Last week in my blog Help For Business In Financial Trouble - Part 1, I wrote about the decision many small business owners face: in light of the financial difficulties the business is facing, should the business close down? The decision is usually very personally painful for a person who has worked long and hard to own and operate a business. The feelings can be compounded when the reasons for business failure have to do with outside market forces more than the business decisions made by the owner. Imagine the hard-working video store owner from 1996 - today it’s very likely that the video store is no longer in business, regardless of whether the owner was a smart, capable businessman.
To add to the distress of closing a business, many business owners, after the business closes, need to seriously consider hiring a MN Bankruptcy Lawyer to File Bankruptcy. While this is far from what the business owner would like to do, it is often the very best choice available to a business owner to protect the financial well-being of the business owner and his or her family.
Why the Owner of a Business Would Have to file a Personal Bankruptcy
Many small business people come to see MN Bankruptcy Lawyers knowing that a bankruptcy might be necessary as a result of the business failure. But many owners are surprised that I discuss filing a personal bankruptcy case - they were thinking that the business might have to file, but not them personally. Part of the reason business owners are often surprised by the mention of a personal bankruptcy has to do with the business owners understanding of the legal form of the business in question. Many business owners have incorporated their businesses; and for many of those that haven’t incorporated their business they have formed a limited liability company (an LLC) to operate the business. When the owners consulted with their business attorney one of the stated reasons to form a corporation or LLC was to prevent personal liability for business obligations. The owners agreed to creating a corporation or LLC to protect themselves. Why didn’t that work? Why is the MN Bankruptcy Lawyer saying that the owner should file a personal bankruptcy?
The answer has to do with the way banks finance business loans. In a typical business loan - think of a Small Business Administration (SBA) loan - the business is the entity borrowing the money. It’s the corporation or the LLC that is obligated on the loan. But the SBA loan also requires that the owner of the business sign a personal guarantee. The personal guarantee provides that if the business is unable to pay the loan as contracted, then the owner has the personal obligation to pay. Personal guarantees are also present in revolving credit agreements - open lines of credit through banks or other lenders, and credit cards in the business name.
The personal guarantee of business owners for business debts is what leads business owners to file personal bankruptcy cases. Once a business starts failing, the flow of income anticipated by the owners starts dwindling, and in the case of a business that closes, income dwindles, eventually, to nothing. The business is no longer generating income for anyone - not the owners of the business and not the creditors of the business.
In most businesses with SBA loans, the SBA lender has a security interest in the inventory, equipment and fixtures of the business, as well as the receivables of the business. The problem is that when a business starts failing, the amount of inventory decreases, the equipment stops being updated and upgraded, and receivables become less likely to be collected. When the business eventually closes, the lender will act quickly to secure the collateral for the SBA loan, and will liquidate that collateral to pay as much as possible of the outstanding loan balance. But the proceeds of liquidation sales are often well below loan balances. When that happens, the owner’s personal guarantee is activated and now the owner owes the lender the amount of the shortfall.
In credit card cases, the problem is more pronounced: credit cards are unsecured debts, so if the business can’t afford to pay the credit card account, the business owner is on the hook for the entire balance owed - there’s no reduction on the balance through the liquidation of assets - that only happens with secured business debt. So now the financial problems of the business have become the financial problems of the owner of the business. And because of that, many business owners who end up winding down their business also end up as bankruptcy debtors.
While this isn’t a happy outcome, a bankruptcy case is in many ways, small business insurance. Having the ability to file a bankruptcy case means that the business owner will not have to worry about losing significant personal assets, or having wages garnished or personal bank accounts levied due to the business failure. Filing a bankruptcy case means that the owner will be able to move on to the rest of her work life without having to fund her obligations for a business that didn’t work well enough to fund the obligations itself.
The Main Issues With a personal, non-consumer (Business) bankruptcy
A business owner who makes the decision to file a personal bankruptcy case to discharge his or her business-related financial obligations should be aware of the issues that are common in what we call non-consumer cases. That is, the bankruptcy case is being filed to discharge non-consumer debt (business obligations).
The first issue is deciding what debts are listed in the bankruptcy schedules. In every case, the business owner needs to list all personally-guaranteed debt. So SBA loans, business credit cards and bank-issued business lines of credit must be listed in a bankruptcy case since all of these credit products require personal guarantees. In the bankruptcy schedules, the business should be listed as a co-debtor on the loan, so that the bankruptcy trustee knows that the debt is a business-related debt and so the creditor can properly identify which account is subject to the bankruptcy.
