For people who are the sole proprietor of their business, filing for personal bankruptcy can have ramifications on the business ownership too. This depends on how the business was legally organized and the type of bankruptcy you have filed in the court. As per U.S. bankruptcy code, individuals can file for bankruptcy under two chapters, depending on their circumstances – Chapter 7 or Chapter 13.
As lawyers of Los Angeles based law firm Recovery Law Group explain, Chapter 7, also known as liquidation bankruptcy is one of the most common types of filing done in personal bankruptcy cases. During this process, a trustee (an individual or an entity) is appointed by the court who oversees the liquidation of all the non-exempt property of the filer so as to settle the debt claims. The non-exempt property is that property which the court permits the filer to keep after the declaration. The amount of assets that any debtor can keep varies from state to state. According to Chapter 7 filing, the debtor’s business ownership can be considered an asset which can be liquidated. However, the methods for assessing the value of the asset can vary widely with debates arising over the proportion of ownership in case of closely held corporations.
Unlike chapter 13, a business going through bad financial times can file for bankruptcy under Chapter 7. However, the business does not get a discharge but its assets are liquidated and the business reorganized so as to distribute the money to the creditors on the basis and priority of their claim. If any remaining amount of due remains, it is wiped off. In case the owners do not want to close the business and liquidate all the assets, they can choose to file for bankruptcy under Chapter 11 to reorganize and pay back the creditors.
Another type of bankruptcy filing for individuals is Chapter 13 which offers to reorganize the finances by taking into account the debtor’s assets, the debt due to him/her, and the expected future source of income or revenue. The court appoints a bankruptcy trustee for this task and the creditors agree to the repayment plan calculated by the trustee after taking into account the various previously mentioned factors. Since only individuals can file for bankruptcy under this chapter, if you are a sole proprietor or own shares in a corporation, only then you can file an individual Chapter 13. You need to list your property interest on Schedule B to get exemption on the equity you have in the business. It is important to remember that in Chapter 13 bankruptcy, debts limits of nearly 1 million in secured debts and about 380,000 in unsecured debts is available.
When you opt for a reorganization filing (Chapter 13), the court mandates a repayment plan and personal living budget, which needs to be adhered strictly. The entire reorganization plan needs to be followed for a long duration, typically 3-5 years. Since some portion of the money will flow from business to the individual during this time frame, the business ownership assets might be affected.
Bankruptcy Outcome May Depend on the Legal Formation of Your Company
A small business is generally organized in one of the three forms –
• Sole proprietorship,
• Limited liability corporation (LLC) and
• Corporation
Corporations can be of 2 types: S-Corp or C-Corp, wherein, in the former case, profits or losses flow through to the shareholders, and in the latter case, corporations are taxed separately from their owners. With LLC, the organization structure has a blend of both individual and corporate structure. Just like C-Corporations, LLC to has a separate legal existence from its owners. The U.S. business code provides the owners in LLC to have limited liabilities for corporate debts. However, not all closely-held corporations can be treated similarly as the unique circumstances might differ. It is therefore important to have a consultation with a bankruptcy attorney regarding your current financial situation.
Sole Proprietorship
In case a business is a sole proprietorship, the law doesn’t distinguish between the individual and the corporation, however, the specifics of the portion varies from state to state. Generally, however, due to the close association between the individual and the business, personal bankruptcy may also be considered a business bankruptcy. Under Chapter 7, the court will regard the business as a personal asset which may be liquidated to pay off creditors.
Personal Bankruptcy in Case of LLC or Corporation Ownership
These types of companies are regarded as separate legal entities, unlike sole proprietorship. Thus when individuals with corporate interests file for bankruptcy, only the portion of business ownership which is held by the bankruptcy filer gets affected. The business can run in the usual manner with debtor’s equity in it becoming an asset in the personal filing.
Homestead Exemptions in Personal Bankruptcy
The court, in many states, allows legal provision which exempts the primary residence of the bankruptcy filer from various legal claims including bankruptcy. This is known as the Homestead Exemption. It is one of the major reasons why many entrepreneurs and celebrities choose one of the exempt states as their primary legal domicile. Some states have no limit on the value of exempt residence!
Business Ownership Interests and Chapter 7 Filing
In liquidation bankruptcy cases, the net value of ownership interest (assets minus liabilities) is assessed by the court, to come up with a plan to make money available for paying the creditors. If, for example, an individual who has filed for Chapter 7 bankruptcy has a small business valued by the court or trustee at $500,000 and the filer also possess other assets worth another $500,000 which can be liquidated (cash, property, vehicle, etc.), then the total amount available to pay the creditor’s claim is a million dollars.
This is to be considered theoretically as just evaluating a business interest won’t generate the money, a buyer willing to make the purchase is required to actually have the cash in hand to repay the creditors. Most of the time, many small businesses have no value due to the debts in books from the building and operating of the business.
However, it may be noted, that some jurisdictions offer a bankruptcy code which allows individuals or small businesses to make a fresh start. The “fresh start exception” law may permit a business to continue operating without the burden of debt which was previously attached to the business, prior to a bankruptcy filing.