Small businesses and the bankruptcy estate

I wrote a while back about strategies for dealing with debt for the small business owner. I will get more focused here about a key issue involved in a business related individual bankruptcy. As I explained in that previous post, most small business owners who become insolvent are forced into a personal bankruptcy even though most of the debt belongs to their business because of the owner’s personal guarantee. I refer to these as business related bankruptcies even though it is actually the individual person who files.

For an oversimplification, when someone files a bankruptcy, everything they own (with some exceptions) goes into an estate under the control of the trustee. The individual then uses exemptions to reach into the estate and keep certain property. Now, the issue in focus is what happens to the business when the owner files. Although the business itself is not in bankruptcy, the owner’s interest in that business goes into the bankruptcy estate the moment the bankruptcy is filed. And, there is only a small exemption for business equipment and tools of the trade so most exemption must come from the “wild card” exemption of 11 USC Sect. 522(d)(5). So, if the company has many assets, accounts receivables, ongoing contracts for work, inventory, or transferable goodwill, the owner may not be able to exempt it all. That creates a real problem and a potential battle over the real value of the owner’s interest or the forced sale of the interest.

Ordinarily, the owner’s interest is actually very small or zero due to debt load or because most of the company’s value is tied to the owner’s personal efforts. However, there is little reason to tempt such complications when there is another option. The best practice in such situations is to wind down the business and dissolve it administratively just prior to filing the bankruptcy. Then, immediately after filing the bankruptcy, create a new Limited Liability Company or S-Corp and begin doing business as a new entity. While the trustee could attack the new company as an alter-ego of the first, there is a strong disincentive because now the trustee has to first win through on an alter-ego theory and then still argue over the value.

There are many details involved in the winding down of the old and the starting up of the new business including how bank accounts, accounts receivables, contracts and employees are all handled. So, it is best to get in with a bankruptcy attorney that is versed in these types of business related bankruptcies early on to give adequate time to plan and prepare.