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Business Litigation that Continues After You File Bankruptcy

If you shut down your business, and file bankruptcy, that often ends business litigation against you. But not in these three situations.

 

Lawsuits against You that Bankruptcy Ends

Many legal claims against you or your closed or closing business are resolved by the filing of your bankruptcy case. They are resolved either legally or practically, or both.

Claims that are legally resolved by your filing of bankruptcy are those intended to make you pay money. Or, claims to determine how much money you must pay. The discharge (the legal write-off) in bankruptcy of whatever debt you owe will usually result in you not needing to pay anything on the claim under Chapter 7 “straight bankruptcy.” There’s not much point to a lawsuit to determine whether you owe money or about how much you owe if any such debt will just get discharged in bankruptcy. That’s true regardless how much the debt amount is, and regardless whether there’s a court-determination of the debt or not.

Claims that are practically resolved by your bankruptcy filing are those that are simply not worth pursuing any further. For example, if you file a Chapter 13 “adjustment of debts” case in which the creditors are slated to receive only a few pennies on the dollar, that fact would hugely reduce the benefit of litigation to prove that you owe more money. A simple cost-benefit analysis would show that the very slight possible benefit of further litigation is not worth the addition time or money spent by the creditor.

Lawsuits that Bankruptcy Does NOT End

However, there are certain types of debts that would still need to be resolved by a court. In these situations the creditor would likely get permission from the bankruptcy judge to start a lawsuit or to continue one already started. Here are three types that need court resolution.

1) Determining the Amount of a Debt

If a debt is being discharged in a no-asset Chapter 7 case—one in which all assets of the debtor are “exempt” and protected—then, as indicated above, the amount of that debt makes no practical difference. Whatever the amount of the debt, it is getting discharged without payment of anything towards that debt.

But in an asset Chapter 7 case, in which the bankruptcy trustee is anticipating a pro rata distribution of the proceeds of the sale of assets, the amounts legally owed on all the debts need to be known for that distribution to be fair to all the creditors.  The same holds true in most Chapter 13 cases, in which the creditors are being paid a portion of their debts. That’s because the established amount of any single debt affects the amounts received by all the creditors. So litigation to determine the validity or amount of a debt needs to be completed, even if by a relatively quick settlement (acknowledging the reduced benefit of further litigation because of the reduced stakes at issue for any individual creditor).

2) Possible Insurance Coverage of the Debt

If a claim against a debtor may be covered by insurance, then the affected parties likely want the dispute to be resolved legally.

That’s because a court needs to determine 1) whether the debtor is liable for damages, 2) whether those damages are covered by the insurance, and 3) whether the policy dollar limits are enough to cover all the damages or instead leave the debtor personally liable for a portion. The following types of business litigation tend to involve insurance coverage issues:

  • vehicle accidents involving the business’ employees or owners, especially those with the complication of multiple drivers (and thus, multiple possible insurance coverages)
  • claims on business equipment damaged by fire or flood, or stolen

In these situations the bankruptcy court will likely give permission for the litigation to continue outside of bankruptcy court, while not allowing the creditor to pursue the debtor as to any amount not covered by the insurance policy limits.

3) Nondischargeable Debts

Some of the biggest fights about business-related debts occur when a creditor argues that its debt should not be discharged in the bankruptcy case.  The grounds for objecting to discharge are quite narrow—in general the debtor must have defrauded the creditor, embezzled or stolen from the creditor, or intentionally and maliciously hurt the creditor or its property.

These discharge fights can happen in both Chapter 7 and Chapter 13. Chapter 13 in the past did not let creditors raise discharge challenges that were allowed under Chapter 7. That changed with the last major changes to the bankruptcy law (in 2005), which for the first time allowed those challenges to be raised in Chapter 13 as well. Since Chapter 13 is often a better solution for debtors who have closed a business (it’s often a better way to deal with business-related debts like payroll and income taxes, for instance), many of the dischargeability challenges by creditors now happen in Chapter 13 cases.

 

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If You Owe Lots of Business Debt You Can Maybe Skip the “Means Test” and Qualify for Chapter 7

One benefit of owing more business debt than consumer debt is that it gives you a largely free pass into a Chapter 7 bankruptcy case. 

 

The Role of the “Means Test”

If your income is too high, you have to pass a “means test” to discharge—legally write off—your debts through a Chapter 7 “straight bankruptcy.” The point of this test is to prevent you from discharging your debts if you have the “means” to pay a meaningful portion of them. So it’s essentially an income and expenses test.

