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.

The Odd Couple: Life Insurance and Bankruptcy

The bankruptcy code treats life insurance oddly. When one files a Chapter 7 money that a person acquires after the filing date is typically not part of the bankruptcy estate. That is to say that money you earn after filing a Chapter 7 is yours to keep without the need to exempt it. There are a few exceptions to this and proceeds from life insurance a debtor becomes entitled to within 180 days following the filing date comes back into the estate pursuant to 11 U.S.C. Sect. 541(a)(5)(C). The phrase “entitled to” is key. So, if you are a debtor and someone dies on day 179 naming you as the beneficiary in a life insurance policy, those proceeds come into the estate because you become entitled to them at that time.

If you become entitled to life insurance proceeds during within those 180 days, you must file an amended Schedule B pursuant to Bankruptcy Rule 1007(h) showing the proceeds as an asset of the estate. Not all is lost, however, because you can also file an amended Schedule C exempting those proceeds to some extent. Under the federal exemption 11 U.S.C. Sect. 522(d)(11)(C) you get to keep as much of the proceeds as are reasonable and necessary to care for yourself and your dependents. If the proceeds are a small amount, you may be able to keep them all, but if they are a large amount, then you have two options.

One of the options you have if you receive a large amount of life insurance proceeds is to hire an expert to give testimony to the bankruptcy court showing how much is reasonable and necessary. The other option is something that not all bankruptcy attorneys realize they can do and that is amend your exemptions from federal to state. Under Kentucky law, KRS Sect. 304.14-300, the entire proceeds of the life insurance are exempt; 100% rather than “reasonable and necessary”. In choosing this option, you must change all your exemptions to Kentucky and so there may be other assets that end up as non-exempt. For example, a debtor can only claim $5,000.00 of homestead exemption in Kentucky compared to the over $20,000.00 in federal homestead exemption. So, it will be important to weigh out the advantages with your lawyer.

Either option you take, expect a challenge from the trustee. In option 1, the trustee will counter your expert and suggest a much smaller number as “reasonable and necessary”. For option 2, the trustee will argue that you cannot change from federal to state for any number of reasons. I hope to address these reasons for objecting to a switch from federal to state exemptions in a later post. For now, it will suffice to say that a number of jurisdictions have addressed the question of changing from one exemption scheme to another post-filing and no jurisdiction has precluded such an amendment to Schedule C exemptions outright. In other words, all courts addressing the question allow the switch except for when certain circumstances exist and that is what I will expound on in a later installment.

One other matter that is important to address regarding life insurance policies. Cash value policies, such as “universal” or “whole life” policies have to be listed in Schedule B as assets of the estate from the very beginning if you or your joint-debtor spouse owns them. This is because the policies themselves have present day value (the cash value that has accumulated). It is also a good practice to list term life insurance policies even though they do not fit the definition of an asset because they have no present day value. A term life insurance policy only has value when the insured passes away. So, list the policy and depending on your lawyer’s computer program, either assign it a nominal value or a value of zero and apply an appropriate exemption to it. That way, if the tragedy of your joint-debtor spouse dying post-filing occurs, at least there will be one less hook for the trustee to grab onto in arguing against the proceeds being exempted.

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.

Issues with surrendering real estate

Reality has set in. The home loan modification you so desperately hoped for fell through after they strung you along for months (“Just keep making the payments during the trial period” or “Your application is being processed, just keep paying”). Your budget is so tight that even in a Chapter 13 your would not be able to pay off the arrearage on the loan for the house and you can take Chapter 7 according to the means test. It is now unavoidable that you will not be able to keep the house and so you tell your attorney to check the “Surrender” button for your intentions on your principal residence. It feels like surrender too, but not entirely in a bad way. Surrender also means the fight is over and the fresh start of debt free living can begin. But, what do you do with the house now?

Some people feel compelled to get out of the house as quickly as possible. It is a desire to get going on that fresh start by getting the old out of the picture and finding a new place; renting an apartment where they will not be reminded of the lost home. Sometimes it is because of a fear that someone will show up unexpectedly and toss you and all your stuff out on the lawn (which won’t happen unless you have some in-laws that are also outlaws and mad at you). Lastly, sometimes it is just a sense of guilt for staying someplace and not paying for it. I understand those driving emotions, but I caution you to sit tight for as long as possible.

Before I explain why you should sit tight, I need to revisit a core principle of Chapter 7. This type of bankruptcy establishes a single point in time where everything you owe and eveything you own goes into a fictional pot called an estate. Then, you use exemptions and reaffirmations to pull assets back out of that pot that you want to keep while leaving most debts behind. Once that point in time is created, everything you earn and every debt you create after that moment remains yours; new assets and new debts do not go into the estate. So, what does that have to do with a house I have surrendered? Aren’t my debts on that house going to be discharged?

Well, yes, those loans you had that were secured against the house will likely be discharged (barring any kind of pre-filing fraud or other bad acts that can prevent a discharge). However, you have a nice, tempting, empty piece of property just sitting there inviting neighborhood kids, hoodlums and other roustabouts to come in and have at it. However, your name remains on the deed for the house until after the Master Commissioner sale is confirmed or your provide them a quitclaim deed. Because this is all AFTER you filed your petition, you are liable for potential debts that could arise as the titled owner of the house.

If someone were to be injured on your property after the filing of the Chapter 7, you could get hit with damages from the injury. Additionally, the mortgage holder of the property could make a case for damages done to the property itself that decreases its value or for the insurance policy they obtain (I’m not saying they would be successful, but who wants the aggravation and expense of finding out if they would be?). You could propably afford to pay the insurance premium on the property if you are not paying the house payment, but home owner’s policies usually become void or voidable if no one resides in the house for over a certain period of time. So, there are several reasons to remain in the house until either the Master Commissioner’s sale is confirmed or a quitclaim deed is filed transferring ownership of the house.

Here is a recap of those reasons:
1) You are potentially liable for injuries that occur on property you still have title to after the Chapter 7 is filed.
2) You will have a hard time getting insurance coverage on an empty house (though there are specialty companies that do this for a high premium).
3) An empty home is an open invitation to high risk behavior that can lead to injury.
4) You are in financial dire straits and living there while not paying the house payment can help you get ahead and find a nice place to move to once the ownership is transferred. Yes, it may feel uncomfortable, but not as uncomfortable as having a post filing debt and not being able to get another discharge for a number of years.

So, plan on staying in your surrendered home for several months even after filing Chapter 7. If you must move, negotiate transferring title to the mortgagee while the bankruptcy is pending.