Help For Small Business is in Financial Trouble - Part 3

Posted by William Kain on August 17, 2016 at 11:36 AM
William Kain

Help_For_Small_Business_In_Financial_Trouble.pngMy last two blogs, Help For Small Business in Financial Trouble & Help For Small Business in Financial Trouble - Part 2, have dealt with the decision as to whether to close a business that is no longer performing financially as the owner hoped. 

In the first blog, Help For Small Business in Financial Trouble, I discussed the practical issues of if and when to close a business. I wrote that the initial analysis is fairly straight-forward: is the business paying its employees? Is the business paying its taxes? Is the business paying its trade creditors? Is the business owner paying him- or her-self? I wrote that if the answer to all four of these questions is no, then my professional opinion is that the business should close.

In the second blog, Help For Small Business in Financial Trouble - Part 2, we discussed the practical problems facing business owners when the difficult decision to close has been made. The owners need to make sure that, to the extent possible, the business’s employees have been paid and that all taxes owed by the business have been paid. To the extent possible, trade creditors should be paid.

The business owner also needs to be well-aware of the existence of security interests in machinery, equipment, inventory and accounts receivable. If the business has secured creditors, the business owner needs to communicate effectively with secured creditors to make sure that the wind-up of the business, and the liquidation of business assets is done in a commercially reasonable and orderly manner.

While all business owners in this situation hope to be able to close the business and move on without becoming entangled with personal debt problems, it is often difficult to avoid personal financial risk when operating a business. And when a business closes with unpaid accounts, it is often the case that the business owner will be personally liable for the unpaid balances of these accounts after all of the assets of the business are liquidated.

So last week I discussed in filing a personal Chapter 7 Bankruptcy for business owners when the owners are not in a financial position to cover the personally-guaranteed accounts the business owes. This week I want to look at the possibility of keeping a business open “through” bankruptcy - that is, having an owner file either a Chapter 7 Bankruptcy or Chapter 13 Bankruptcy case while continuing to operate the business. Later, I will discuss under what circumstances a business should consider a business Chapter 7 Filing.

Keeping a Business Open - Chapter 7

It is rare to have businesses stay open if the business owner files a Chapter 7 Bankruptcy, but it can be done under certain circumstances. First, let’s look at what types of businesses can, and cannot, tolerate having a business owner file a chapter 7 case.

Sole Proprietors

The first consideration is the form of the business. I have trouble imagining a circumstance in which a sole proprietor of a business can file a personal chapter 7 bankruptcy and keep his or her business afloat. Why? A sole proprietor owns all of the assets of a business peronally, and likewise is personally responsible for all business debt. So by definition, all business assets are personal assets of the owner, and all business liabilities are personal liabilities of the business owner. If the business owner’s financial difficulties come from nonbusiness-related problems, such as large medical bills, or personal liability for an accident that was not sufficiently covered by insurance, the business owner might well have to consider filing a bankruptcy case. However, the owner will have to include all the debt the business owner carries - even business-related debt for which the owner is current on payments. And the owner will have to list all of the assets he or she owns in the bankruptcy schedules. And if the business is financially feasible and operating at a profit, then the business might be exposed for liquidation by the bankruptcy trustee. The individual who is considering filing a personal Chapter 7 Bankruptcy case while operating a business that has some profitability needs to understand that keeping the business open is probably not feasible.


Partnerships, LLCs and Corporations

The ability of owners to keep a business open while going through a personal bankruptcy case is enhanced if the business is a partnership, LLC or corporation. If the owner is not the sole proprietor of the business, then the assets of the business are owned by the partnership, LLC or corporation, not the individual business owner personally. Similarly, the debts of the business are the business’s obligation, not necessarily the obligation of the owner.

So in the scenario in which the owner has a large, unexpected, unaffordable debt that has nothing to do with the business - the unexpected accident or uninsured large medical bills - there is a chance an owner can file a chapter 7 bankruptcy case and receive a discharge, all the while keeping the business operating.

But owners should be mindful of three issues in this scenario: First, if the owner has signed a personal guarantee of a business obligation, it is likely that the loan documents give the lender the right to call the note due - that is, accelerate the payment schedule on the note - if one of the owners files a bankruptcy case, whether the loan in question is in current status, or not.

Second, the owner filing a bankruptcy case very well could be part of a business organization in which the establishing documents of the business - the business’s bylaws or partnership agreement - provide that if a business owner files a bankruptcy case the owner can be removed as an owner by the other partners, members or shareholders. It’s a common provision in business operating agreements. If this provision is present in the operating agreement, a business owner is well advised to speak with his or her partners in advance of making any final decision as to whether a bankruptcy filing is needed. Depending on the circumstances that surround the owner’s financial issues, it’s possible that the owner’s partners might be sympathetic to the financial circumstances of the partner and waive any operating agreement provision that triggers a buyout in the event of a personal bankruptcy.