If you don’t pass the “means test,” you could be found to be under a “presumption of abuse” of the bankruptcy laws. If so, you would not be allowed to continue with your Chapter 7 case.  

One way to get out of the “means test” is by having less income than the permitted “median family income” for your state and family size. Most people who file under Chapter 7 have low enough income to avoid the “means test.” But the “median family income” amounts are quite low. If your income is above permitted amount, you have to go through the “means test.” As a result you may be forced into a lengthy and relatively expensive 3-to-5-year Chapter 13 payment plan instead of a usually-less-than-four-month Chapter 7 case.

If You Owe More Non-Consumer Debts than Consumer Debts

Because the “means test” was intended for consumer bankruptcies not business ones, it only applies to consumer cases. What’s critical is how the law distinguishes between the two.

You can avoid taking the “means test” altogether—including the “median family income” step—if your debts are not “primarily consumer debts.” That’s the standard. If your debts are not “primarily consumer debts,” you would be eligible for a Chapter 7 case regardless of your income, even if it’s above the “median” amount.

In fact if you don’t have “primarily consumer debts,” you avoid other kinds of “presumptions of abuse” as well. You can avoid not just the income-and-expense “means test,” but also other ways that your Chapter 7 case could be challenged in a consumer case. Congress has apparently decided that if your debts are mostly from a failed business, you should be permitted an immediate Chapter 7 “fresh start” without the precautions in the law supposedly designed to prevent abuse of the bankruptcy laws by consumers.

What’s “Consumer Debt”?

To determine whether you can avoid the “means test,” we need to be clear what a “consumer debt” is. The Bankruptcy Code defines a “consumer debt” as one “incurred by an individual primarily for a personal, family, or household purpose.” (Emphasis added.)

The focus is on the purpose for which you initially incurred the debt, even if the debt would otherwise seem like a consumer debt. Small business owners often finance their business’s start-up and ongoing operation with their consumer credit—credit cards, home equity lines of credit and such. Given their purpose, these might qualify as non-consumer debts in calculating whether you have “primarily consumer debts.” This is definitely something to discuss with your attorney to learn how the local bankruptcy judges are interpreting this issue.

 What Does “Primarily Consumer Debts” Mean?

If the total amount of your “consumer debt” is less than the total amount of your debts that are not “consumer debts,” then your debts are not “primarily consumer debts.”

So you have to decide (with the help of your attorney) separately for each one of your debts whether it is a “consumer debt” or not. Then you add up the two columns of debts, and if the total for those that are not “consumer debts” is larger than the total for those that are “consumer debts,” then you do not owe “primarily consumer debts.” And you can skip the “means test.”

Some Business Debts May Be Larger Than You Think

Even after looking closely to see if some of your seemingly “consumer debts” may have actually had a business purpose, you may still believe that you have more of the “consumer debts.” But sometimes business owners have business debts that end up being larger than they thought they were. That could push their not-“consumer debt” higher than their “consumer debt.”

For example, if you had to break a commercial lease for your business premises when you closed your business, the unpaid lease payments projected out over the intended term of the broken lease could be huge. Same thing with a business equipment lease.

Or closing your business may have left you with other hidden or unexpected debts, such as obligations to business partners or unresolved litigation, with potentially large damages owed (and to be discharged in bankruptcy).

Conclusion

The potential good news about such larger-than-expected business debts is that they may result in your non-“consumer debts” outweighing your “consumer debts.” That would enable you to skip the “means test” and avoid other “presumptions for abuse.” That would allow you to discharge all your debts through a Chapter 7 case instead of being forced to pay all you could afford to pay of those debts under a lengthy Chapter 13 case.

 

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Practical Considerations about Accusations of Business Fraud and Bankruptcy

When a small business fails, allegations of fraud against the owner are not uncommon. But they are often handled well in bankruptcy.

 

There are practical reasons why the owner of an unsuccessful small business tends to be accused of causing or contributing to the failure through fraud or misuse of funds. If you are considering closing down your business or have already closed it down, and are getting such accusation or you fear getting them, you want to know how are those accusations going to be handled if you file a bankruptcy case.

