Facets on a gem bend light and change how we see things.

The same thing happens when bankruptcy law encounters a small business owner and the business itself.

Seen from one angle of the law, the business is a valuable asset.

Seen from another, it is nothing more than a job for the owner, having no real value without the owner.

It depends on where you stand and where the light hits.

Is incorporating dangerous?

The question comes up when individuals have a small business that provides a living, but the owners have accumulated crushing debt.

I wrote earlier about how incorporation could create a separate legal entity that could continue to operate during the bankruptcy of its shareholders.

My good friend Doug Jacobs pointed out that under some circumstances, incorporation could be seen as a fraudulent transfer.  And that’s not good.

A fraudulent transfer is one where the entity conveying property either intends to put it beyond the reach of his creditors, or, receives less than the asset was worth in exchange, leaving the transferor less able to pay his debts.

The bankruptcy code allows the bankruptcy trustee to recapture assets transferred in fraud of creditors.

My counter argument to Doug’s point is that incorporation hardly conveys away the value of the business, as the debtor simply exchanges his outright ownership of the business for outright ownership of the stock in the corporation that owns the business.

If there is real value there, a bankruptcy trustee can reach it by dissolving the corporation.

My second argument is that before incorporation, the business was indistinguishable from the individual. The idea of “transferring” debts to the newly created corporation is facially pleasing, but cannot relieve the individual of any liability he had before incorporation.

It is an axiom of law that no agreement between two entities can bind a third: that is, the individual and his corporation cannot by agreement cut off the right of the individual’s creditor to look to the individual for repayment, even though the new corporation and the individual might agree that the corporation will be henceforth liable.

This analysis is probably more theoretical than real.

The small businesses my clients usually operate are little more than personal services businesses. Incorporation simply provides cover for the trustee who, because of incorporation, doesn’t have to shut the business down as part of his duties to preserve the assets of the estate.

Law colored by local culture

But whether you see incorporation representing a meaningful transfer or not, the issue highlights the fact that the legal culture does vary from place to place.

I practice in Silicon Valley; Doug practices in the Central Valley. Like it or not, even though the law is the same in both places, judges often bring a slightly different perspective to the bench, depending on where they practice.

For that reason, when you select a bankruptcy lawyer, you want one who knows the judges before whom your case will be heard and understands the legal culture in that community.

Image:  Nemo & Pixabay

When your incorporated business fails,  you may be more at risk than you think.

I know you incorporated to separate yourself as the owner from the risks of the business.  The corporation is a separate legal person, distinct from the individuals who own the stock in the corporation.

But when the business has to shut down, the actual degree of separation is tested.

You’ve got to know if the business can safely file bankruptcy.

Or, will using bankruptcy to shut down the business drag the owners down as well?

Can this corporation safely file bankruptcy?

Businesses looking to go out of business typically file Chapter 7.  The business closes, a trustee is appointed, and any valuable assets are sold for the benefit of creditors.

The trustee then controls the corporate checkbook and the timeline on which creditors get paid through the courts.

Bankruptcy trustees are further empowered to recover money paid by the debtor corporation where the transfer is a preference or a fraudulent transfer.  That’s the beginning of the complications in a business Chapter 7.

Before choose bankruptcy as the method for winding down, consider these five potential complications.

1.   Owe payroll taxes?

Corporate officers and anyone with signature authority on the corporate bank account may have personal liability to the IRS and any state taxing authority for amounts withheld from the paychecks of employees.

This liability exists whether the corporation files bankruptcy or winds down outside of bankruptcy.

More about “borrowing” from Uncle Sam

Filing bankruptcy may preserve assets from other aggressive creditors from which those taxes can be paid.  That benefits the individual officers, since every dollar the trustee pays on payroll taxes reduces what they’ll have to pay.

But bankruptcy empowers the trustee to hire professionals, investigate the debtor’s books, and pursue recovery of money owed to the corporation, either under state law, or under bankruptcy law.

The expenses of that pursuit are paid ahead of the priority taxes.

Thus a bankruptcy filing could work to shrink the pool of money for payment of payroll taxes, and drag out the time before payment is made.

2.  Made guarantees?

Landlords often require the personal guarantee of the individual shareholders before they commit to a real property lease for the corporation.  Or the lease may have been in the shareholder’s name from the start.

Any individual guarantor on a lease gets no protection from his obligations to the landlord when the tenant corporation files bankruptcy.

A bankruptcy trustee calls the shots when a corporation files Chapter 7.  He’s got the keys.

Trustees are usually quick to either vacate the premises or surrender it back to the landlord, freeing the landlord to look for new tenants.

But any pre bankruptcy lease arrears have no priority for payment in the bankruptcy case, so if there is a dividend payable to the landlord, it may be small and far in the future.  The individual is on the hook.

3.  Used corporate credit cards ?

Almost without exception, some living, breathing human being is personally liable for every credit card.  Even if the card has the business name embossed on it, the application for that card undoubtedly contains a promise of the owner to pay the card issuer.

So, any liability of the individuals on the credit card won’t be eliminated by the business’s bankruptcy.

It can get worse:  the corporation may not, in fact, be liable at all on the card.  Not all “business credit cards” are really issued to the business. They’re issued to the people who run the business.

