Bankruptcy is a legal process that allows individuals and businesses to protect family and business assets from being seized by creditors, and to reorganize or eliminate qualified debts. Not all debts can be discharged or reduced via a bankruptcy proceeding. For example, most taxes and student loan debt cannot be discharged or reduced though bankruptcy.
Individuals and small businesses have the right to file for bankruptcy to obtain financial relief from creditors. Bankruptcies are governed by the US Bankruptcy Code. See 11 USC §101 et seq. The Bankruptcy Code is, in turn, rooted in the US Constitution with Article I granting to Congress the exclusive enumerated power to enact laws with respect to bankruptcy. See US Const., Art. I, Sec. 8. In practical terms, this means that bankruptcies are handled by federal courts.
Bankruptcy is something you should not fear. Many business owners use bankruptcy strategically to remove crushing debt loads and to sever unprofitable parts of an otherwise sound business. At the personal level, bankruptcy can alleviate the constant stress and worry that comes from being unable to make debt payments. Often, there is a great feeling of relief after a bankruptcy is completed. The bankruptcy process is intended to give a person or business a "second chance" at success. It is a new beginning, not an end or a disgrace.
A bankruptcy is started by filing of a petition with a federal bankruptcy court. In general, a petition must include information on the debtor's assets, financial accounts and debts. If the debtor is seeking a reorganization of debts, then a payment plan must also be submitted to the court. The bankruptcy proceeding is ultimately governed by an assigned bankruptcy judge, but the court appoints a court officer, called a "Trustee," to handle the specifics of the case.
There are three types of bankruptcies for individuals and small businesses. They are known by their Chapters in the Bankruptcy Code:
Bankruptcies can be complicated. To determine which type, if any, will get your finances back on track, you will need to know a little more about them.
Chapter 7 is designed to eliminate and discharge all qualified debt. However, for individual debtors, Chapter 7 is available only for those with certain incomes. The income criterion is based on the debtor's gross monthly income compared to the median gross monthly income for the area where the debtor lives and for the debtor's household size. For example, as of 2020, in the Denver metropolitan area, the median gross monthly income for a single-person household is approximately $6,100. Therefore, generally speaking, any single-person debtor in the Denver area with less monthly income than $6,100 will be eligible to file under Chapter 7.
Even if a debtor fails the income test, some debtors may still be eligible to file for Chapter 7 discharge. To determine this, the courts use a second test called the "means test." The means test evaluates the debtor's monthly income, living expenses, and debt payments. The means test is complex, but in simple terms, if there is sufficient income above and beyond monthly living expenses to continue making debt payments, then Chapter 7 is not available. The debtor must instead file under Chapter 13.
Chapter 13 is designed to reorganize an individual's debt with the expectation that the debtor will pay back some percentage of the debt. Under Chapter 13, the individual debtor is considered to have sufficient income to make payments. When filing a Chapter 13, the debtor is expected to submit a payment plan detailing how much can be repaid and over what time period. The repayment plan must be approved by the creditors and the bankruptcy court.
That being said, not every individual debtor is eligible to use Chapter 13 because debt limits are imposed. The limits are changed every three years, but currently, an individual can file under Chapter 13 if the individual has no more than $419,275 in unsecured debts and $1,257,850 in secured debts. A secured debt is one that is collateralized, or secured, by an asset. For example, a home loan is typically secured by the mortgage on the house. If a person has debts that exceed these limits, then Chapter 11 must be used.
Chapter 11 and Chapter 13 personal bankruptcies are similar. In both, the debt is reorganized, some assets might be liquidated or turned over to the creditor and a repayment plan must be submitted and approved.
When a bankruptcy petition is filed, there are two immediate legal effects:
That is why a bankruptcy trustee is assigned. The trustee has control over the assets in the bankruptcy estate and holds them in trust for the creditors. Generally, possession of assets remains with the debtor, but the trustee has ultimate control and can command that assets be physically delivered to the trustee. With respect to personal bankruptcies, assets might include the debtor's personal residence, other real property, vehicles, furnishings, the content of bank accounts, stock holdings, etc. For businesses, assets might include inventory, machinery, accounts receivable, real and intellectual property, etc.
As the bankruptcy proceeds, the trustee has the power to liquidate -- sell -- any and all assets in order to generate monies for the benefit of creditors.