Reasons Why Creditors of Business Owners Raise Fraud Objections

A bankruptcy filed after the failure of a business can stir up more objections than a regular consumer bankruptcy case for a number of practical reasons:

  • The relationship between the former business owner and his or her creditor is often more personal and emotional than a simple debtor-creditor relationship. Consider the relationships between the former business’s partners, between the owner and investors who were friends or relatives, or between the owner and an ex-spouse. Because of the mix of business and personal in these relationships, the business failure is taken more personally, with more of a tendency by the creditor to feel cheated. So the decision whether to fight the discharge (legal write-off) of the debt in bankruptcy is made less as a cost-benefit business decision than an emotional one.
  • The business context tends to provide many all-too-convenient opportunities for the debtor to blur the rules or act unscrupulously, especially when financially “desperate.”
  • If a business owner takes certain actions in good faith which could have resulted in success, but the business does not succeed, those same actions can look questionable in hindsight.
  • In these kinds of disputes, there is often more money at stake than in a consumer bankruptcy. At the same time these kinds of creditors, unlike conventional commercial creditors, may not feel that they just can take the loss and walk away. So they tend to fight even if it’s not such a wise business decision to do so.

What Happens in Bankruptcy?

So if you have been accused by a former business partner, investor, or similar business creditor of some sort of business fraud, or fear that you will be so accused, does this mean that you should avoid filing bankruptcy?

You need to discuss your unique circumstances thoroughly with your bankruptcy attorney, likely together with your business or litigation attorney if you have one.

But in general, perhaps surprisingly, for some practical reasons these kinds of accusations often go away, or at least are resolved relatively quickly, when you file bankruptcy.

Reason #1: The “Automatic Stay”

The filing of your bankruptcy case stops, at least temporarily, any litigation against you that is already in progress. And it stops, again at least temporarily, a new lawsuit from being filed against you (and against your business if it is a sole proprietorship). This pause in the litigation gives your creditor the opportunity to reconsider whether continuing to pursue you would really be worthwhile.

Reason #2: Much Harder to Make a Case against You

Your bankruptcy filing changes the legal issues in your favor. It’s more difficult for your creditor to prevail against you. It’s usually easy enough outside of bankruptcy for a creditor to prove that you owe money. But once in bankruptcy, the debt or claim will be discharged—forever written off—unless the creditor establishes much more: that the debt is based on some rather serious bad behavior by you. The creditor has to convince the bankruptcy judge that you owe the debt because you engaged in fraud, misrepresentation, embezzlement or theft, fraud in a fiduciary capacity, or by intentionally and maliciously injuring the creditor or his or property. Much more difficult to do, and unless there is a good case against you most creditors will realize that they are wasting their time and money to try.

Reason #3: Revealing Your Actual Finances

The documents you file under oath in your bankruptcy case should show your disgruntled creditor that even if the case against you succeeded, you don’t have the money to pay a judgment. Perhaps more important, it should show his or her attorney that it’s not economically sensible. Sensible people would think twice paying thousands of dollars in attorney fees and cost on a case that could be very hard to win, and then at best gets them a judgment that could never be collected. Or if it could be collected, it would be so slowly that the risk and effort would simply not be worthwhile.

Conclusion

Although there are reasons for some small business bankruptcies to be contentious, filing bankruptcy can give you big advantages if you are being pursued for an alleged business fraud. You decrease your creditor’s chances of winning and give him or her good reasons to stop pursuing you.

 

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Save Your Sole Proprietorship Business through Chapter 13

Chapter 13 can greatly reduce both your business and personal monthly debt service while you continued to run your business.

 

“Adjustment of Debts of an Individual with Regular Income”

That is the formal name given to Chapter 13 of Title 11—the U. S. Bankruptcy Code.

As the word “Individual” indicates, you must be a person to file a Chapter 13 case—a corporation cannot file one. (This also applies to a limited liability company (LLC) and other similar types of legal business entities.)

But if you have a business which you operate as a sole proprietorship, you and your business can file a Chapter 13 case together.

To explain, if you (or you and your spouse) own a business that is operated in your own name, then, unlike a corporation  that is treated as a legal “person” separate from you, your sole proprietorship business and you are treated as a single legal entity.

The assets of your sole proprietor business are simply considered your personal assets. The debts of your business are simply your debts.

This is true even if your business is operated not under your own individual name(s) but rather under an assumed business name, and you are doing business under that name. You are likely operating as a sole proprietorship if you have not gone through the formalities of creating a corporation, a limited liability company, or other such legal business entity.

