I still remember being in the bankruptcy meeting room waiting for my client’s turn to see the Chapter 7 Trustee. What I saw was a classic mistake made by young and inexperienced bankruptcy attorneys.
Trustee: So how long have you owned the painting supply business?
Debtor: About 8 years.
Trustee: I see that you rent the store space and that you value the business equipment at $5,000, is that right?
Debtor: Yes, that’s correct.
Trustee: Are you owed accounts receivables? Do customers owe you money today?
Trustee: How much do they owe? What is the total?
Debtor: About $15,000.
Trustee: And your inventory of paint, how much is that worth?
Debtor: About $10,000 to $15,000.
Trustee: Okay, and my understanding is that you are a sole proprietor. You are not incorporated. Is that correct?
Debtor: Yes, that is correct.
Trustee: Okay, well I’m going to claim your inventory and accounts. I want you to stop operating the store now and deliver the keys to my office.
And just like that, the business was over.
The tragic thing is, neither the bankruptcy attorney nor the client thought this would happen. They thought the business was safe because the business owed way more in debts than it had in assets. In truth, the business did owe a lot of debt for rent, supplies, utilities, taxes, etc, but none of that mattered.
When you are a sole proprietor there is no such thing as a business being separate from you. You are the business. The business assets are your assets. In your mind you think of the business as a separate creature, but it is not. The “business” is nothing more than a collection of assets and debts that is combined with your personal property and debts. There is no distinction.
Now consider how this case would have turned out had the business owner incorporated the business prior to bankruptcy. Instead of owing a painting supply business the debtor would have owned stock in a company that operated a painting supply business. The corporation would have owned the business property and the corporation would have owed the various debts. Since the debts of the company would have exceeded the value of the business assets, the stock of the company would have been worthless. The business would have been safe from the Chapter 7 Trustee since the company’s stock would have had a negative net worth. The trustee could not “cherry pick” the business assets.
There is a key difference between owning a business individually and owning stock of a company that operates a business.
SHOULD YOU INCORPORATE YOUR BUSINESS PRIOR TO FILING BANKRUPTCY?
Some businesses are so simple that there is no need to incorporate. A home daycare may not have very many assets to protect (but watch out for receivables). Some businesses are simple personal service businesses, so incorporation may not be necessary. But if the business owns significant assets or if substantial inventories or receivables exist, it is probably best to incorporate the business prior to bankruptcy.
Transferring assets to a new company on the eve of bankruptcy can be a dangerous activity. Chapter 7 trustees have special powers to undue property transfers, so incorporating a business is not a simple solution. It is best to hire a very seasoned corporate attorney to set up the new business. You may want to delay the bankruptcy filing until the current inventory and receivables are gone and new inventory and receivables are built up in the new corporation. You need to be counseled by an attorney who is familiar with the bankruptcy law of Fraudulent Conveyances and Insider Preferences.
If you own a business that supports your family and need to file bankruptcy, slow down. Make sure you don’t lose your business in the bankruptcy process. Consider the safer Chapter 13 alternative if you sense too much risk in the quick but dangerous Chapter 7 case.
Image courtesy of Flickr and Marius Watz.