Posted On August 31, 2022
What Is the Difference Between Bankruptcy and Insolvency?

What Is the Difference Between Bankruptcy and Insolvency?

People who are struggling to meet their financial obligations every month may find themselves asking, “What is the difference between bankruptcy and insolvency?” Although the two terms are frequently used interchangeably to describe someone in financial distress, they are not the same. While a person who is in bankruptcy is insolvent, someone who is insolvent is not necessarily in bankruptcy. 

In 2021 around 400,000 people filed for bankruptcy in the United States with only one state coming ahead of Nevada with the most filings. That number does not reflect the number of people who found themselves to be in an insolvent state. 

The Difference Between Bankruptcy and Insolvency

Insolvency describes a consumer’s financial state when his or her debts add up to more than the person’s assets. Bankruptcy, on the other hand, is a legal process that is often used to resolve a consumer’s poor financial state. 

A debtor can only be considered in bankruptcy once that person has filed a petition with the bankruptcy court, it has been accepted, and it is given a case number. Proving insolvency to the court is a part of the bankruptcy proceedings. When a person or company is in bankruptcy, it means that the courts are helping to straighten out how the insolvent debtor will handle unpaid debts, including which creditors (if any) will receive payment and which ones will not.  

Bankruptcy is just one of the tools that can be used to remedy insolvency. For instance, a company may restructure its pay scale among higher-paid employees, reduce staff, or find other ways to cut expenses and costs. These tactics may allow the company to get out of insolvency without filing for bankruptcy. An individual may also be able to get out of insolvency without entering into bankruptcy by working more hours, taking on an additional source of income, or scaling back costs to put more towards payments on what the person owes. 

Types of Insolvency

Two types of insolvency are recognized across the United States. They are Balance Sheet Insolvency and Cash Flow Insolvency. To determine whether a debtor meets the definition of insolvency, and the type of insolvency the person or business meets, various tests are performed. 

Balance Sheet Insolvency

Balance Sheet Insolvency occurs when a company or an individual’s assets are worth less than the debtor’s liabilities. To make this determination, the debtor’s inflow, outflow, and assets are evaluated. Assets are assessed at a current “fair market” value. The term “fair market value” defines the price that a buyer would purchase the property for from the seller. This term is heavily debated. This is part of the reason why insolvency is so difficult to define. 

If the balance sheet test reveals that the debtor’s outflow is more than the inflow, and debts are worth more than assets, then a condition called “negative net assets” is identified, and the debtor is declared to be insolvent. Even if the company or person were able to liquidate the assets back into cash, the debtor would not have enough money to pay all of what is owed, so restructuring without filing bankruptcy is most likely not an option. If assets can be sold to resolve the debt, however, bankruptcy may not be necessary.

Cash Flow Insolvency

The cash Flow Insolvency test is also referred to as the ability to pay test. This test looks at a company or individual’s ability to pay debts or bills when they become due. In most cases, cash flow insolvency occurs when consumers or businesses have exhausted other means of resolving their debt, like taking out loans or selling possessions. When people run out of assets to sell and can no longer take loans to make their payments, and their income is not enough to cover their monthly obligations, they are likely in cash flow insolvency.  

Some instances of cash flow insolvency are temporary. If you are expecting a large sum of money soon, like an inheritance distribution, for instance, you may be able to rearrange your monthly payments until you receive the income. Taking the cash flow insolvency test can help determine whether to investigate debt settlement options or file bankruptcy. 

Using one of these tests can help companies and individuals see their financial status and determine what steps need to be taken to become financially stable again. The tests can also assist in proving insolvency if bankruptcy needs to be filed. 

Types of Bankruptcy in Nevada

Various types of bankruptcy exist in Nevada, and each has its own eligibility requirements, benefits, and drawbacks. When individuals are insolvent, they might consider filing Chapter 7 or Chapter 13 bankruptcy. Businesses that are struggling financially, however, usually file Chapter 11 bankruptcy. One exception to this is if the company is small and the owner is also filing for personal bankruptcy.  

The major difference between a Chapter 13 and Chapter 7 bankruptcy is the ability of the debtor to pay back a portion of the debts owed over time. Some other differences include:

  • The time frame that it will take to conclude the bankruptcy. Chapter 7 is usually completed in less than a year. Chapter 13 takes between three and five years, depending on the repayment schedule.
  • A Chapter 13 bankruptcy includes a structured repayment schedule that can allow a debtor to continue making payments on some or all of the debts that are owed.
  • Chapter 7 bankruptcy may involve the liquidation of assets or property repossession. 
  • A trustee is assigned to a Chapter 13 filing to keep the funds collected and disburse them to creditors that have filed a proof of claim for the monies owed to them. 

Benefits of Filing Bankruptcy When You Are Insolvent

No matter what chapter is filed, creditors cannot try to collect on the debt while the debtor is in bankruptcy status. When the bankruptcy is over, then creditors cannot attempt to collect on debts that were discharged in the bankruptcy. Completing the bankruptcy process helps with getting a fresh financial start so that the people involved can move forward. A filer needs to file in the correct district and follow all the requirements that are outlined by the court to complete their bankruptcy. Failure to do this can lead to a dismissal of the bankruptcy. If a dismissal is ordered, then the debtor continues to owe all debts and is no longer protected from collection attempts. A Las Vegas bankruptcy lawyer can help individuals and businesses in Nevada file for bankruptcy and complete all the necessary steps to obtain a discharge.

If you are a company or an individual who has fallen too far behind in your payments, a creditor can take you to court to recover the amount owed. If a court has rendered a judgment against you, garnishments can be issued to try to collect the monies. Additionally, if you owe a debt that is secured by your home, vehicle, or other property, your creditors can repossess your property to reduce or eliminate what you owe. 

Filing bankruptcy can place a temporary stay on your financial affairs, stopping creditors from taking further action. A bankruptcy attorney can help by:

  • Helping you file for the correct Chapter of bankruptcy 
  • Assist you in gathering and submitting the necessary documentation.
  • Inform creditors of the bankruptcy filing to stop the collection process while the bankruptcy is active
  • Send notices to all parties who are involved regarding filings and decisions of the court, including when the case has been concluded
  • Represent you in court
  • Follow up with creditors once the bankruptcy has been completed if they continue to attempt to collect 

A bankruptcy attorney can also let an insolvent debtor know what types of debts cannot be wiped away with bankruptcy. 

Why Do People Become Insolvent?

Individuals and businesses become insolvent for various reasons in Nevada. In some cases, financial mismanagement is the culprit. Oftentimes, however, people face unexpected hardships that lead to insolvency. Some of the most common reasons individuals and businesses become insolvent include:

  • Unexpected illness or injury that leads to enormous medical bills
  • Job loss or reduction in salary
  • Divorce
  • Loss of customers/clients

People who are insolvent often consult with a bankruptcy attorney to help them determine whether bankruptcy is necessary and, if so, what type of bankruptcy to file. Your attorney will consider your income, the value of your assets and whether they can be liquidated, and the amount and types of debts you owe.