How a Personal Bankruptcy Filing Can Help Small Business Owners
Small business owners are often faced with personal debts that they are unable to pay. These debts may have resulted from using credit cards to pay for business expenses; guaranteeing business loans; or investing personal savings into the business. Delis, restaurants, beauty salons, retail stores and home improvement contractors are some of the most common types of small businesses in New York.
How a Business is Organized Impacts Bankruptcy Options
A business organized in New York as a sole proprietorship does not have an identity separate from its owner. In that case, any debts incurred in the name of the business are considered to be debts of the individual owner.
If a New York business is organized as a corporation or limited liability company, it is a legal entity separate from its owners. The purpose of forming a corporation or LLC in New York is to limit the personal liability of the shareholder(s) (in the case of a corporation) or the member(s) (in the case of an LLC). This limitation on personal liability is the main reason why small businesses are organized as corporations or LLCs. For instance, if the entity enters into a contract to purchase goods and fails to pay for them, the corporation is liable for payment, but the shareholders or members are not. In reality, however, many debts incurred by the corporation or LLC are personally guaranteed by the owner. This holds true for credit extended to a small business corporation or LLC in the form of loans or credit cards. The end result, regardless of the manner in which a New York small business is organized, is that the individual owner of the business is usually liable for loans made to the business and for credit cards issued in the name of the business.
Personal Bankruptcy If A Small Business Has Closed
If the business has already closed down, then it is important to account for any equipment, inventory or other business assets remaining. Often, such assets will be encumbered by the security interests of creditors. A security interest means that the creditor has a right to recover the assets to satisfy the debt. Often, a lender will take a security interest in all of the business’s assets in order to secure a loan made to the business. Another common scenario is when a seller of a small business, such as a deli, agrees to take payments of the purchase price over time and takes a security interest in the assets of the business. If the purchaser fails to make the payments, the seller may take back the business assets.
Assets subject to a security interest may be turned over to the secured lender, who, in turn, will sell the assets to satisfy the debt. In reality, however, the assets are usually worth far less than the amount owed. In that case, the business owner will be liable for the difference between what is owed and what the assets are sold for.
Assets that are not subject to a security interest must either be preserved, turned over to the Chapter 7 trustee, or sold for fair value. If sold, the proceeds must either be preserved or used to pay the company’s creditors. The one thing that the owner of a failing business must not do is take the company’s assets for his or her personal benefit. A Chapter 7 trustee will look closely at all transactions between the business and the debtor during the time leading up to a bankruptcy filing.
Bankruptcy If A Small Business Is Still Operating In New York
If the business is still operating, the debtor needs to decide whether to continue operating the business or to close the business down. The most important factor is whether the business is profitable. Debtors often try to keep a business going, often due to the emotional commitment that the debtor has invested in the business, even when it is clearly losing money. It is important to remember that any new debt incurred after the bankruptcy filing will not be discharged. Consequently, the debtor will be liable for any post-petition debt incurred in order to keep a failing business afloat.
Business Assets May be at Risk
A Debtor's Interset in a Business Can Be Sold By A Chapter 7 Trustee
A debtor’s interest in a business is an asset that can be sold by a Chapter 7 trustee. A debtor’s interest in a business may consist of either shares in a corporation or a membership interest in a limited liability company. In either case, the debtor’s ownership interest is an asset that must be disclosed in the bankruptcy filing.
The major issue is whether the ownership interest has any value. In the simple case of a single shareholder corporation, the question is whether the corporation’s assets exceed its liabilities. If so, a bankruptcy trustee may sell the corporation’s assets, pay the corporation’s debts, and use the remainder to pay the debtor’s creditors. This is more likely when the corporation's creditors and the debtor's personal creditors are the same, as is often the case (e.g. credit cards in the name of the corporation and debtor). However, even where the corporation or LLC appears to have zero net value, a Chapter 7 trustee may still try to sell its assets using a variety of legal theories. Careful analysis of all potential outcomes is important prior to filing a personal Chapter 7 bankruptcy.
Keep in mind that a Chapter 7 trustee "steps into the shoes" of the debtor, i.e. the trustee will acquire whatever rights the debtor has in the business. Generally, a debtor must have at least a majority ownership interest in the company in order for a trustee to sell the company's assets. The trustee must abide by the company's articles of incorporation, shareholder agreement, limited liability company membership agreement, etc. when attempting to sell a company or its assets.
In contrast to selling the company's assets, the Chapter 7 trustee may find a buyer for the debtor’s ownership interest in the corporation. In this case, a buyer would purchase the debtor’s shares, thus assuming ownership of the corporation, along with taking on the corporation’s liabilities. This would generally only happen in the case of an ongoing business that could be operated profitably by someone other than the debtor. A trustee will generally try to sell the debtor's shares to other exisiting owners of the company.