Chapter 13 Help Your Sole Proprietorship Business in 5 Major Ways

1) Chapter 13 addresses both your business and personal financial problems in one legal and practical package.  You are personally liable on all debts of your sole proprietorship business, as well as, of course, your individual debts. So as long as you qualify for Chapter 13 otherwise, you can simultaneously resolve both your business and personal debts.

2) Chapter 13 stops both business and personal creditors from suing you, placing liens on your assets, and shutting down your business. The “automatic stay” imposed by the filing of your Chapter 13 case stops ALL your creditors from pursuing you, including both business and personal ones. Your personal creditors are prevented from hurting your business, and your business creditors are prevented from taking your personal assets.

3) Chapter 13 enables you to keep whatever business assets you need to keep operating. If you do not file a bankruptcy, and one of either your business or personal creditors gets a judgment against you, it could try to seize your business assets.  Also, if you filed a Chapter 7 “straight bankruptcy,” under many circumstances you could not continue operating your business. However, Chapter 13 is specifically designed to allow you to keep what you need and continue operating your business.

4) Chapter 13 gives you the power to retain crucial business and personal collateral. If you are behind either on business or personal loans which are secured by either business or personal collateral, Chapter 13 will stop the repossession of the collateral. Then it will give you ways to keep collateral that you would otherwise lose, and often under much better payment terms. You will often be given the opportunity to lower the monthly payments, or at least be given more time to catch up on your late payments. In certain limited situations—such as some judgment liens and some second mortgages on your home—the liens can be gotten rid of altogether.

5) Chapter 13 can solve both business and personal tax problems. Business owners in financial trouble are generally also in tax trouble. Chapter 13 gives business owners time to pay tax debts that cannot be discharged (permanently written off), all the while keeping the IRS and other tax agencies at bay. Chapter 13 usually stops the accruing of additional penalties and interest, enabling the tax to be paid off much more quickly. Tax liens can be handled especially well. At the end of a successful Chapter 13 case you will have either discharged or paid off all your tax debts, and will be tax-free.

 

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Chapter 13 Can Especially Protect Your Co-Signers

Chapter 13 “adjustment of debts” goes a big step further than a Chapter 7 case by protecting your co-signers and their assets.

 

The Regular “Automatic Stay”

The automatic stay—your protection against just about all collection efforts by your creditors—kicks in just as soon as your bankruptcy case is filed. It applies to all bankruptcy cases, including those filed under Chapter 7 and Chapter 13. It is one of the most powerful and important benefits of filing a bankruptcy case.

But it protects only you—the person or persons filing bankruptcy—and your assets. It does not protect anybody else who may also be legally liable on one of your debts.

The Very Special “Co-Debtor Stay”

The very first section of Chapter 13—Section 1301—also deals with the automatic stay, but adds another layer of protection—applicable to your “co-debtors, or co-signers—that only applies to cases filed under Chapter 13.

Section 1301 states that once a Chapter 13 case is filed, “a creditor may not act, or commence or continue any civil action, to collect all or any part of a consumer debt of the debtor from any other individual that is liable on such debt with the debtor.” (Emphasis added.)

A creditor on a consumer debt is already prevented by the regular automatic stay from doing anything to collect a debt directly from the debtor. Now, under Chapter 13 only, and only on consumer debts, that creditor is also prevented from collecting on the same debt from anybody else who has co-signed or is otherwise also obligated to pay that debt.

A Very Special Protection

If you think about it, that’s rather powerful, and quite unusual. The person being protected—your co-signer—has nothing to do with your bankruptcy case filing. The co-debtor stay gives you the power to protect that person—likely somebody you really care about—who is not filing bankruptcy and so is not under the direct jurisdiction of the court. The person may not even know that you are protecting them from the creditor.

Conditions and Limits of the Co-Debtor Stay

Besides being limited to consumer (not business) debts, the “co-debtor” protection:

1. Does not protect spouses from joint liability on income taxes. That’s because income tax debts are not considered “consumer debts” for this purpose.

2. This protection does not extend to those who “became liable on… such debt in the ordinary course of such individual’s business.”

3. Creditors can ask for and get permission to pursue your co-debtor to the extent that:

(a)  the co-debtor had received the benefit of the loan or whatever “consideration” was provided by the creditor (instead of the person filing the bankruptcy)—in effect that you were co-signing for him or her; or  

(b)  the Chapter 13 plan “proposes not to pay such claim.”

