’s payroll is cash-flow insolvent. This kind of problem is sometimes temporary and can be resolved through refinancing, asset sales, or negotiated extensions without ever filing anything in court.

Balance-sheet insolvency is the deeper problem: your total debts exceed the total value of everything you own. Even selling every asset at full market price would leave you owing money. The IRS uses this same definition when deciding whether you qualify for certain tax exclusions on forgiven debt — your liabilities must exceed the fair market value of your assets immediately before the discharge.¹

What the Law Is Trying to Do

The Bankruptcy Code pursues two goals that pull against each other. The first is a genuine fresh start for honest debtors. The U.S. Courts put it directly: “One of the primary purposes of bankruptcy is to discharge certain debts to give an honest individual debtor a ‘fresh start.'”² Once a debt is discharged, the debtor has no further personal liability for it, and creditors are permanently barred from trying to collect.

The second goal is treating creditors fairly. Without a legal framework, whichever creditor filed the first lawsuit or seized property the fastest would recover the most and everyone else would get nothing. Insolvency law replaces that race with a collective process, with a strict order of priority and proportional sharing within each class.³

The Automatic Stay

The most powerful protection in bankruptcy law takes effect the moment you file a petition: the automatic stay. It is a court-imposed freeze that immediately stops lawsuits, foreclosures, garnishments, repossessions, and virtually all collection activity against you and your property, including collection phone calls.⁴⁵ Creditors who violate it can face sanctions from the bankruptcy court.

The stay is not permanent. It lasts until the case closes, the case is dismissed, or the court grants a creditor’s motion to lift it — for example, a secured lender wanting to foreclose on a car or house where the debtor has stopped paying. If you had a prior case dismissed within the past year, the stay may be limited to 30 days unless you convince the court to extend it.

The Main Chapters of Bankruptcy

The Bankruptcy Code offers several chapters, each built for a different financial situation. The chapter you file under determines whether you keep your property, how long the process takes, and what you owe when it ends.

Chapter 7: Liquidation

Chapter 7 is the most common form of individual bankruptcy and the fastest. A court-appointed trustee collects any non-exempt property you own, sells it, and distributes the proceeds to creditors. In exchange, most of your remaining debts are wiped out through a discharge order, typically issued 60 to 90 days after the first meeting of creditors.²

Here is the part that surprises most people: the vast majority of individual Chapter 7 cases are “no asset” cases. The debtor’s property is either exempt or already subject to valid liens, so there is nothing left for the trustee to distribute. The debtor walks away with their protected property and a discharge. More than 99 percent of individual Chapter 7 debtors receive a discharge.²

Not everyone qualifies. Chapter 7 uses a means test that compares your recent income to the median income for a household of your size in your state. If your income is below the median, you pass automatically. If it is above, a second calculation looks at whether you have enough disposable income to fund a Chapter 13 plan instead. Only individuals can receive a Chapter 7 discharge; corporations and partnerships can liquidate under Chapter 7 but do not get a discharge of their debts.⁶

Chapter 13: Repayment Plan for Individuals

Chapter 13 lets individuals with regular income keep their property and repay debts over three to five years under a court-approved plan.⁷ This is the route people take when they earn too much to pass the Chapter 7 means test, or when they want to save a home from foreclosure by catching up on missed mortgage payments through the plan. At the end of the plan, remaining qualifying unsecured debts are discharged. Eligibility requires that your debts stay below periodically adjusted caps for secured and unsecured debt.

Chapter 11: Business Reorganization

Chapter 11 is designed primarily for businesses that want to keep operating while restructuring their debts. The debtor usually stays in control as a “debtor in possession” and proposes a reorganization plan to pay creditors over time.⁸ Individuals whose debts exceed the Chapter 13 limits can also file under Chapter 11.⁹

Traditional Chapter 11 is expensive and complex. Congress created Subchapter V as a streamlined version for small businesses. To qualify, the business’s debts must not exceed $3,024,725, with at least half arising from business activity, and the business cannot be publicly traded.¹⁰

How Creditors Get Paid

When there is money to distribute, bankruptcy law follows a strict order. Secured creditors — mortgage lenders, car loan holders, anyone with collateral — generally get paid first from the value of that collateral. Everything else runs through the priority system for unsecured claims.

The Bankruptcy Code ranks unsecured claims in this order:¹¹

Domestic support obligations such as child support and alimony.
Administrative expenses of running the bankruptcy case, including trustee fees and professional fees.
Involuntary case gap claims incurred in the ordinary course of business between an involuntary petition and the court’s order for relief.
Employee wages, up to a statutory cap per person, for wages earned within 180 days before filing.
Employee benefit plan contributions, subject to limits.
Certain federal and state tax obligations.