Third, the attraction of keeping a business open while a business owner goes through a Chapter 7 Bankruptcy is that the business is viable, and thus has some value if the business were to be liquidated. If the owner of a viable business is looking at filing a bankruptcy case, that owner has to be aware of the possibility that a Chapter 7 Bankruptcy Trustee might have an interest in liquidating the business, if the owner has more than nominal equity in the business.

In this scenario, it’s important to understand that the business itself is not filing a bankruptcy case. And I’m assuming the business is an LLC or a corporation, not a sole proprietorship. As mentioned before, if a sole proprietor files a bankruptcy, the proprietor is the owner of all business assets and all business debt - so by definition, the sole proprietor will expose his or her business to liquidation if he or she files a chapter 7 bankruptcy case. So in a situation where an LLC member, or corporate shareholder files a chapter 7 case, the bankruptcy debtor does not own the business assets. But that person owns the entity that owns the assets. So the LLC or the corporation is what has to be valued to determine if the bankruptcy trustee would have an interest in liquidating it.

There are some simple, balance sheet-based valuations that can be done on a business, and they are effective since bankruptcy trustees are, in most cases, going to have liquidate the assets of the business - it is extremely difficult for trustees to market businesses. So using a simple approach of the value of the inventory, equipment, fixtures and accounts of a business, less the short- and long-term obligations of the business can work to fix a value on a business. If a business owner wants to keep a business open, it is usually because the business has some value. Because the bankruptcy code does not categorically exempt business interests in the exemption statute, there is a limited amount of exemption value available to protect business interests. So it is possible that the business is valuable enough that a bankruptcy trustee will liquidate the assets of the business, and in doing so effectively shut the business down.


Service versus Retail

The ability to keep a business open during a Chapter 7 Bankruptcy often hinges on the type of business the owner has. When the business is a retail sales business, it is extremely unlikely that the business can stay open. The reason for this is that when a business sells inventory, the filing of a chapter 7 bankruptcy by a business owner will create a problem with either the retention or procurement of inventory, or both. First, look at the problem the trustee poses with a retail business. If a business owns retail inventory that is not subject to a security interest or some sort of floor-plan financing agreement, that inventory can usually be very easily collected and sold by the bankruptcy trustee. A retail store without inventory will not be able to survive very long.

Then look at the issue from the perspective of vendors and suppliers. When a business owner files a chapter 7 bankruptcy case, if the business owner has signed a personal guarantee with a vendor/supplier, and account balance owed on the account will have to be listed as a debt on the owner’s schedules, and the personal liability on that debt will be subject to a bankruptcy discharge. In that event, it is predictable that the vendor/supplier will stop extending credit to the business and will then only deal with the business COD or even on a pay in advance agreement. In either case, this change in how the vendor/supplier provides inventory to the business will hamstring the ability of the business to maintain good levels of inventory.

In cases where the inventory is subject to the security interest of a lender, a personal bankruptcy can have the same effect - since the personal guarantee of the business owner will be discharged in the owner’s chapter 7 bankruptcy, the lender will be more likely to not renew lines of credit or revolving credit arrangements, and the lack of financing going forward will create problems for the business owner when it comes to maintaining inventory levels. For these reasons, it is very difficult for retail businesses to stay open when the business owner files a personal chapter 7 bankruptcy case.

Service-based businesses have more of a chance of staying open if the owner of the business files a personal bankruptcy. That is because much of the value of the business is based on the service provided by the owner, not on any tangible thing the owner sells. And since in the United States we no longer put a value on people, the value of the business usually ends up being the value of any furniture, machinery, equipment and fixtures the business owns, together with accounts receivable, less any outstanding business debt. So for small lawn service, daycare or hair styling businesses, to name just a few examples, the value of the business is usually quite modest and can easily be exempted under the exemption provisions of the bankruptcy code.

There can be problems with keeping a service business open when the owner files a chapter 7 bankruptcy case when the owner carries a large amount of receivables. The receivables of a business are an asset of the business, and if the amount of receivables owing to the business is large, then the value of the business might be significant enough that the business entity cannot be fully exempted. If a service business is partially or completely non-exempt, one of the easiest ways for a chapter 7 trustee to liquidate the business is to collect the receivables of the business. If this happens, and even if the amount collected is not remarkable, the cutoff of income from collected receivables can cripple a business that provides services.

That’s a look at the issues that surround chapter 7 cases when business owners file bankruptcy. Next week I will write about the (limited) circumstances under which an LLC or corporation would consider filing a chapter 7 case, and also look at Chapter 13 as an option for business owners with debt problems.

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Topics: Bankruptcy, Business Debt

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