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Professional Judgment
 
Bankruptcy

Mandatory court-ordered bankruptcy payments represent a philosophical dilemma. The primary basis for need analysis is to assess a portion of the family's discretionary income. However, need analysis does not currently consider certain forms of consumer debt (e.g., auto loans, personal loans, credit card debt) as offsetting assets, nor for the associated monthly debt service as offsetting income.

So on the one hand, mandatory bankruptcy payments represent a non-discretionary reduction in family income, and so are not available to the family to pay college bills. The family's ability to pay is genuinely impaired. On the other hand, if the bankruptcy was used to establish a payment plan for consumer debt that would not normally be considered by the need analysis formulas, why should it be considered now that repayment is court-ordered? Moreover, many financial aid administrators feel that it is bad public policy to reward "bad behavior" with additional student aid funding. After all, allowing an adjustment for bankruptcy is equivalent to providing the family with money to help retire their debt.

Note, however, that the mandatory bankruptcy payments could also have resulted from certain forms of non-consumer debt, such as the failure of a family-owned business. Although debt associated with an investment, farm or business asset is allowed on the FAFSA as part of the calculation of the net worth of the asset, the FAFSA does not allow a negative net worth for such assets.

It is also worth noting that most personal bankruptcies are voluntary in nature. So even though the payments to the bankruptcy trustee are mandatory, the decision to file for bankruptcy and the type of bankruptcy (Chapter 7, 11, 12 or 13) is usually left to the discretion of the family.

Some financial aid administrators will allow an adjustment for mandatory bankruptcy payments under a Chapter 13 filing because the family could have filed for Chapter 7 to eliminate the entire debt. They feel that the effort to make some payments on the debt should be rewarded. However, some families file for bankruptcy under Chapter 13 because they filed for Chapter 7 within the past six years and so are prohibited from filing another Chapter 7 bankruptcy.

So the question is whether to focus on the mandatory nature of the payments and thereby permit PJ for those payments, or look at the nature of the debt serviced by those payments and ignore the portion of the monthly payments that corresponds to debt that would not normally have been allowable on the FAFSA.

The discussion is focused on mandatory monthly payments to the bankruptcy trustee. [In one case part of the debt was secured by the parent's home mortgage, and so was added on to the mortgage, increasing the monthly mortgage payment. It would be inappropriate to allow an adjustment for the increase in the monthly mortgage payment, as the value of the family's primary residence is ignored by the Federal need analysis methodology.]

Some financial aid administrators will base their decision in part on whether the bankruptcy was forced on the family by the creditors. Most financial aid administrators will want to review the nature of the debt that is being addressed by the bankruptcy before deciding whether to allow and adjustment. For example, most financial aid administrators will allow an adjustment when the bankruptcy filing resulted from debt for medical bills.

If an adjustment is made, it should be used to reduce the AGI by the amount of the mandatory payments to the bankruptcy trustee after reducing the mandatory payments by any amounts that are attributable to debt that would not have been allowable on the FAFSA. Documentation should consist of a copy of the court order establishing the mandatory payments.

Note that Section 479A(b)(1) of the Higher Education Act permits financial aid administrators to exclude from income the proceeds of the sale of a farm or business asset if the sale results from a "voluntary or involuntary foreclosure, forfeiture, or bankruptcy or an involuntary liquidation". There is no mention of the proceeds of the sale of the family's primary residence in this section of the act.

See also FinAid's section on Bankruptcy and Financial Aid. Note also that students whose parents are denied a PLUS loan because of an adverse credit history, such as debt discharged in bankruptcy, are eligible for additional unsubsidized Stafford.

 

 
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