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.

What options do small businesses have to deal with debt?

This economy has been tough on the small business owner. Many of the people I talk with are sole owners of a Limited Liability Company, S Corporation, or sole proprietorship. Invariably, the owner has invested a great deal of his or her own resources into the business to fuel their dream. Because small business ventures, especially start-ups, lack assets and reliable revenue streams, banks always insist that the company and the owner individually AND the owner’s spouse all co-sign any loans. They typically also insist on a lien against personal property, such as the family residence.

So, when a small business start-up becomes insolvent (which statistically accounts for the majority of new businesses) there is far more at stake than just the business assets. The home and other personal property are at stake as well. Because of what is at stake, many folks understandably push on past the point of wise investing and empty out retirement accounts and cash in other exempt assets to keep the business going just a little longer.

When the economy first began faltering, this strategy had some wisdom to it because everyone expected a rebound in a few months. Now, though, the new reality of our economy is setting in and fewer people are expecting a big turn around. Because of this, the small business owner is compelled to a new level of shrewd thinking.

However, what happens when one’s best laid plans simply are no match for sluggish sales? It basically boils down to two possibilities: 1) an out of court work-out, or 2) bankruptcy. The way to determine which route to go involves an analysis of debt, income and assets. One business owner I consulted with was being pressed very hard by creditors and wanted to do a bankruptcy, but when I reviewed the assets he had that were not encumbered (were not collateral on a debt) he realized how much he stood to lose in a bankruptcy. The analysis allowed him to explore an out of court restructuring of debt because he had a dollar number where it made sense to incur additional debt and a cut off point. In other words, the analysis gave him a make it or break it line. I’m happy to say he avoided bankruptcy and his business is still going.

Out of court work-outs are generally a good thing to attempt, but you have to be careful. I’ll visit that more in-depth soon. The other option is bankruptcy. If most of your total debt is from business debt (your home loan debt is non-business in nearly every instance, so that is often a stumbling point for this) then you can file a personal Chapter 7 bankruptcy without having to pass the means test (the test that sets a threshold of income for taking Chapter 7 bankruptcy). I say a personal bankruptcy because a business cannot receive a discharge from debt; only an individual, and as I said earlier, small business owners are on the hook individually 99 and 44/100s percent of the time. Whether or not the business also takes bankruptcy is a case by case analysis. Often, the company can be dissolved prior to filing bankruptcy and then a new business can be created afterwards. Sometimes the value of the business is so low that one can exempt their ownership interest.

Many small business owners have heard about Chapter 11 bankruptcy. This is an option to consider if you have too much at stake in terms of non-exempt assets (assets you stand to lose in a bankruptcy) to file a Chapter 7 but your creditors are unwilling to cooperate in a work-out. However, Chapter 11s are not a viable option for the overwhelming majority of small businesses because they are incredibly expensive. And, if any secured creditor has a perfected security interest against your cash collateral (including revenue coming in), then you are going to have to have a new source of funding on-line whether that is a new creditor who gets a super-priority position for the new value they bring or if it is an investor who will inject unencumbered cash.

The case of mismatched law: alimony and bankruptcy

Alimony, or maintenance as it is called here in Kentucky, is an interesting topic because how state law defines and treats alimony does not necessary mesh with the bankruptcy code. In this post, I am talking about when a non-debtor ex-spouse owes the person filing bankruptcy (the debtor) alimony or maintenance (the two terms are interchangeable and I’ll stick with alimony since it is the most recognized). The scenario is a divorced debtor filing a bankruptcy (it can be either a chapter 7 or a chapter 13) because their ex has failed to pay the alimony as ordered as is now in a world of hurt. So, the debtor has to list the alimony owed to him or her because it comes into the bankruptcy estate through 11 USC Sect. 541. There is even a “clawback” provision in 11 USC 541(a)(5)(C) that reaches 180 days beyond the filing date of the petition in cases where a divorce has not yet been finalized.

To be sure, 11 USC Sect. 522(d)(10)(D) appears to exempt alimony (“the right to receive”) so that the debtor gets to hold on to it. However, appearances can be deceiving because the bankruptcy courts do not have to accept the determination of the parties or the state court in deciding if a certain asset is alimony. The debtor may have a court order that calls what the ex owes them alimony and he or she may believe it is alimony, but the bankruptcy court can decide differently. If the bankruptcy court deems the awarded monies to actually be a property settlement, then it is not exempt beyond any available “wild card” exemption from 11 USC 522(d)(5).

