Whether a business is incorporated or not can have a dramatic impact on the outcome of a bankruptcy case, especially in Chapter 7 cases where the bankruptcy trustee has the power to sell non-exempt assets. Successfully filing a business bankruptcy in Nebraska depends on understanding the important difference between incorporated and unincorporated business assets.
Let’s assume a debtor owns a paint store that has $100,000 of liabilities and $25,000 of inventory and another $25,000 of receivables. Looking at the business as a whole it is apparent that the business is insolvent—it has $50,000 of assets (the inventory plus the receivables) but $100,000 of debt. If I were to ask you what the business is worth you might be tempted to reply that it is worth nothing since there is twice as much debt as there are assets. Nothing could be further from the truth.
If the paint store is not incorporated, the bankruptcy trustee will see $50,000 of assets to liquidate and will probably order the debtor to cease business operations and demand immediate possession of the store. In an unincorporated business entity the business assets are not connected to the liabilities—they are separate and distinct things. To the business owner they are connected, but not to the bankruptcy trustee. The trustee has the power to sell the assets and to pay a pro-rata distribution to all of the debtor’s creditors, not just the business creditors. In the process of liquidating the assets, the business is destroyed and the debtor is left to find another career.
In an unincorporated business entity the business assets are not connected to the liabilities—they are separate and distinct things.
Quite a different outcome is achieved by the debtor who incorporated the business. In the above example, the debtor does not own the inventory or receivables. Rather, the debtor owns stock in a company that owns $50,000 of assets and owes $100,000 of debt. The stock of the company is worthless in this example and the trustee will not liquidate the business.
So, does this mean that a debtor should immediately incorporate their business before filing bankruptcy? The answer is probably yes, but incorporating a business to protect the assets does not automatically fix the problem. First, transferring $50,000 of free and clear assets to a new corporation merely creates another non-exempt asset, namely, stock in a company worth $50,000. The assets may have been transferred, but the liabilities were not. Creating liabilities in the new company takes time as old debts get paid off and new debts are created in the new company. This can be a slow process. Also, the Chapter 7 Trustee is empowered to undo transactions through what we call the Fraudulent Conveyance Act—defined as a transfer of assets from one person or entity to another without receiving equivalent consideration in return. So, if assets are not carefully transferred and new debts are not correctly incurred by the new company, the Trustee may claim the entire transfer to be a sham and go after the assets.
The point of this discussion is not to advise debtors how to transfer assets to evade the long reach of the bankruptcy trustee, but rather to warn potential debtors of the inherent danger of taking an unincorporated business into Chapter 7. Careful planning is required, and unincorporated business debtors may want to consider filing a Chapter 13 payment plan instead of risking income generating assets in the Chapter 7 liquidation process.