Within each level, creditors share proportionally based on the size of their claims. A creditor owed $10,000 gets twice as much as one owed $5,000, but neither can jump ahead of a higher-priority class.³ General unsecured creditors — credit card companies, medical providers, personal loan lenders — sit below all priority claims and often receive pennies on the dollar, if anything at all.

Debts That Survive a Discharge

Bankruptcy does not erase every obligation. Several categories of debt remain fully enforceable after a discharge, including:¹²

Most tax debts, including recent income taxes, taxes where no return was filed, and taxes involving fraud.
Domestic support obligations. Child support and alimony cannot be discharged under any chapter.
Student loans, unless you prove “undue hardship” in a separate court proceeding, which is a notoriously difficult standard.
Debts obtained by fraud, false pretenses, or false representations.
Debts for willful and malicious injury to a person or property.
Debts for death or personal injury caused by driving under the influence.
Criminal fines and restitution.
Debts you failed to list in your paperwork, if the omission prevented the creditor from participating.

People sometimes file expecting to eliminate a specific debt only to find it falls into one of these categories. Student loans and tax debts are the most common surprises.

Property You Can Keep

Filing bankruptcy does not mean losing everything. The Bankruptcy Code lets individual debtors exempt certain property from the bankruptcy estate, putting it out of reach of the trustee and creditors.² The federal exemptions cover equity in a primary residence, a motor vehicle, household goods, jewelry, tools of your trade, and a wildcard amount you can apply to any property.

Most states have enacted their own exemption schemes, and many require you to use the state exemptions instead of the federal ones. Homestead protection varies dramatically: some states cap it at modest amounts, and a handful allow unlimited homestead protection. Which exemptions apply to you depends on where you have lived for the past two years. In most individual Chapter 7 cases, the debtor’s property is entirely exempt, which is why the trustee files a “no asset” report.

What It Takes to File

Federal law imposes prerequisites designed to make sure bankruptcy is actually necessary and that the debtor understands the consequences.

Every individual debtor must complete a credit counseling course from a government-approved agency within 180 days before filing. The counselor reviews your finances and considers whether alternatives such as a debt management plan might work. You must file a certificate proving you completed it; without it, the court will dismiss your case.¹³

After filing, individual debtors must complete a separate personal financial management course before receiving a discharge. Skipping it means you will not get your debts wiped out, no matter how smoothly the rest of the case goes.¹³

Court filing fees for individual cases run roughly $300 to $340 depending on the chapter. Attorney fees for a straightforward Chapter 7 case typically range from $800 to $3,000 depending on complexity and local market. Chapter 13 and Chapter 11 cases cost more because they last longer and involve ongoing filings. Courts can allow individuals to pay the filing fee in installments.

Tax Treatment of Forgiven Debt

This part catches people off guard. When a creditor forgives or writes off a debt outside of bankruptcy, the IRS generally treats the forgiven amount as taxable income. A lender who cancels $20,000 you owed will send you a 1099-C, and the IRS expects that $20,000 on your return.

Insolvency law provides two important exceptions. Debt discharged in a bankruptcy case is completely excluded from gross income, with no dollar limit.¹⁴ And even outside of formal bankruptcy, if you were insolvent when the debt was forgiven, you can exclude the forgiven amount up to the extent of your insolvency.¹ If your liabilities exceeded your assets by $15,000 and a creditor forgave $20,000, you can exclude $15,000 and must report the remaining $5,000 as income.

To claim either exclusion, you file IRS Form 982 with your tax return.¹⁵ The trade-off is that excluding discharged debt from income generally requires you to reduce certain tax attributes such as net operating loss carryovers, credit carryovers, and the cost basis of your property. The exclusion saves you from a tax bill now but can increase future taxes when you sell those assets. Additional exclusions exist for qualified farm debt and qualified real property business debt.¹⁴

1
Internal Revenue Service. What if I Am Insolvent?
2
United States Courts. Chapter 7 Bankruptcy Basics
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Office of the Law Revision Counsel. 11 U.S. Code 726 – Distribution of Property of the Estate
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United States Courts. Automatic Stay
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Office of the Law Revision Counsel. 11 USC 362 – Automatic Stay
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Office of the Law Revision Counsel. 11 U.S. Code 727 – Discharge
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United States Courts. Chapter 13 Bankruptcy Basics
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United States Courts. Chapter 11 Bankruptcy Basics
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Internal Revenue Service. Chapter 11 Bankruptcy – Reorganization
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U.S. Trustee Program. Subchapter V
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Office of the Law Revision Counsel. 11 U.S. Code 507 – Priorities
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Office of the Law Revision Counsel. 11 U.S. Code 523 – Exceptions to Discharge
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U.S. Trustee Program. Credit Counseling and Debtor Education Information
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Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
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Internal Revenue Service. About Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)