The bankruptcy court makes its determination as to whether or not an award of alimony is truly alimony or if it is actually a property settlement mechanism by looking at what actually transpired. There are different aspects that the court may focus on and so it is more likely to be alimony if: 1) it ends at death or remarriage, 2) it can be modified based on need, 3) the debtor did not have property or resources to meet their basic needs, 4) it is subject to the tax treatment for alimony in the tax code (taxable to recipient; deductible by payor), and 5) the payments go directly to the debtor. If, on the other hand, the award of monies was in lieu of other property or debt, then it is unlikely to be deemed alimony. These are not necessarily exclusive factors, but will give an idea of how the courts analyze an alimony claim of exemption. The bottom line is that the court wants to be sure that the monies are actually for the support and sustenance of the recipient. This is consistent with the other items in Sect. 522(d)(10)(D) because each is a replacement for wages.

Be careful entering into a bankruptcy if you are the recipient of alimony or maintenance. When you interview your prospective attorney, but sure they understand the nuance behind the stated words of the law. They need to be able to analyze how likely the court is to see the award as alimony. If the award is sizable, then you can expect to have an objection to the exemption be filed by the trustee. If you win by convincing the court that it is indeed alimony, you will still have to show that all of it is “reasonably necessary” to live on – and that does not mean living in style or luxury.

Yet another reason to consider Chapter 13 over Chapter 7

In either chapter 13 or chapter 7 bankruptcy there is an automatic stay with broad protection that stops creditors from attempting to collect debts. This stay is found in 11 USC Sect. 362 of the bankruptcy code. There is an additional “stay” afforded debtors who file chapter 13 and it is found in 11 USC Sect. 1301.

Upon first glance at Section 1301 it appears to be a protection given to non-filing co-debtors such as mom or dad who co-signed on the car loan. However, the intent is actually to expand the protection given to debtors. In other words, if the provisions are violated, it is the debtor who would file the action against the creditor. The co-debtor can join in that action, but it does not give standing to the co-debtor to pursue the action unilaterally (or at least that is what some courts have decided). See In Re: Marlon Durone Stacker (Bankr. S.D. Ill., 2011). This explains why there is no provision for the awarding of attorney fees for a violation of Section 1301 whereas there is such an award under Section 362.

The idea is that during the protracted chapter 13, a creditor would take action against the co-debtor and in so doing, would coerce the debtor into paying more to that creditor than the plan allowed. Congress wanted to prevent such an end run around the automatic stay by crafting this more limited provision.

Section 1301 is also limited in that if the co-debtor received consideration (something of value) from co-signing on the loan, then then stay does not protect them to that extent. So, if a non-debtor business partner co-signed a loan and the consideration (value) came into the business to both his and the debtor’s benefit, then action against that co-debtor is not prevented. Or, perhaps a friend co-signed a loan for $1,000.00 and received $200.00 of it, then the creditor can pursue him or her for that $200.00, but no more than that. Another limitation is that if the chapter 13 plan only provides for a certain amount of the loan to be repaid, then the amount in excess of the plan is not protected. So, if the plan provides for $9,000.00 of a $10,000.00 debt to be repaid, then the creditor can still pursue the co-signor for the extra $1,000.00.

There are some other, non-enumerated limitations to Section 1301. For example, the creditor may still be able to report a delinquency on the co-debtor’s credit report. One could say that this constitutes a false report because the terms of the agreement have been altered by the chapter 13 plan. But, the plan only altered the relationship between the creditor and the debtor, not the creditor and co-debtor. However, such an action could constitute a violation of both Section 362 and Section 1301 if one can show that there was intentional action by the creditor likely to coerce the debtor into paying beyond the plan. See In re Singley, 233 B.R. 170 (Bankr. S.D. Ga., 1999). If you look at the Singley case, be aware that the court there said the intent of the creditor had to be shown to be one of coercing the collection of the debt, but other courts say the intent only has to be that the act of violation was intended to occur regardless of the result.

Despite the limitations of Section 1301, non-filing co-debtors being protected from lawsuits, garnishments and the like may make the extra work of a chapter 13 worthwhile.

Debt and Divorce

In Kentucky marital law there is no presumption that debt incurred by one spouse is marital debt and the recent Supreme Court of Kentucky opinion in Rice v Rice, 2009-SC-000730-DG, March 24, 2011 (to be published) reaffirms that doctrine. Sometimes you can tell when a court gets hacked off, and some of that comes through in this opinion written by Justice Noble. One clue as to the court being upset is when they use the word “egregious” and it appears in this opinion.

The husband and wife had been married for 42 years. The wife, Carolyn, worked at an $8.00 an hour job. The husband, Jackie, allowed their adult son to accumulate around $65,000.00 debt by letting him use credit cards and co-signing for loans. This went on for about four (4) years before Carolyn got wind of her husband allowing this mountain of debt to arise and when she confronted Jackie about it, he just changed the mailing address for the bills so she would not find them. Are you starting to see what lead to the divorce?