4. Even if a creditor does not seek or get the above permission, this co-debtor stay expires as soon as the Chapter 13 case is completed, or if it’s dismissed (for failure to make the plan payments, for example), or converted into a Chapter 7 case.

Conclusion

Choosing between Chapter 7 and 13 often involves weighing a series of considerations. If you want to protect a co-signer or someone liable on a debt with you from being pursued for that debt, seriously consider Chapter 13 because of the co-debtor stay. 

 

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Are You Eligible to File a Chapter 7 Bankruptcy Case? How About a Chapter 13 One?

Eligibility depends on 1) the kind of debtor, 2) the kinds and amounts of debts, 3) the amount of income and 4) of expenses.

 

1) The Kind of Debtor

If you are a human person, you may be eligible for either a Chapter 7 “straight bankruptcy” or a Chapter 13 “adjustment of debts” case. You and your spouse may also be eligible to file one or the other of these together in a joint case.

However, if you are the owner or part-owner of a business partnership, corporation, limited liability company or other similar business entity, that business entity could not file its own Chapter 13 case. But it could file a Chapter 7 one. Regardless what your business entity itself could file, you could individually file either a Chapter 7 or 13 case, to address your own personal liabilities (beyond whatever liability for which the business itself would be responsible).

2) The Kinds and Amounts of Debts

If your debts are “primarily consumer debts” (more than 50% by dollar amount), then to be able to file a successful Chapter 7 case you have to pass the “means test.” That’s a test related to your income and expenses (discussed more below.)  If 50% or more of your debts are not consumer debts, than you can skip the “means test.”

Chapter 7 does not limit the amount of debt you can have to be eligible to file a case. However, you cannot file a Chapter 13 case if your debts exceed the maximums of $383,175 in unsecured debts and $1,149,525 in secured debts (or if you do file a case it will very likely be “dismissed” (thrown  out)).

3) Amount of Income

You can quickly and easily satisfy the “means test” and be eligible for a Chapter 7 case if your income is no more than the regularly adjusted and published “median income” for your family size and state.

To be eligible for Chapter 13 you must have “regular income.” That is defined not very helpfully as income “sufficiently stable and regular” to enable you to “make payments under a [Chapter 13] plan.”

Also for Chapter 13, if your income is less than the “median income” for your family size and state of residence, then the plan generally must last a minimum of three years (but in many situations it can last longer, especially if you need it to, but for no longer than five years). If your income is at or above the applicable “median income” amount, the plan must almost always last five years.

4) The Amount of Expenses

In Chapter 7, if your income is NOT less than “median income” for your family size and state of residence, then you may still pass the “means test” and be eligible for filing a Chapter 7 case IF, after accounting for all your allowed expenses, you don’t have enough money left over to pay a meaningful amount to your creditors.

In Chapter 13, a similar accounting of your allowed expenses determines the amount of your “disposable income,” the amount you must pay into your plan each month.

Summary

Once you recognize that you need relief from your creditors, choosing between Chapter 7 and 13 is often not difficult. But because there are many, many differences between them, the choice can sometimes turn into a delicate balancing act between the advantages and disadvantages of those two options. That’s why when you have your initial meeting with your bankruptcy attorney, it’s smart to be aware of and communicate your goals, but also be open-minded about how best to accomplish them.

 

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Business Disputes that Follow You Into Your Bankruptcy Case

A creditor can challenge the discharge of its debt in bankruptcy. This is not common, but is more so after a debtor closes a business.

 

Why Creditor Challenges Are More Common in Closed-Business Bankruptcies

For the following reasons, creditors tend to object more to the discharge of their debts in bankruptcy cases that are filed after the debtor has operated and closed a business:

  • The amount of debt owed, and thus the amount at stake, tends to be larger than in a conventional consumer case, making objection more tempting to the creditor.
  • In the business context some debtor-creditor relationships can be very personal, so when the business fails, these creditors take it personally. Consider debts between former business-partners who are blaming each other for the failure of the business, or between a business owner and the business’ primary investor who believes the owner drove the business into the ground, or between the contract buyer of a business and its seller in which the buyer feels that the seller misrepresented the profitability of the business. In these situations the aggrieved creditor is more personally motivated to fight the discharge of its debt.
  • The owners of businesses in trouble find themselves desperate to keep their businesses afloat. So they make questionable decisions which then expose them to objections about fraud and such once they file bankruptcy.
  • In the kinds of close creditor-debtor relationships mentioned above, the creditor often has hints about the business owner’s questionable behavior, and so is more likely to believe it has the legally necessary grounds to object.

