This is a source of great confusion in the marketplace. If you own a business, does the business need to file bankruptcy or you? Can I just file on business debts and not my personal debt? These are all great questions.
The short answer:
Filing personal bankruptcy as a business owner discharges personal debts, including personal guarantees on business debts. The business itself isn't discharged from its debts. Non-exempt business assets or ownership interests may be sold to repay creditors, depending on your business structure and bankruptcy chapter.
The bankruptcy court plays a crucial role in overseeing the process, approving repayment plans, and ensuring that debts are reorganized or liquidated appropriately.
SOLE PROPRIETORSHIP
Filing bankruptcy is the opposite of poker. In poker, you get to hide your cards from everyone else, including the dealer. You don’t show your cards to anyone else right? Well, when you file bankruptcy it is just the opposite. When you file bankruptcy, you must show all your cards to the bankruptcy trustee and your creditors.
If you are operating as a sole proprietor, you are liable for all of the business debts and personal debts. There is no shell that protects you from the business debts. Yes, I realize you are in debt because of the business, but you are the one liable for the debt at the end of the day.
So, if you are filing a chapter 7 or chapter 13 bankruptcy in Minnesota, you must disclose all of your assets, including your business assets, and you must disclose all of your debt, including business debt and personal debts—since you are the one ultimately responsible for the debt.
Again, while the reason for the bankruptcy might be your business, the bankruptcy filing requires you to disclose it all. I always tell clients, the person you are trying to protect is you!
CORPORATIONS
What if you own a corporation (like an LLC or S or C corporation)? A limited liability company (LLC) is a business structure that offers personal liability protection to its owners, similar to a corporation, but with simpler tax and operational flexibility. Again, if you file bankruptcy, you must disclose all of your assets. So, if you own 75% of ABC LLC, you must list your ownership of those shares. Corporations, unlike a sole proprietorship, is a different entity unto itself.
A corporation can file a bankruptcy- a sole proprietorship (the business itself) cannot. When you own a corporation, the issues can get tangled because often the corporation will owe a creditor money but so will the shareholder. How is this so? Well, most corporations are mom and pop type corporations. They are smaller in size and typically have very little in the way of assets.
If you own ABC CONSULTING INC, the company may own some accounts receivable and a computer or two but the business is really you! Do you think a lender would lend money to this business without you, the consultant, personally guaranteeing the debt too? Doubtful. And that is why the issues become tangled.
Let’s take an example to illustrate the point better. Suppose Carl owns 100% of ABC CONSULTING INC.
ABC CONSULTING INC. owns no real estate, has a small balance in the check book of $300.00, owns two computers worth $500.00 and has accounts receivable of $10k. So, the business has a value of $10,800.00. Often, the “blue sky value” or the equity a business like this has is limited because presumably Carl’s customers like Carl not you or me.
So, if Carl quits the business, or sells the business, there is no guarantee Carl’s customers would stay with you or me. So, much of the time there is little other value to the business.
For these reasons, banks are reluctant to lend the corporation money itself. If Carl quits, the bank is left with maybe $10,800.00 in value. If the bank lends the corporation 50k the bank would stand to lose close to 40k in money.
Because of this, the bank will often want the shareholder of the corporation to pledge his personal liability for the debt too. That way, if the corporation fails, the bank can pursue the shareholder too. Instead of recovering $10,800.00 in value, the bank has a chance of collecting the balance of what is owed to them through the shareholder.
ONE CORPORATION AND ONE PERSON- BUT TWO SOLUTIONS
Because the shareholder will often pledge their personal liability on corporate debts, two decisions must be made. One, does the individual shareholder need to file bankruptcy? Often the answer is yes. The second question is, assuming the corporation's debts exceed the value of the corporation, what do you do with the corporation? It's important to understand how personal bankruptcy can affect the business. The personal bankruptcy affect can include halting lawsuits against the business owner, but it may not stop creditors from pursuing the corporation itself.
If the shareholder wants to continue the business, it will be hard to use the same corporate shell because the corporate creditors can sue the corporation and levy on the corporation’s bank accounts. Well, that sucks. So, what do you do?
Often, the shareholder will file a bankruptcy and then let the corporation go defunct (stop operating the corporation and either dissolve it by statute or stop paying the registration fees and the state will administratively close the corporation.)
In most instances, the shareholder lets the corporation go defunct and then starts to operate under a different name. The shareholder may start a new corporation or operate as a sole proprietor. If there are assets that remain in the old corporation, you will want to meet with a business lawyer to make sure any asset sales to a new corporation pass state and federal laws regarding the transfer.