Anyway, the trial court that granted the divorce assigned each of the parties one half (1/2) of this debt even though Carolyn had not authorized it. The Court of Appeals let that decision stand, but the Supreme Court would not tolerate it. They held that a debt incurred or authorized by one spouse and which the other spouse neither authorized nor received a benefit from is not marital debt.

The reason it was important that Carolyn take her fight to the Supreme Court of Kentucky instead of filing bankruptcy is that the assignment of debt may have been deemed a “domestic support obligation” by the bankruptcy court. So, even though her legal obligation to the creditors may have been extinguished in bankruptcy, she might have remained on the hook to Jackie for around $32,500.00 because domestic support obligations are not discharged.

Discharge of Debt and Domestic Support Obligations

The changes in the bankruptcy code from the 2005 BACPA essentially eradicated a debtor’s ability to discharge their domestic support obligations. So, if you are divorced or pay child support, it is important to understand what you can do regarding debts arising from the divorce or child support. A recent decision by Judge Scott, Judge for the Eastern Distric of Kentucky Bankruptcy Court, offers a concise explanation of how domestic support obligations arise and how they are impacted by the automatic stay from collection activity of 11 U.S.C. Section 362.

Domestic support obligations (I’ll call these “DSO”s here on out) are defined liberally by the bankruptcy code at 11 U.S.C. Section 101(14A). When a DSO arises because it is “in the nature of” maintenance, alimony or child support, then the automatic stay of Section 362 does not prevent collection actions from property that is NOT part of the estate. The clearest example of this is when the divorce court ordered one party to pay his or her ex-spouse monthly payments (either alimony payments or child support) and the receiving party can still expect to receive those monthly payments from the debtor’s ongoing wages, which are not part of the estate of a Chapter 7. The receiving spouse need do nothing in the bankruptcy court to take action to enforce this order of support.

The recent decision referenced above gives a great example of a very different way that a DSO can arise. In that case, the debtor was ordered to maintain payments on the marital residence until it sold. However, he did not do so (perhaps he could not or maybe he thought he was pulling one over on his ex-wife, I have no idea) and the marital residence foreclosed. There was a deficiency of around $45,500 from the foreclosure as compared to the assessed value of the house. Presumably, the full debt on the house was covered by the sale proceeds and the $45,500 represented equity. So, the debtor had been ordered by the divorce court judge to pay 1/2 of that to his ex-wife. The debtor argued that since the house did sell and there was no net gain from said sale, that he did not owe his ex-wife one cent. Neither the divorce judge nor Judge Scott bought this argument.

The debtor went into bankruptcy with a $22,750 plus DSO as a result of the foreclosure on the marital residence. Since it was not in the nature of alimony, maintenance or child support, the automatic stay did prevent the ex-wife from pursuing collection activity, so she moved the court to lift the stay. She attempted to do so, but failed to sufficiently explain to the bankruptcy court the reason why she should be allowed to have the stay lifted.

The end result is that the debtor clearly has to repay his ex-wife the $22,750 that he theoretically could have realized if he had kept current on payments and sold the house on the open market. However, since the ex-wife did not fully carry her burden of proof, she is going to have to wait until the bankruptcy is closed to take action to collect this debt.

Several lessons come from this case. First, you really should consult with an attorney familiar with both family law and banruptcy law if you are going to allow property that was subject to a decree or court order in a divorce be repossessed or foreclosed upon. The long term cost to you may be far more than you want to incur. Second, remember that bankruptcy does not take care of every sort of debt and you need to recognize what debts will remain. This could help you decide between pursuing a work-out outside of bankruptcy, filing a Chapter 7, or filing a Chapter 13. Third, if you are owed a DSO, be sure to adequately provide evidence to the bankruptcy court of the “good cause” (the reason why you are harmed) required by 11 U.S.C. Section 362(d)(1) for the automatice stay to be lifted.

Keeping your property through bankruptcy: How exemptions work

When a person files a bankruptcy (referred to as a debtor in bankruptcy parlance), everything they owe and everything they own goes into an estate. In effect, at the moment your attorney pushes that button to electronically file your case, you both as poor and as rich as the day you were born – well, sort of. Unlike a newborn babe, you still have duties under the bankruptcy code and there are some debts that do not go away without a fight (such as some tax debts and student loans). But, for the sake of this missive, we will not concern ourselves with those issues.

Debtors want to keep their stuff. As George Carlin has noted at some length, our stuff is important to us and drafters of the bankruptcy code felt the same way. The avenue to retaining possessions is through the use of exemptions. The overly simplified explanation of exemptions is that you can exchange the exemption that the code provides to you for the property you want to keep. Everyone is afforded certain exemptions. In many state, such as Kentucky, you can elect to use the federal exemptions under 11 U.S.C. Sect. 522(2) or state law exemptions under 11 U.S.C. Sect. 522(3). I touched on this choice briefly in an article about the importance of knowing state law exemptions as well as the federal.