But Objections to Discharge Are Still Not Very Common

When former business owners hear that any creditor can raise objections to the discharge of its debt, they figure an objection would very likely be raised in their case. But in reality these objections occur much less frequently than might be expected, for the following reasons:

  • The legal grounds under which challenges to discharge must be raised are quite narrow. To be successful a creditor has to prove that the debtor engaged in rather egregious behavior, such as fraud in incurring the debt, embezzlement, larceny, fraud as a fiduciary, or intentional and malicious injury to property. These are not easy to prove, so creditors do not tend to try unless they have a strong case.
  • In his or her bankruptcy case the debtor publically files a set of papers containing quite extensive information about his or her finances, and does so under oath. The debtor is also subject to questioning by the creditors about that information and about anything else relevant to the discharge of his or her debts. If the information on the sworn documents or gleaned from any questioning reveals that the debtor truly has no assets worth pursuing, a rational creditor will often decide not to throw “good money after bad” by raising an objection.

Conclusion

In a closed-business bankruptcy case there are these two opposing tendencies. Challenges to discharge are more likely, especially by certain kinds of closely related creditors. But these challenges are still relatively rare because of the narrow legal grounds for them and the financial practicalities involved. A good bankruptcy attorney will advise you about this, will prepare your bankruptcy paperwork to discourage such challenges, and will help derail any such challenges if any are raised.   

 

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Some General Guidance about Business Bankruptcy

If your business needs bankruptcy relief, you have to start with basic questions about how your business was set up and its debt amount.

 

The Sole Proprietorship Business

The most straightforward business bankruptcies tend to be those in which the business is a sole proprietorship. Your business is operated through you, not through a separate formal business entity. In other words, you and the business are legally a single entity because you have NOT set up that business as a separate legal entity–a corporation or limited liability company (LLC), or a partnership. You operate it under your own name, or through an assumed business name but not a corporation, LLC, or partnership.

Other Forms of Business

But what if your business is not a simple sole proprietorship, but instead is in one of these separate legal entities, and you are contemplating bankruptcy relief (for either the business, you personally, or both)?

If so, if you have not already done so, you should quickly find and sit down with a competent business bankruptcy attorney.  There are advantages and disadvantages to every form of doing business. But one practical disadvantage of running your business as a corporation/LLC/partnership is that this can make things more complicated in the bankruptcy world. This CAN give you more flexibility—you can file a bankruptcy for yourself without directly filing for the business, and the other way around. But with more flexibility and more options come more complications.

The General Guidance

Beyond these initial points, here are some basic rules for background purposes. They will help you be a bit more prepared when you come to meet with me or another attorney.

1. A corporation, or LLC, or partnership cannot file a Chapter 13 “adjustment of debts.”

Only an “individual” can. This means that you and your sole proprietorship can together file a Chapter 13 case. And if your business is a corporation, LLC, or partnership, you (and your spouse) can file a personal Chapter 13 case to deal with your own liabilities, but that will almost never be adequate for dealing with the business’ own liabilities if you are trying to keep operating that business.

2. Chapter 13s are sometimes mislabeled “wage-earner plans,” but any source of “regular income” is allowed.” The requirement is simply “income sufficiently stable and regular to… make payments under a plan under Chapter 13.” So if your business income—combined with any other income—is even somewhat stable, you would likely qualify under this “regular income” requirement.

3.  But you and your sole proprietorship CAN’T file a Chapter 13 case if your total unsecured debt is $383,175 or more, or if your total secured debt is $1, 149,525 or more. (Note: these were adjusted for inflation as of April 1, 2013 and are valid for the following 3 years.) While these may seem like relatively high maximums, be aware that they include BOTH personal and business debts (since you are personally liable for all the debts of a sole proprietorship). Also the unsecured debt amounts can include less obvious ones such as the portions of your mortgages and other secured debts in excess of the value of the collateral. So a $750,000 debt secured by real estate now worth $550,000 adds $200,000 to the unsecured debt total. Also some debts—especially business ones—can be much higher than you’d expected, such as damages from the terminated lease of business premises, or resulting from business litigation. This can also be pertinent if your business is not a sole proprietorship, because you are likely personally liable for most or all of your corporation’s or LLC’s debts through personal guarantees and otherwise. Either way, add up your potential debts carefully before assuming that you can file a Chapter 13 case.