The debtor may be able to exempt all, or a portion of, the debtor’s interest in the business by utilizing the federal wildcard exemption of up to $15,425. However, the debtor’s ability to use the wild card exemption depends on other factors, such as whether a homestead exemption must be claimed to protect the debtor’s home.
Keep in mind that a company’s assets consist of more than equipment and inventory. Customer lists; existing leases; telephone numbers; websites; and trademarks are all intangible assets that may have value.
Assets That Can Be Taken By A Chapter 7 Trustee
Receivables are an asset that can be taken by a Chapter 7 trustee.
Money owed to a debtor is an asset that must be disclosed in a bankruptcy filing. This includes business receivables, i.e., money due for services performed, or goods sold, by the debtor’s business. In the case of a debtor operating as a sole proprietor, receivables may be taken outright by a Chapter 7 trustee. The debtor may be able to exempt all, or a portion of, the receivables, by utilizing the federal wildcard exemption of up to $15,425, keeping in mind the limitation on use of the wildcard exemption when the homestead exemption is used.
If the debtor’s business is a corporation or LLC, the receivables are considered an asset of the business and are treated in the same manner as other corporate assets, as described above.
Chapter 7 vs. Chapter 13 For Small Business Owners
As can be seen from the above, a small business owner contemplating bankruptcy may risk losing the business in a Chapter 7 bankruptcy. If a debtor wishes to continue to operate the business, it may be necessary to file a Chapter 13 bankruptcy. In Chapter 13, the debtor retains their ownership interest in the business and may continue to operate the business. However, the debtor must propose to repay unsecured creditors at least what the creditors would receive in a Chapter 7 bankruptcy. Thus, it may be necessary to obtain an estimate of the value of the business.
Business Debts That are Non-dischargeable
Taxes owed to governmental entities for sales taxes or withholding taxes are not dischargeable in bankruptcy. Small business owners are still responsible to pay these taxes, even after filing for bankruptcy. These taxes are considered priority debts, meaning that they must be paid in full before any unsecured creditors are paid. So to the extent that the debtor has any assets that will be sold by a Chapter 7 trustee, these priority debts will be paid first, thereby reducing or eliminating the debtor’s responsibility for paying them after the bankruptcy case is closed. In a Chapter 13 bankruptcy filing, these priority debts for taxes will be paid ahead of most other unsecured debts.
Bankruptcy for Franchisees
Debtors who operate as sole proprietors under a franchise agreement in New York and who wish to continue operating the business must be very careful before filing a Chapter 7 bankruptcy. A franchise agreement is what is known as an “executory contract.” In Chapter 7, only the bankruptcy trustee has the right to either reject or assume such contracts. If the trustee fails to assume the contract within 60 days of filing the bankruptcy petition, the contract is deemed rejected. In that case, the franchise agreement will be deemed to have been breached, with the consequence that the debtor no longer has the right to operate under the agreement. This may result in the debtor being forced to cease operating the business.
In the alternative, the Chapter 7 trustee could assume the franchise agreement. However, the only purpose in doing so would be for the Chapter 7 trustee to sell the business or to sell the rights to the franchise agreement.
No matter what the Chapter 7 trustee decides to do, filing a Chapter 7 bankruptcy can be extremely risky for a debtor that operates a business under a franchise agreement. If bankruptcy is necessary, however, the debtor can file a Chapter 13 bankruptcy. In Chapter 13, unlike in Chapter 7, the right to assume or reject contracts belongs to the debtor, not the trustee. Thus, a debtor in Chapter 13 may assume a franchise agreement and continue operating his or her business.
Chapter 7 Bankruptcy for Corporations and Limited Liability Companies
While a corporation or LLC can file for Chapter 7, it rarely makes sense for the typical small business. First, when a corporation or LLC files for bankruptcy, it ceases to operate. Generally, the sole purpose of filing a Chapter 7 for a corporation or LLC is to provide for a structured liquidation of the company’s assets in order to pay its creditors. This is rarely necessary for a typical small business. For larger companies, a Chapter 7 bankruptcy allows the owners to turn over the company’s assets to a Chapter 7 trustee, who will sell the assets and pay the company’s creditors with the proceeds. The Chapter 7 trustee will also demand business records, bank statements, etc. for the business. Trustees will closely examine transactions between the business entity and the individual owner(s), looking to recover money or assets that were improperly transferred to the owners or other insiders of the business. This is another reason to generally avoid filing a Chapter 7 bankruptcy for a corporation or LLC. Keep in mind that corporations and LLCs do not receive a discharge in Chapter 7.
Andrew M. Doktofsky P.C. is a debt relief agency. I help people file for bankruptcy relief under the Bankruptcy Code.