As I noted, though, that view of exemptions is overly simplified. For the vast majority of bankruptcies, that very simple explanation will suffice. However, the truth is that your exemption only covers your “interest” in the property. Interest, in this instance, refers to the monetary value of that property that is exempted. In other words, the estate actually has the property and the trustee, who is under a duty to maximize the return to creditors from the estate, can sell that property. If the property is sold, you would receive the dollar amount of the exemption you claimed and the rest would be distributed to creditors.

What Debtors want is for the trustee to ‘abandon’ the property. This means they are going on record as releasing the property from the estate. If the property is not secured against a debt, then abandoned property comes back to the debtor free and clear. Until the trustee has abandoned the property, then the debtor needs to be careful about selling or otherwise disposing of the property and careful about encumbering the property as collateral for new debt. The trustee almost never does, but can take months or, in some cases, years to abandon property and in rare circumstances you may need to prompt your attorney to file a motion for the trustee to abandon the property if they are taking an unreasonably long time to do so.

Now, there is no need to be concerned if the amount of your exemption covers the fair market value of the property. There is no motivation there for the trustee to take action because they will incur costs in selling the property and they would end up losing money. The only time to be concerned is if the value of the property may be significantly higher than the available exemption. Then, it may be worthwhile to the trustee to attempt a sale of the property.

Another time to be concerned is if your property is likely to increase significantly in value while it is part of the estate. This can happen with real estate (during a normal market) if the trustee keeps the case open for a really long time to administer it. Remember, though, this is very rare. You may have been able to cover the full amount of the equity in your house at the beginning of the case, but the trustee could attempt to realize any increase in equity that goes beyond the exemption limit down the road. Combine increasing value of property with an initial underestimate of its value and you could have something to be concerned about.

From a purely financial standpoint, none of this matters, because you are assured of holding onto the value of your exemption either way. To remember where this whole discussion even matters, we return to George Carlin. Quite frankly, your stuff is probably far more valuable to you than to the free market simply because it is yours. You would rather have that antique chest of drawers your aunt passed down to you than the $750.00 representing your exempt interest in it because of the sentimental value and familiarity of the item.

So, be sure to give a reasonable dollar value for your property to your attorney. Let them have good information so that they can make the best use of the exemptions available. Secondly, be aware that if you have property that currently exceeds exemptions; you may not be able to retain that property. Finally, for any property of significance (e.g. real estate as opposed to the pots and pans in the kitchen) do not dispose of it or encumber it until the trustee abandons it.

Emergency filing

Here is the main thing I have to offer about filing an emergency bankruptcy petition: DO NOT DO IT. Now that I have that out of the way, I will rejoin the world of reality. Sometimes filing a last minute emergency bankruptcy petition happens. Such filings are referred to a “skeletal” petitions because there is no way anyone can do all the work it takes to prepare the schedules and statements of financial affairs in the last minute, the last hour, or even the last day. So, all that gets filed is the petition (the first three pages), the mailing matrix of creditors, and a few verifications and notice items. The flesh of the petition is then left to complete and must be filed within fourteen (14) days. For me, a practitioner who likes to cross the t’s and dot the i’s, that is not enough time with all the other matters I must also tend to. Invariably, something gets left out and amendments must be filed or the Debtors do not get everything pulled together to meet the deadline and their case is dismissed.

There seems to be two reasons that skeletal petitions become inevitable: 1) people so dread the idea of filing bankruptcy that they put it off until the very last possible moment even when they see it coming, or 2) people ignore and deny the lawsuits and judgments or foreclosure until the garnishment hits or the master commissioner sale is about to happen and they wake up surprised. Bottom line is that folks want to hold on to the notion that if they just wait, things are bound to get better.

This reminds me of the story of the guy that was stranded on an tiny island and was starving to death. Despite his dour predicament, he was sure God was going to save him. A ship comes by and the Captain hollers over and offers to help. The man, steadfast in his faith yells back, “Jesus is coming for me; He’ll save me. You go ahead.” A second ship comes by, but the man remains rooted deeply in his faith that God will work a miracle and save him. So, the man sends the second Captain away and moments later is face to face with Jesus in heaven, having expired on earth. The man is thrilled, but perplexed. He asks Jesus why he did not rescue him off of the island. Jesus looks back and says, “I sent two boats after you!”

So, perhaps bankruptcy is your boat. Certainly, remain hopeful of a better alternative, but go ahead and get prepared for what you already see coming at you. The benefits to seeing an attorney early on and then gathering together the information and documents needed are: 1) fewer chances of mistakes if the bankruptcy is filed so you are more likely to sail through it, 2) lower cost, and 3) peace of mind rather than panic.