Bankruptcy for the Self Employed: Verifying Your Income

A self-employed person can file a Chapter 7 or Chapter 13 bankruptcy, but the debtor must prove average income for the six months before the filing of the case, as well as provide up to four years' worth of yearly income documentation.

Both your current income and earning history are an essential part of a bankruptcy case, and all figures reported in bankruptcy forms are subject to proof. Most debtors rely on paycheck stubs from their employers; however, this often isn't an option for self-employed business owners and independent contractors. Instead, self-employed filers use bank statements, tax returns, profit and loss statements (monthly and yearly), payment receipts, and other verification documents to substantiate income disclosures.

Learn more about bankruptcy for small businesses and the bankruptcy chapter that will work best for you.

Proving Self-Employment Income in Bankruptcy

If you've kept good books, documenting your self-employment income should be a snap. However, even if your financials aren't up-to-date (or don't exist), reporting irregular income isn't as complicated as you might think, primarily because very few people transact business in cash.

You'll start with the following documents:

  • three years of personal and business bank account statements
  • three years of invoices, contracts, check stubs, signed statements documenting cash payments, and other business receipts, especially for payment and expense transactions that don't appear on bank statements, and
  • two years of federal tax returns (or tax transcripts) if you're filing for Chapter 7, and four if you're filing for Chapter 13.

When organizing your documents, keep in mind that you'll provide copies of some documents to the bankruptcy trustee assigned to administer the case. You'll also use the documents to create profit and loss statements if you haven't already done so.

Why do you need more tax documents in Chapter 13? You won't use the extra returns as income proof, but rather to fulfill another requirement: Filers must repay all recently-incurred tax debt through the Chapter 13 repayment plan. So the Chapter 13 trustee will compare the up-to-date filings to the amount of back taxes you claim to owe.

Self-Employed Debtors Should Create Profit and Loss Statements Early

In most cases involving self-employment income, the bankruptcy trustee will ask for a profit and loss statement shortly after filing, or possibly at the 341 meeting of creditors (the hearing all filers must attend). At the meeting, the trustee (and bankruptcy creditors, in a minority of cases) will ask the debtor standard questions and about any inconsistencies or unusual entries in the petition. One way to ensure figures match and to avoid uncomfortable trustee questions is to create the profit and loss statement first—not after the fact—and to rely on it when completing the petition.

Preparing a Profit and Loss Statement for a Bankruptcy Case

You can have an accountant prepare your profit and loss statements, but it's not hard to make them yourself. You'll start by using the documents listed above to reconstruct your financial history.

Many trustees will want two years' worth of monthly and yearly profit and loss statements, but you should verify the standard practice in your area. (Your bankruptcy attorney will know, or you can call the local U.S. Trustee's office.)

The most straightforward approach is to list all business income received and expenses incurred by month, and arrive at your monthly net income by subtracting expenses from income. Creating a yearly profit and loss statement is as simple as adding together all monthly totals. Then repeat the process for each year needed.

Keep in mind that the bankruptcy trustee won't expect anything elaborate—accuracy is what counts. Before getting started, learn more about how to prepare a simple profit and loss statement.

Reporting Self-Employed Income in Bankruptcy Forms

Some debtors find it helpful to understand how income gets reported in the petition. Here's a summary of the three different ways you'll list self-employment income:

  • Current monthly income gets entered on Schedule I: Your Income.
  • You'll list year-to-date earnings and the total amount earned during the two full years before filing on Your Statement of Financial Affairs for Individuals Filing for Bankruptcy (sometimes referred to as "SOFA").
  • You'll use the amount you earned six months before filing when completing the means test

Once you've assembled your documents and have created your profit and loss statement, you'll either give all of your work to your bankruptcy lawyer or begin completing the bankruptcy paperwork yourself. Your bankruptcy case will start once you file the completed bankruptcy forms with the bankruptcy court.

How the Bankruptcy Court and Trustee Use Self-Employed Income Disclosures

In both Chapters 7 and 13, SOFA figures help the bankruptcy trustee identify bankruptcy fraud. For instance, a case involving a low-income debtor with a seemingly lavish lifestyle might suggest that the debtor is minimizing income in an attempt to avoid paying creditors. An asset investigation might be triggered if it appeared that the debtor was hiding assets.

Other income disclosures serve different purposes depending on whether the debtor filed a Chapter 7 or Chapter 13 case. For instance, not everyone qualifies for a Chapter 7 debt discharge—a filer's income must be low enough to pass the Chapter 7 means test. The court will also check the filer's income by comparing Schedule I: Your Income amounts to Schedule J: Your Expenses. If the amount remaining is enough to make a reasonable payment to creditors, a bankruptcy judge might convert the Chapter 7 to a Chapter 13 case.

By contrast, a filer must earn enough to qualify for Chapter 13. The court uses the means test figures and Schedule I amounts to determine whether disposable income exists to meet the requirements of a confirmable (viable) three- to five-year repayment plan.

Consult With a Bankruptcy Lawyer

A well-prepared bankruptcy case will move through the process without issue. By contrast, filing an inaccurate petition or failing to provide documents that adequately prove your income could raise red flags in bankruptcy and result in case dismissal. Knowledgeable local bankruptcy lawyers will look for potential issues and resolve problems beforehand or advise you of the best course of action for you.

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