What is the Chapter 13 "liquidation test"?

When an individual files chapter 13 bankruptcy, they have decided to voluntarily commit future income for paying certain debts. This type of bankruptcy uses a court approved plan to determine which creditors are paid what, and how much the debtor must pay to the trustee each month.

There's a number of requirements for chapter 13 plans; if the requirements are not met, the plan cannot be confirmed. A plan must be confirmed to successfully use chapter 13 to reorganize or repay debts. One such requirement is the "liquidation test" or best interests of creditors test of section 1325(a)(4). In essence, this test requires that the chapter 13 plan pays unsecured creditors (e.g. charge card accounts, medical bills, and personal loans) at least as much as they would have been paid in chapter 7.

Who Does The Liquidation Test Impact?

Only some debtors are affected by the liquidation test. Each debtor may claim exemptions to protect property he or she owns. For many debtors, these property allowances provided by statute are adequate to cover every asset they own. For these debtors who exempted everything no property would be sold and nothing would be paid to unsecured creditors in chapter 7. Since the liquidation test looks to how much a chapter 7 would have paid creditors, and the chapter 7 would have paid nothing, the liquidation test in chapter 13 does not require any payments to unsecured creditors when all property has been exempted.

It should be noted that even if the liquidation test does not require payment to unsecured creditors, other requirements such as disposal income derived from means testing might require these payments.

One reason people file chapter 13 is that they have property that they could not keep in chapter 7. For these people, the liquidation test determines how much they must pay in chapter 13 on account of these assets.

Other Chapter 13 Requirements Can Overshadow the Liquidation Test

The liquidation test doesn't require a dedicated stream of payments on account of assets. It only requires that the payments to unsecured creditors in the plan are adequate, even if those payments are required by other bankruptcy laws.

For instance, a debtor with a large disposable income might be required to pay more under the means tests than under the liquidation test. The liquidation test wouldn't require extra payments on top of the disposable income unless liquidation value is greater than total disposable income.

If there are priority claims against the debtor (such as income taxes), these claims must already be paid in full in the chapter 13 plan. As most priority claims are also unsecured claims, money paid under the plan to these claims is counted when calculating the liquidation test. For example, if there was a $10,000 priority unsecured tax claim and the debtor owned assets that would yield $5,000 for creditors in chapter 7, the liquidation test is met because by paying the tax claim, as the plan makes unsecured creditors as well off as in chapter 7. This reflects the fact that the priority claim would have been paid first before under unsecured creditors in a chapter 7.

Additional Observations About 1325(a)(4)

A few more technical observations about the liquidation test:

1. The test is based on the date the plan goes into effect (typically the confirmation date), not the date the bankruptcy was filed. If value of property has changed or administrative claims have arose while the chapter 13 case was pending, the result may be different than a real chapter 7 filed in place of the chapter 13.
2. The requirement concerns the amount chapter 7 would pay to the creditors, not the value of the assets themselves. Costs in selling the assets or administering a chapter 7 can impact the liquidation test.
3. The liquidation test has a present value requirement, and if the plan does not pay the claim in cash immediately, interest might be required.

Different courts apply these technical points differently when evaluating whether the plan complies with the liquidation test requirement of 1325(a)(4).

Liquidation tests are also present in chapter 11 and chapter 12 cases.