Business owners filing Chapter 7 beware!  You may have to close your business until the Chapter 7 Trustee surrenders any claim to it.

That is the nightmare that potentially awaits unincorporated business owners who file Chapter 7.  Why is that?  And why does this only happen to unincorporated business owners?

The problem occurs because the moment a Chapter 7 case is filed all property of the debtor becomes vested in the Chapter 7 Trustee and the Trustee is charged with the duty of preserving the bankruptcy estate.  A debtor who continues to operate a sole proprietorship after the case is filed is diminishing the assets of the business by spending funds in a checking account and collecting accounts receivables and using business equipment.  And in the eyes of the trustee appointed to the case, many debtors do not run their business very well so they may direct the debtor to stop all business activity until they decide if any assets are worth claiming.

You can imagine the nightmare this presents.  Chapter 7 trustee’s don’t meet with debtors until at least a month after the case is filed, and they may wait even longer to decide if they will claim a business asset or surrender them back to the debtor.  In the meantime, a debtor may be forbidden to earn an income.

How can this be prevented?

SOLUTION #1: Incorporate the Business

The least expensive and most effective solution to the sole proprietorship dilemma is to incorporate. It has never been easier or less expensive than now to incorporate a business. Services such as LegalZoom will incorporate a business for as little as $150 plus filing fees. After the business is incorporated–a process that can be completed in a few days–the next step is to transfer assets into the new company.  Then, when the bankruptcy is filed, the debtor is not operating a business but is rather the owner of stock in a company running a business.

SOLUTION #2: Motion to Abandon Property

In the alternative, a business owner could opt to file a motion in the bankruptcy court to compel the trustee to abandon the business assets and to ask for an expedited hearing on the motion. This is an expensive option that will basically double the cost of the bankruptcy case, and there will still be a delay in business activity until the expedited hearing takes place.  In addition, the outcome of such a hearing is uncertain and it may require additional hearings to settle the matter thus causing the business to be shut down for an extended time.

A cold wind is blowing out there and it is impossible to say who will be told to shut down.

SOLUTION #3: Do nothing.

In 25 years of bankruptcy practice, I have seen few cases where a trustee actually compelled a debtor to cease business. However, in recent weeks we have seen a trustee pick up this issue and threaten debtors with penalties for dissipating business assets and operating businesses without trustee approval. In fact, the trustees have a point: the continued operation of an unincorporated business potentially reduces assets of the bankruptcy estate.  But it is rare for a trustee to make a shutdown demand, so perhaps this is much to do about nothing. The problem is, a cold wind is blowing out there and it is impossible to say who will be told to shut down.

Image courtesy of Flickr and Hannah Rosen.