Before you file bankruptcy, you need to know what happens to your business in your bankruptcy. And like so many things, there’s no single, simple answer.
Two factors drive the fate of the business. One is whether the business is itself a legal entity, like a corporation or LLC. The second is what chapter you are filing.
Form of business matters
Corporations and LLC’s are by law legal “persons”, separate from their owners. As a legal person, the entity can have its own assets and its own debts, which are not the assets or debts of the owner. Thus, when the owners file bankruptcy, the business entity is not a debtor and is not “in bankruptcy”.
Instead the ownership interest of the owner is merely an asset of the owner’s bankruptcy estate when the owner files bankruptcy. The estate then owns the shares of a corporation or the membership of an LLC.
The value of that ownership interest depends on whether there is a market for the ownership interest, or alternatively, is there value left over if the business were liquidated and the entity’s debts were paid.
Bottom line, an entity may continue operating when the owner files bankruptcy.
When the business and its owner are one
It’s a different story when the business is not a separate entity, but a sole proprietorship. When it is the individual who owns the business, at law, the business and its owner are a single person. The entrepreneur owns the assets and is liable for the business debt.
Thus, when a sole proprietor files bankruptcy, the business itself is part of the bankruptcy. The business gets the benefits of the bankruptcy and is exposed to administration in the case.
Which chapter matters
Control over the assets of the bankruptcy estate is one of the fundamental differences between Chapter 7 and Chapter 13.
In 7, an outside trustee is appointed to administer the case and sell assets if that would allow payment to creditors. In 13, the debtor retains control of the assets and is expressly authorized to operate a business.
Business in Chapter 7
Put most simply, Chapter 7 trustee’s is interested in a corporation or LLC only if the debtor’s interest can be sold, or liquidated for meaningful net dollars. So business entity with few assets or significant debt is “safe” in the owner’s bankruptcy.
It’s a different story if the business is a proprietorship. The Chapter 7 trustee has different concerns about the continued operation of a proprietorship. One is liability.
If the debtor operates the business after filing and either incurs new debt or a person is injured in the business, the bankruptcy estate is responsible. Those post filing debts would be paid before the existing creditors. That’s a potential black mark for the trustee. So, most trustees’ instinctive reaction to an operating proprietorship is to shut it down to preserve the status quo.
Self-employment is a grey area
Some forms of businesses are sole proprietorships, but have few of the characteristics of an operating business. Think: knowledge workers, consultants, contract workers.
These kinds of “business” seldom have meaningful debt. They don’t have business premises or employees. They have no value separate and apart from the person who supplies the labor. So they usually pose less of a liability or new debt risk for the trustee. And thus the imperative on the part of the trustee to shut the business is less.
Abandonment may be a solution
When the trustee’s approach to a business is difficult to predict, one strategy is for the debtor to bring an immediate motion to compel the trustee to abandon the business back to the debtor.
An order for abandonment relieves the estate of any of the troublesome risks we listed and makes clear the debtor’s right to continue making a living.
Brainstorm before filing
If you expect to continue a business beyond filing an individual bankruptcy case, take the time to game out the possible outcomes for your business in bankruptcy with an experienced bankruptcy lawyer. A lot depends on it.
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