If you recently got a money judgment from a lawsuit and are considering Chapter 7 bankruptcy, you may be wondering if you can keep your lawsuit winnings or if you’ll lose them in the bankruptcy. Your lawsuit award does become property of the bankruptcy estate – but that doesn’t mean you automatically have to give it up. Whether you can keep money from a lawsuit in Chapter 7 bankruptcy depends on the type of lawsuit, the type of damages you received (for example, is the money for pain and suffering or to replace lost wages?), and your state’s exemptions laws.
When you file for bankruptcy, you ask the court to permanently free you from most debts by "discharging" them, though there are particular exceptions that you will remain responsible for. To earn this discharge, you disclose everything about your finances to the bankruptcy court and allow a bankruptcy trustee to collect some of your assets and distribute the proceeds to your creditors.
However, bankruptcy law allows you to keep certain property in order to help you with your fresh start. What you can keep depends on state laws called exemptions. Exemption laws designate categories of assets that debtors can keep in bankruptcy.
To determine if your lawsuit award is exempt in bankruptcy, you’ll have to figure out what exemptions are available to you and the nature of your lawsuit award.
Each state has a list of property that you can claim as exempt (if it’s exempt, you get to keep it). In some states you must use that state’s exemptions. In other states, you can choose between the federal exemptions or the state exemptions. To find out which states give you the choice, see The Federal Bankruptcy Exemptions.
If you have changed your residence in the last two years, the question of which set of exemptions apply is more complex. (To learn more see, Which State Exemptions Can I Use?)
Once you have determined which exemptions are available to you, the next step is to review the judgment to see the breakdown of amounts awarded for different reasons. For example, your award might be comprised of different amounts of money for lost wages, pain and suffering, reimbursed expenses, punitive damages, and the like.
States often designate some types of damages as exempt, and others as not. So for example, you might be able to keep the part of your award that compensates you for lost wages, but not the part for punitive damages.
Most states will allow you to exempt some types of winnings but not others, and that may mean you can keep part of your award but not all of it.
For example, states might allow you to exempt some or all of the following:
For an overview of what lawsuit awards are exempt in your state, visit Nolo’s Bankruptcy Exemptions by State page and click on your state.
Deciding whether an award is exempt or not is not always straightforward. For example, Virginia's exemption laws allow an unlimited amount towards personal injury and wrongful death claims. Virginia's courts have interpreted "injury" to mean any kind of harm, and so personal injury claims include all claims that relate to harm to an individual, including claims for libel and civil rights violations. The federal exemption, on the other hand, specifies that only "personal bodily injury" claims are exempt. The addition of the word “bodily” means that under the federal exemptions, you can only exempt lawsuit awards that relate to your physical harm. That would not include things such as libel or civil rights violations.
Fortunately, one universal bankruptcy rule is that courts are to liberally interpret exemptions in favor of debtors. So if you can make a good argument that the wording of the law could include your lawsuit award, the courts have to take it seriously.
If your state allows you to use the federal bankruptcy exemptions, and you decide to use them, you can keep the following:
What amount is reasonably necessary for your support is determined on a case-by-case basis.
If you receive the lawsuit award before you file for bankruptcy, you can maximize your chances of exempting the award by putting it in a separate bank account and refraining from putting other money in the account. If you combine the award with other sources of income, it becomes difficult to prove that all of the funds in the account can be traced to the exempt award. This precaution of separating funds you have received is important with any source of income that you intend to exempt, such as back payments for child support or Social Security.
If you cannot exempt your legal award, and you need the money to live on, you might consider delaying your bankruptcy filing for a few months while using the award to pay for ordinary living expenses. You can then file for bankruptcy after you have used all of the money.
Keep in mind that during this delay, creditors will still be able to try to collect from your award by garnishing your bank accounts (assuming the creditor has a judgment). But still, the trade-off may be a wise one compared to the prospect of losing it all in bankruptcy. Your creditors have much less information about your finances than will the bankruptcy trustee, and they will only be able to garnish your account up to the amount of their judgments.
If you do this, make sure you keep records of how you spent the money. The bankruptcy trustee will certainly take note that you received an unusually large sum of money not long before filing for bankruptcy, and will want to know how you spent it. If you used the money for anything other than necessary living expenses and the court finds you acted in bad faith, this will create problems in your bankruptcy.
Unacceptable uses of lawsuit award money. Examples of red flags include spending your lawsuit award on: luxury goods and services, gifts, paying bills some months in advance, and even transferring funds into an exempt retirement account such as an IRA.
Acceptable uses of lawsuit award money. Uses that are generally acceptable include: spending the lawsuit award on moving expenses, home or car repairs, medical costs not covered by insurance, or catching up on your rent or mortgage. Be sure to check with a local bankruptcy attorney to find out what is acceptable in your district and among the local bankruptcy trustees.
Once you file for bankruptcy, you cannot set aside money for any purpose over and above the exemption limits. So if you will have nonexempt funds, plan carefully before filing to make the most of your fresh start.