4. If your debt totals are above one of the above debt limits, you can still file a Chapter 7 “straight bankruptcy” case, but that is very seldom an effective way to keep a business operating. Chapter 7 tends to be a better option for cleaning up after a closed business, whatever its legal form.

5. If your debt totals are above one of the Chapter 13 debt limits and you are trying to save the business, one option is a Chapter 11 “business reorganization.” Also, a business corporation, LLC, or partnership can file a Chapter 11 case to keep the business afloat. The disadvantage of Chapter 11 is that it is a hugely more complicated repayment procedure than Chapter 13, and therefore many times more expensive. This, and the many times higher filing fee, plus significant ongoing court and U.S. Trustee fees, unfortunately makes Chapter 11 a practical solution in only limited small business situations. Bankruptcy courts have tried to address this shortcoming with streamlined “fast-track” Chapter 11s, but they are still often prohibitively expensive.

6. If you do end up filing a personal Chapter 7 case when owing substantial business debt, you may have the advantage of being exempt from qualifying under the “means test” (a test based on your income and allowed expenses) if your business debts are more than half of your total debts.

To repeat, if you are trying to save your financially struggling business, it is crucial to get competent business bankruptcy advice, and to do so just as soon as possible. You have no doubt been working extremely hard trying to keep your business alive. You very likely now need a solid game plan for using the bankruptcy and other laws to your advantage.

 

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Filing a Chapter 7 Case to Save Your Business

A Chapter 13 case is often the preferred way to keep a sole proprietorship business alive. But can a regular Chapter 7 one ever do the same?

 

In my last blog I said that “if you own an ongoing business… which you intend to keep operating, Chapter 7 may be a risky option.” Why? Because Chapter 7 is a “liquidating bankruptcy,” so the bankruptcy trustee could make you surrender any valuable components of your business, thereby jeopardizing the viability of the business. But this deserves further exploration.

Your Assets in a Chapter 7 Bankruptcy

When a Chapter 7 bankruptcy is filed, everything the debtor owns is considered to be part of the bankruptcy “estate.” A bankruptcy trustee oversees this estate. One of his or her primary tasks is to determine whether this estate has any assets worth collecting and distributing to creditors. Often there are no estate assets to collect and distribute because the debtor can protect, or “exempt,” certain categories and amounts of assets. The exempt assets continue to belong to the debtor and can’t be taken by the trustee for distribution to the creditors. The purpose of these “exemptions” is to let people filing bankruptcy keep a minimum amount of assets with which to begin their fresh financial start afterwards. In the vast majority of consumer Chapter 7 cases, the debtor can exempt everything in the estate, leaving nothing for the trustee to collect.  This is called a “no-asset” estate.

Business Assets in a Chapter 7 Case

If you own a sole proprietorship, are all the assets of that business exempt and protected? In other words, is the entire value of the business covered by exemptions, whether approaching the business as a “going concern” or broken up into its distinct assets.

Many very small businesses cannot be sold as an ongoing business because they are operated by and completely reliant for their survival on the services of its one or two owners.  In most such situations the business only has value when broken into its distinct assets.  So the Chapter 7 trustee must consider whether the debtor has exempted all of these business assets to put them out of the trustee’s reach.

The assets of a very small business may include tools and equipment, receivables (money owed by customers for goods or services previously provided), supplies, inventory, and cash on hand or in an account. Sometimes the business may also have some value in a brand name or trademark, a below-market lease, or perhaps in some other unusual asset.  

Whether a business’ assets are exempt depends on the nature and value of those assets, and on the particular exemptions that the law provides for them. For example, a very small business may truly own nothing more than a modest amount of office equipment and supplies, and/or receivables. In these situations the applicable state or federal “tool of trade” or “wildcard” exemptions may protect all the business assets. You need to work conscientiously with your attorney to make certain that all the assets are covered.

So it is possible for a business-owning debtor to have a no-asset Chapter 7 case, potentially allowing the business to pass through the case unscathed.

The Potential Liability Risks of the Business

However, there is an additional issue: will the trustee allow the business to continue to operate during the (usually) three-four months that a no-asset case is open or instead try to force the business to be shut down because of its potential liability risks for the trustee?