In many cases, there is so little in the way of assets, there is not much to be transferred anyway. Some shareholders choose to file a bankruptcy for the corporation too. Often, it is easier to operate as a different entity than it is to file a bankruptcy for the old corporation. I have been practicing law for nearly 20 years and I might have filed one chapter 7 bankruptcy for a corporation. In most cases, dissolving the old corporation or letting it go defunct is the way to go.
PARTNERSHIPS AND LIMITED LIABILITY COMPANIES (LLCs)
Partnerships and LLCs with multiple members present a unique scenario in personal bankruptcy filings. Similar to sole proprietorships, partners in a partnership are personally liable for the business’s debts. This means that if you file for personal bankruptcy as a partner, your share of the partnership’s debts will be included in your bankruptcy estate. However, the bankruptcy trustee usually won’t interfere with the day-to-day business operations of the business.
In contrast, LLC members typically have limited liability, meaning their personal assets are generally protected from the LLC’s debts. However, if LLC members have personally guaranteed the LLC’s debts, those debts become personal obligations and will be included in a personal bankruptcy filing. The bankruptcy court usually does not interfere with the day-to-day business operations of an LLC.
CHAPTER 7 VS. CHAPTER 13 BANKRUPTCY FOR BUSINESS OWNERS
The type of bankruptcy you file—Chapter 7 or Chapter 13—can significantly impact your business. Chapter 7 bankruptcy involves liquidating non-exempt assets to repay creditors. In the case of a sole proprietorship, this could mean selling the business’s assets. However, if you own a corporation or LLC, your ownership interest (shares or membership) might be considered an asset that could be sold. After the liquidation process in Chapter 7, any remaining debt is discharged, unless there are personal guarantees.
Chapter 13 bankruptcy, on the other hand, allows you to repay your debts over time through a court-approved repayment plan. This option may be more suitable for business owners who want to keep their businesses running. Under Chapter 13, you can propose a plan to pay back your creditors over three to five years, using your future income, including business income.
TAX IMPLICATIONS OF BUSINESS BANKRUPTCY AND BUSINESS ASSETS
Filing for bankruptcy can have tax consequences for both your business and you personally. For example, in a Chapter 7 bankruptcy, the discharge of business debts could be considered taxable income. It's crucial to consult with a tax professional to understand the potential tax implications of filing for bankruptcy as a business owner.
PRACTICAL STEPS FOR BUSINESS OWNERS FACING BANKRUPTCY WITH A BANKRUPTCY TRUSTEE
If you’re a business owner facing financial difficulties, taking proactive steps can make a significant difference. Here are some practical actions to consider:
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Consult with professionals: Seek guidance from an experienced bankruptcy attorney and a financial advisor to understand your options and develop a plan.
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Communicate with creditors: Open communication with your creditors can sometimes lead to negotiated settlements or modified payment plans.
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Explore alternatives to bankruptcy: Depending on your situation, alternatives like debt consolidation, out-of-court workouts, or assignments for the benefit of creditors might be viable options.
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Consider the long-term impact: Bankruptcy can affect your credit score and ability to obtain financing in the future. Weigh the immediate relief against the potential long-term consequences.
Remember, facing financial challenges as a business owner is not uncommon. By taking proactive steps and seeking professional guidance, you can navigate the complexities of bankruptcy and emerge stronger on the other side.
SEEKING PROFESSIONAL GUIDANCE
Navigating the complexities of bankruptcy as a business owner can be daunting. It's crucial to seek guidance from experienced bankruptcy attorneys and financial advisors. They can help you understand your options, make informed decisions, and protect your interests throughout the bankruptcy process.
Remember, bankruptcy is a legal tool that can provide a fresh start for individuals and businesses alike. By understanding the implications of filing for bankruptcy as a business owner, you can make informed decisions and move forward towards financial stability.
CONCLUSION
It can be a bit confusing to own a business entity that has caused you to incur debt and wonder how the strands of bankruptcy law intertwine with the realities of a broken business. Much of the time, it comes down to you, the person who has signed the personal guarantees.
At the end of the day, the usual result is the owner files a bankruptcy and the shell of the entity, the corporation, usually gets dissolved or goes defunct. The owner/debtor, if they want to continue in business, will usually operate as a different entity.
Of course, if there is value to the corporation- in other words, the corporation's assets exceed the liabilities, the trustee may then take over as shareholder and liquidate the shares of the company. By liquidate, I mean reduce the shares to money by selling the corporation to someone else. This does not happen very often.
