For a Chapter 13 repayment plan to be approved by a bankruptcy court, it must meet a number of tests and include certain provisions.  Many of those provisions are designed to protect creditors and ensure that creditors of a certain class (type) are being treated alike.  

One of these tests is called the Best Interest of Creditors Test or the Liquidation Test.* To understand how the Liquidation Test works, we first have to look at how exemptions work in a Chapter 7 case.

Exemptions

Exemptions or exempt property are assets that a bankruptcy debtor is allowed to keep after the bankruptcy is completed.  Any asset that doesn't fit within one of the exemption categories is considered to be non-exempt.  In a Chapter 7 case, a non-exempt asset can be sold by the bankruptcy trustee who will distribute the proceeds to the debtor's creditors. 

Chapter 13 cases have exemptions, too.  But, in a Chapter 13 case the debtor is allowed to keep the non-exempt assets.  Instead of turning over those assets to a trustee to sell, the debtor makes payments each month to a trustee, who then distributes the money to creditors. Some people describe it as "buying" back the assets.  

For a Chapter 13 case to work, the payments made to unsecured creditors have to at least equal what those creditors would have received if the debtor had filed a Chapter 7 case.  That is the Best Interest of Creditors or the Liquidation Test.  

How the Best Interest of Creditors Test Works

Lots of people have trouble wrapping their minds around the concept.

So, here's an example.  

Let's say when you file your bankruptcy case you have three items of property that don't fit your allowed exemptions:  some stock in Microsoft, a painting and a Rolex watch. You estimate that together those items are worth $22,000. Your Chapter 7 trustee would take possession of those items and sell them and pass out the proceeds to your creditors.  That's the liquidation part.  

What happens if you file a Chapter 13 case?  You still have the same non-exempt property, only this time you keep the property in your possession.  After all, you're hoping that one day each of those items will be worth more than it is today, so it's important for you to hold onto them. Your job in the Chapter 13 case is to propose a plan that will pay your unsecured creditors at least $22,000 over the plan period, which will likely be 60 months.  If you can do that, you've satisfied the Best Interest of Creditors Test, because your Chapter 13 plan pays those creditors at least what they would receive in your Chapter 7 case.  

Why do we keep talking about unsecured creditors?  

Because in a liquidation, the trustee is primarily there to protect the unsecured creditors.  Secured creditors have their collateral to protect them. 

Liquidation Test:  the Advanced Course

The comparison of the value of assets in a Chapter 7 and a Chapter 13 is  not dollar for dollar. Chapter 7 trustees rarely get the retail value out of the sale of debtor's property. The stock would likely sell at the prevailing stock market price, but the value of the other items is speculative. Trustees often sell items like the painting and the Rolex at auction because it is much easier and more efficient than searching for a buyer. But that also means that the trustee is likely to receive less for the sale than she would selling one on one.  

Even if the trustee were able to sell the assets at retail, the creditors would not receive 100% of their value. The trustee's costs of sale and commission will reduce the amount going to the creditors. It is appropriate to reduce the stated value of the assets by a certain percentage to arrive at an estimate of the amount a Chapter 7 trustee would realize in a sale. Often that reduction is about 10%.    

To learn more about how Chapter 13 plans work, read Your Obligations Under a Chapter 13 Bankruptcy Plan.

*The Best Interest of Creditors Test can be found in the Bankruptcy Code at 11 U.S.C. Sec. 1325(a)(4).