How could the Chapter 7 trustee be able to shut down the business? Recall that everything that a debtor owns, including his or her business, becomes part of the bankruptcy estate.  As the technical owner—even if only temporarily—of the business, the trustee becomes potentially liable for damages caused by the business while the Chapter 7 case is open. For example, if a debtor who is a roofing subcontractor drops a load of shingles on someone during the Chapter 7 case, the estate, and thus the trustee, may be liable for the injuries.

The main factors that come into play are whether the business has sufficient liability insurance, and the extent to which the business is of the type prone to generating liabilities. There’s a lot of room for the trustees’ discretion in such matters, so knowing the particular trustee’s inclinations can be very important. That’s one of many reasons why a debtor needs to be represented by an experienced and conscientious attorney who knows all of the trustees on the local Chapter 7 trustee panel and how they deal with this issue.

Conclusion

In many situations it IS risky to file a Chapter 7 case when you want to continue operating a business. You need to be confident that the business assets are exempt from the bankruptcy estate, and that in your situation the trustee will not require the closing of the business to avoid any potential business liability. 

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Bankruptcy: a Tool for Business Success

Bankruptcy doesn’t just clean up after the failure of a business. Bankruptcy can also prevent that failure in the first place.

 

General Motors: 2009 vs. 2013

When General Motors filed bankruptcy in 2009, it was insolvent: it owed about $173 billion and had assets of less than half that, about $82 billion. It was not able to pay its bills when they became due.

Through bankruptcy the business shed a significant amount of its debts, reduced its U.S. plants from 47 to 34 and its U.S. employees from 91,000 to 68,500.  It sold or closed the following vehicle brands: Hummer, Pontiac, Saturn, and Saab. In return for a $50 billion loan from the U.S. government, the nation’s taxpayers became 60.8% owners of G.M.

Now, four years later G.M. is profitable again. By the end of 2013 the government is expected to sell the last of its common stock in the company. According to the Center for Automotive Research, the rescue of the U.S. auto industry—including G.M.—saved 1.14 million jobs at automakers and other companies that rely on them.

If you own and operate a small business, maybe a bankruptcy could save that business, and your job in that business.

Your Business as a Sole Proprietorship

Practically speaking, your business is operated as a sole proprietorship if you did not create a corporation, limited liability (LLC), partnership, or any other kind of formal legal entity when you set up that business. You own and operate your business by yourself for yourself, although the business may have a formal or informal “assumed business name” or “DBA” (“doing business as”).

There are various advantages and disadvantages of operating your business this way. For our immediate purposes what’s important is that you and your business are legally treated as a single economic entity. That’s different than if your business operated as a corporation which would legally own its own assets and owe its own debts, distinct from you and any other shareholder(s). This blog post, and the next few on this broad topic of business bankruptcies, assumes that you operate your business as a sole proprietorship.

Chapter 7

Chapter 7, “straight bankruptcy,” or “liquidating bankruptcy,” allows you to “discharge” (legally write off) your debts in return for liquidation—surrendering your assets to the bankruptcy trustee in order to be sold and the proceeds distributed to your creditors. In most Chapter 7 cases you receive a discharge of your debts even though none of your assets are surrendered and liquidated, because everything you own is protected–“exempt.”

But if you own an ongoing business—again, a sole proprietorship—which you intend to keep operating, Chapter 7 may be a risky option. You and your attorney would need to determine if all your business’ assets would be exempt under the laws applicable to your state. Certain crucial assets of your business—perhaps its accounts receivable, customer list, business name, or favorable premises lease—may not be exempt, and thus subject to being taken by the trustee. Proceed very carefully to avoid having your business effectively shut down in this way.

Chapter 13

The Chapter 13 “adjustment of debts” bankruptcy option is generally better designed than Chapter 7 for ongoing sole proprietorship businesses. It provides much better mechanisms for retaining your personal and business assets. Even business (and personal) assets that are not “exempt” can usually be protected through a Chapter 13 plan.

You and your business get immediate relief from your creditors, usually along with a significant reduction in the amount of debt to be repaid.  So Chapter 13 helps both your immediate cash flow and the long-term prospects for the business. It is also an excellent way to deal with tax debts, often a major issue for struggling businesses. Overall, it allows you to continue operating your business while taking care of a streamlined set of debts.

Next…

In the next few blogs we will focus on some of the most important benefits of filing a business Chapter 13 case.

 

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