Insolvency Vs. BankruptcyDifferences You Need to Know Between the Two!

Written By:
Lisa Borga

The terms “bankruptcy” and “insolvency” are often confused, even though they have very different meanings.

It is understandable that people confuse these terms since if a person is going bankrupt, they are insolvent.

However, if a person or company is insolvent, it means that they cannot pay their debts.

If a person or business is insolvent, it may or may not declare bankruptcy.

However, for partnerships, limited liability companies, and corporations, filing Chapter 7 bankruptcy does not eliminate business debts or personal obligations as it does for individuals, so it is of limited value.

insolvency vs bankruptcy

Understanding Bankruptcy

Bankruptcy is a legal procedure in which a debtor liquidates their assets and property to pay off their debts.

This is done when the debtor cannot pay their debts. The individual or business can choose to declare bankruptcy.

Additionally, a creditor can file to have an individual or business declared bankrupt, which is called an involuntary bankruptcy.

This procedure is rare and can only be filed under Chapter 7 or Chapter 11.

Bankruptcy for Individuals

Bankruptcy is a way for individuals to deal with their debts when they can no longer pay them.

Once the individual has completed Chapter 7 bankruptcy, most of their unsecured debts are cleared.

However, the individual’s assets will be taken in exchange for having the debts cleared.

This does allow individuals who declare bankruptcy a fresh start.

Additionally, filing bankruptcy involves a stay of proceedings that prevents creditors from contacting the debtor.

Instead, they must contact a trustee.

So, once the bankruptcy is filed, the debtor no longer has to worry about the creditors contacting them demanding payment.

Bankruptcy for Businesses

Businesses can declare Chapter 7 bankruptcy as a way to shut their business down and liquidate their assets.

But, the business owners will not receive a discharge, nor will they be able to use any exemptions as a way to protect their assets.

However, a bankruptcy trustee will be able to use the business’s assets to pay off as much of the business’s debts as possible.

These limitations make Chapter 7 bankruptcy less useful for many businesses than for individuals.

Bankruptcy Example

Sally works as a bookkeeper for a small business.

She decides she is doing well enough to use most of her savings to take a vacation.

But, soon after her vacation, her boss decides to purchase new accounting software and decides he no longer needs a bookkeeper.

Without a job or much savings, Sally runs up her credit cards for living expenses.

Soon she finds that with her credit card debt along with other debts, she is insolvent.

So, she decides to file for bankruptcy.

Sally hires an attorney and fills out the necessary paperwork for the bankruptcy.

This involves listing all her assets and creditors as well as other financial information.

Sally’s attorney will file the petition with the Bankruptcy court.

The case will be handled by the federal courts and follow U.S. Bankruptcy Code.

Advantages and Disadvantages of Chapter 7 Bankruptcy

There are several advantages to bankruptcy for people in serious debt, but there are some disadvantages as well.

Therefore, debtors should seriously consider their situation before declaring bankruptcy.

They should also consider possible alternatives to bankruptcy.

Advantages

  • Most Unsecured Debt Is Cleared: When an individual declares bankruptcy, most unsecured debt will be discharged. This includes personal loans and medical debt, as well as credit cards. There is also no maximum amount of debt that can be discharged. Although, an individual must receive credit counseling within 180 days before they file for bankruptcy. This counseling must be from an approved credit counseling agency.
  • Retain Some Property: You get to keep all exempt property. This means that although you will likely lose luxuries, you will be allowed to keep a lot of necessities, such as a lot of your clothing, a computer, and a car to get to work, depending on its value. The exemptions vary by state.
  • Collection Will Stop: Once you file for bankruptcy, creditors must stop their collections efforts and wage garnishments as well.
  • Process Is Relatively Fast: The bankruptcy process should only take approximately three to six months.

Disadvantages

  • Income Limit: There is an income limit for filing bankruptcy. If someone has an income above this limit, they cannot file for Chapter 7 bankruptcy. Also, if your disposable income is too high, your bankruptcy will be changed to a Chapter 13 bankruptcy, which may discharge only part of your debts or possibly none of your debts.
  • Affects Credit Score: The bankruptcy will remain on your credit report for up to ten years. This will affect your ability to get credit for a while. Although it’s possible that for some people filing for bankruptcy, their credit may be low enough already that it will make little difference.
  • Not All Debts Are Discharged. Some debts such as car loans, student loans, and mortgages are not discharged by Chapter 7 Bankruptcy. Additionally, some debts such as child support, alimony, and some taxes will also not be discharged.

What Is Insolvency?

insolvency vs bankruptcy

Insolvency is a situation in which a person or business is unable to pay its debts.

Businesses or individuals can become insolvent. Although, it is more associated with businesses.

There are a couple of different ways a business can become insolvent.

One problem that could cause a business to become insolvent is cash flow insolvency.

This is a situation in which a business does not have sufficient cash to pay its debts, but they do have non-liquid assets available.

The business may also be facing balance sheet insolvency, which occurs when the value of a company’s assets is lower than its debts.

Causes of Insolvency

There are many issues that can lead to insolvency. One problem that can lead to insolvency is cash flow problems.

This could be caused by customers being slow to pay their debts or by the business overspending.

But, in either case, it can make it difficult for a business to pay its debts.

Another issue that can lead to insolvency for a business is losing a business contract.

This is particularly a problem if the business depends on the contract for a large part of its income.

It could take a while to replace the income making it difficult for the business to meet its obligations.

Sometimes a business can become insolvent due to losing a lot of customers.

This can be caused by a business’s service or product declining in popularity due to changes in the market.

It could also result from customers changing to a competitor’s product.

These situations might require changes, such as changes in marketing, changes in the product, or maybe changing to a different product altogether.

The solution might be difficult to find, which means in some cases, it could be difficult to regain solvency.

Another issue that can cause insolvency is costs that are unexpected and thus have not been accounted for.

Lawsuits are one cause of unexpected costs.

Sometimes lawsuits can require a business to pay out a large sum of money, which can make it difficult for the business to meet its other obligations.

Primary Differences Between Insolvency and Bankruptcy

There are a number of differences between insolvency and bankruptcy, and here are some primary differences.

  • Insolvency is a situation in which a person or business is unable to pay its debts, whereas bankruptcy is a legal process.
  • Bankruptcy is one form of insolvency, but there are other types of insolvency.
  • Businesses or people that are insolvent do not always declare bankruptcy.
  • Both people and businesses can become insolvent.

How To Avoid Bankruptcy

It is a good idea for businesses and people to learn the common causes of insolvency and bankruptcy so they can take precautions that may help prevent these conditions.

One of the best ways to avoid insolvency or bankruptcy is to practice careful budgeting and bookkeeping.

This can help both individuals and businesses remain aware of their cash flow, thus helping them avoid taking on debts they likely won’t be able to pay.

Insurance can also be helpful as it can help cover some unexpected expenses, such as a loss of income or lawsuits.

Without proper care, even a successful business or someone with a lot of assets can become insolvent if they don’t do an adequate job of handling their finances.

This can happen because insolvency means being unable to pay debts when they are due rather than not having enough assets.

Insolvency might require a business to sell its necessary assets to pay debts, which will not work well if the business is to keep operating.

Having a professional accountant can help in many cases.

It can be difficult in some cases for a busy business owner to keep sufficient track of the business’s finances.

Therefore, having an accountant manage the business’s finances can reduce the risk of insolvency.

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  1. Cornell Law School "insolvency" Page 1 . May 16, 2022

  2. Cornell Law School "Bankruptcy" Page 1 . May 16, 2022