Filing bankruptcy doesn’t make the situation worse:  if the corporation is liable and if there are assets to pay creditor claims, the credit card folks get something toward the balance.  Only it’s a long time down the road.

4.  Benefited from paying the bills?

File bankruptcy for the business, and you may get yourself sued by the trustee for an avoidable preference.

When you and the business are jointly liable for a debt, every payment the business makes on that debt reduces your personal exposure to the creditor.  And that, in the eyes of the law, is a preference.

The bills that the business paid to your benefit when other bills weren’t getting paid is an unfair discrimination between creditors of the business.  The trustee is authorized to sue you to make it more fair to other creditors.

The problem of preferences is the only item on this list of complications that is unique to bankruptcy.  Depending on the facts of the business’s operation, filing a Chapter 7 may just invite a lawsuit against you as the shareholder.

5.  Enjoyed  business help with personal expenses?

The more corporate money that flowed to insiders, the greater the threat that a bankruptcy trustee will challenge the payments,.

“Challenge” here is shorthand for “sue you”, or at least look hard at expenditures that made life easier for shareholders at a time when other creditors weren’t getting paid.

Often, the facts are just the opposite:  the shareholders were putting more money into the corporation, or going without to keep the business afloat.

But the idea of a fraudulent transfer, a payment for which the payor did not get a fair return for its money, has a long lookback period.  A bankruptcy trustee could be looking back years to see if the shareholders got more than was fair under fraudulent transfer law.

And if the books and records are sketchy, the shareholders may end up spending lots of time producing documents or explaining what happened.

Even if the end result is OK, the experience can be unnerving.

The bankruptcy takeaway

The issue of how to close out a failed corporate business can be complex.  While I’ve listed the ways a corporate bankruptcy might end up biting the shareholders, the benefits can be equally significant.

File bankruptcy and much of the wind down work passes to the trustee.  The business creditors understand there is nothing available to pay their claims against the corporation.  Assets are distributed in an orderly and predictable manner.

Make sure you’ve asked yourself the five questions I’ve laid out and that you take your answers to experienced bankruptcy counsel for a review.

More

Winding up a failed business

 

Financial partnerships are at least as challenging as marriages.  And business deals don’t have love to smooth the rough spots in the relationship.

The traditional marriage service ends with the charge that what God has joined together,  let no man put asunder.

That’s great with love, but not so great with money.

Something will likely asunder the business venture.

Yet people pool their money in business, real estate, and investments without a thought to how the partnership will end.

Chances are, it will end, and that end can be very messy and miserably expensive.

My charge to those pairing up for an investment is this:

At the start of any venture involving pooling money, lay out some rules for how you part in the end.

Think of your business wind-up rules as a prenuptial agreement for your business. [Read more…]

It isn’t just marriage that can get you roped in to a bankruptcy case that isn’t your own.

Own community property and a bankruptcy filing by your spouse or your soon-to-be ex can drag you into a bankruptcy court.

But the issue is broader:  joint ownership of any kind of asset in any state, community property or not,  exposes you to a loss of control of your property if your co owner files bankruptcy.

The bankruptcy court has the power to force the sale your property or require you to buy out your co owner.  On a timeline not of your choosing.

Co owners at risk

If your partner in a business or a piece of real property files bankruptcy, the partner’s interest may be sold for the benefit of your partner’s creditors.

Oops!

And since the sale price of just your partner’s interest in the property would probably be less than the fraction of the partner’s ownership, the Bankruptcy Code gives the bankruptcy trustee the power to sell your interest too. [Read more…]

Usually I rant about mistakes clients made when they incorporated their ongoing business.

Come hard times for the business, those mistakes eat into our options for the owners survival when the corporation goes down.

Invariably,

• the vendor accounts remain in the name of the proprietor,
• the stock may not have been issued, and
• it’s unclear whether there was an explicit transfer of the assets to the corporation.

If the business is beyond saving, I want the incorporated business to go out of business. The business can shut down either through a bankruptcy filing or just by closing the door.

The goal is to let the corporation die without killing the owner in the process.

That requires  as much distinction between the assets and debts of the business and the assets and debts of the business owner as possible.

Yet when the incorporation was sloppily done, that line between owner and business may be murky.

Owner still needs to eat

The challenge when a small business fails is making sure that the owner has a way to make a living after the doors close. [Read more…]

Incorporate to protect yourself from the debts of your  business, shriek the ads.

That’s the theory of incorporation:  create a separate legal entity in the form of the corporation.

Let that entity incur debt and expose itself to other risks.  If it fails, the personal holdings of the owners of the corporation are safe.

But, in the real world, most big ticket debts that a corporation might incur require the guarantee of the owner.

So if both corporation and owner are liable for the business debts, what has incorporation gained you?

You’ll be surprised.

Incorporate to protect the business

Consider the same move, incorporation,  for the opposite reason.

Incorporate to protect the business from the owner’s debts.

A sole proprietor and his business are one and the same in the law.

When the proprietor has a tax problem or there’s a judgment outstanding against him, all of the business cash and assets are exposed to that debt.

The business bank account can be levied for the owner’s back child support or a judgment against the owner for unpaid magazine subscriptions. [Read more…]