But there are typically other debts with businesses that do not require personal guarantees: utility bills and invoices from vendors and suppliers are typical bills that many businesses owe, but that usually do not have personal guarantees attached to them. In cases where the business owner has no non-exempt assets, it is a good practice to list these “trade payables” as creditors, simply for notice purposes, but to indicate on the schedules that they are, in fact trade payables and that the owner has no personal liability on the account. This is helpful to these trade creditors to advise them of the closing of the business, and it eliminates or reduces contacts from the creditor to the business owner for collection of the business debt.
While sending notice to trade creditors is a good practice, it can’t always be done. In cases where a business owner files a personal bankruptcy case, but has non-exempt assets that a Chapter 7 Trustee is going to liquidate to pay creditors, trade payables should not be included in the schedules identifying unsecured creditors. In a personal bankruptcy case where there are non-exempt assets, the only creditors entitled to receive a dividend from the liquidation of these assets are the creditors to whom the business owner has personal liability. If trade creditors are listed on the schedules in an asset bankruptcy case, confusion ensues when these creditors are advised to file claims (as they would be - the clerk of bankruptcy court sends claim forms to all “listed” creditors). When trade creditors file claims in a personal, non-consumer, bankruptcy case, it is up to the Chapter 7 Trustee to object to the claims and get a court decision as to whether the claim will be allowed.
So what’s the best practice? Business owners should check their records closely to see whether they have personally guaranteed a business-related debt. If it is clear that the owner either did or did not guarantee the debt, no problem - depending on the circumstance the business creditor either is or is not listed. But there are potential creditors for whom the owner is not sure whether there is a personal guarantee. In these cases, the best practice is to list the creditor - when and if that creditor files a claim, the creditor will have to produce some document that shows personal liability. If there is no proof of personal liability, the Chapter 7 Trustee will object and the court will decide the status of the claim.
HOw Taxes Play A Role in Your Bankruptcy
Many businesses that are financially stressed also have tax problems. The federal and state tax laws require employers to withhold income tax. And the state requires business owners to contribute to unemployment and workers compensation funds. If businesses sell certain retail items, the state also requires business owners to collect and pay sales tax.
Depending on the form the business operates under, tax liability can raise major issues as businesses close and the business owner decides whether to file a bankruptcy case. In cases where the business has operated as a sole proprietorship or a partnership, the tax liability associated with the business is the personal liability of the business owner. But things get a little more complicated when the business has operated as an LLC or a corporation. In those cases, the tax liability is the business’s, until the taxing authority takes the step to personally assess the business’s tax liability against the business owner who is identified as the responsible party.
It is important for business owners to understand that non-income tax liability is not discharged in Bankruptcy. So if a business owner who has been operating as a sole proprietor files a Chapter 7 Bankruptcy case, and the business owner has unpaid business-related taxes, those taxes will not be discharged in the bankruptcy case. The business owner will have to work out some sort of repayment agreement with the Internal Revenue Service and/or the state taxing authority.
In the case of a business operating as an LLC or corporation, it is the business, and not the owner, who is “immediately” liable for the business taxes. The member of the LLC or the sole shareholder of the corporation does not have personal liability for business taxes, at least immediately and shortly after the time when the business closes. The taxing authorities will first try to collect unpaid business taxes from the business. It is only after a period of time that, assuming the business is unable to pay tax liability, the taxing authority assesses personal liability against the business owner. In a case where there is just one member of the LLC or one shareholder of a corporation, then the sole member/sole shareholder is the individual assessed with the liability. Things get trickier when there is more than one member of the LLC and more than one shareholder of the corporation.
In those situations, the business owners will have filed a notice with the IRS and the state taxing authority identifying a “responsible taxpayer” - the specific owner to whom personal responsibility will be placed in the event the business is unable to afford to pay its tax obligations. Most business formation agreements among partners will contain an agreement as to how tax liability will be shared among the owners so that the responsible taxpayer is not carrying the entire burden of tax liability for the business.
In Chapter 7 Bankruptcy cases, whether the business’s tax obligation has been personally assessed isn’t always an issue, but it can be. This issue will come up when a business owner files a personal bankruptcy to discharge business obligations the owner has personally guaranteed, and there are non-exempt assets to distribute in the case. When the bankruptcy trustee distributes non-exempt assets, priority creditors, such as taxes, get paid in full before any other creditor. If a tax liability has not been personally assessed when a business owner files a personal, asset, bankruptcy, then the taxes that will eventually become the owner’s personal liability will not be paid because the obligation to pay them has not yet been assessed against the bankruptcy debtor.
So in cases like this, the business owner should wait to hire a MN Bankruptcy Attorney and File a Bankruptcy Case until the personal assessment of tax liability has been made. Since many Chapter 7 Bankruptcy cases are no-asset cases, this issue doesn’t come up often. But it is a common issue when a business owner decides to file a Chapter 13 Bankruptcy case. I will discuss that next week. In the meantime subscribe to my blog to recieve the Free Bankruptcy Articles in your inbox.