However, whether an asset is sold depends on many factors. One important factor is whether selling the asset will generate money for the general benefit of creditors. For example, imagine the debtor owns a vehicle with a market value of $10,000 and lender financing against the vehicle of $20,000. If the vehicle were sold, all the money obtained would be paid to the financing company holding the vehicle as collateral. The trustee would most likely not choose to sell the vehicle since no money would be generated that could be paid for the general benefit of the creditors. The vehicle could be turned over to the lender, or kept by you if you can continue to make payments and you satisfy other factors, like showing you need the care to continue to work.
Another important factor in deciding whether assets are sold is the debtor's use of personal exemptions. The Bankruptcy Code and state law provide exemptions when a bankruptcy is filed by an individual. There are no exemptions for a formally incorporated business.
Personal exemptions allow a debtor to exempt from the bankruptcy estate statutorily-defined monetary values with respect to certain assets or certain assets entirely. The exemption amounts and types of assets are listed in the relevant statutes and the exemptions themselves vary from state to state. Under some statutes, certain assets are exempt regardless of value (such as health and medical aids). Other assets are exempt up to set monetary limits. For example, in Colorado, $75,000 of the value of an individual's personal residence is exempt. This means that if, for example, the house had a market value of $300,000 with a note and mortgage of $225,000, then the debtor’s equity in the home ($75,000) would be exempt from the bankruptcy estate and could not be liquidated by the trustee. By contrast, in Virginia, the homeowner's exemption is $5,000 plus additional amounts per dependents living at the residence and/or for personal property.
For bankruptcy purposes, the structure of your business matters because only separately existing legal entities can file for bankruptcy. A sole proprietorship can be used to run a business, but sole proprietorships are not legally distinct and separate from their owners. By contrast, formal corporate entities like corporations and limited liability companies are legally separate and distinct from their owners. Formal corporate entities are created by filing legal papers with the relevant state authorities. They have their own tax ID numbers, they can sue and be sued in their own names, can enter into contracts, etc.
This distinction matters for two reasons. First, a sole proprietorship files for bankruptcy in the name of its owner; a corporate entity files for bankruptcy in the corporate name.
Second, this distinction matters for what is considered part of the bankruptcy estate. For a sole proprietor, legally all assets and liabilities of the business are assets and liabilities of the individual. Thus, all assets and debts, both personal and business, become part of the bankruptcy estate. In effect, a bankruptcy filed by a sole proprietorship is a personal bankruptcy. This may implicate the manner in which the debtor’s exemptions are used.
By contrast, if the debtor's business is operated formally as a corporation, and the individual enters bankruptcy but not the business, then what enters the personal bankruptcy estate are the shares of stock. The trustee controls the stock shares, NOT the actual business. As such, all business assets are still owned by the corporation and ownership of those assets does not transfer to the bankruptcy estate. While the trustee can potentially sell the shares of stock, the business itself may continue to operate free and clear of any control by the trustee. It is important to keep in mind that any change in ownership of the stock of a corporation, particularly if it is a majority share, can impact the operation of the business as the new owner will control what happens. This may have important personal, financial and practical implications.
The same three types of bankruptcies are available to businesses. Chapter 7 filings, which are the most commonly filed, are for businesses that cannot continue to operate and the expectation is that the assets of the business will be liquidated. All business assets and debts become part of the bankruptcy estate and are subject to the control of the trustee. When a business Chapter 7 is filed, officers and employees are typically terminated and the trustee begins the process of liquidating the business and distributing the sale proceeds to creditors.
In general, a bankruptcy by a formally organized business does not impact the owners of the business. For example, if the business is a formal corporation with shareholders, the corporate bankruptcy does not implicate the individual shareholders or put their personal and family assets at risk. This is true whether the corporation is a "C corp" or an "S corp." Those designations are for tax purposes, not for bankruptcy purposes.
For a Chapter 11 business bankruptcy, the expectation is that the business will continue to operate while its debts are reorganized. Some assets may be liquidated or turned over to the relevant creditors, but the expectation is that the business will come out of bankruptcy as a viable, financially sound enterprise. A business in Chapter 11 must be generating consistent and reliable revenues. In general, the officers and employees of the business continue to work and to operate the business. The day-to-day operations continue in the normal manner, but higher level decisions can only be taken with approval of the trustee.
As noted above, a debtor filing Chapter 11 must submit to the court a reorganization and repayment plan. In general, the creditors must agree to the reorganization and the payment plan and the court must approve. Under Chapter 11, long-term reorganizations plans are often proposed extending debt payments 10 to 20 years into the future.
A Chapter 13 business bankruptcy is similar to a Chapter 11 filing but is only available for small businesses. A small business cannot have more than $419,275 in unsecured debts and $1,257,850 in secured debt. If these limits are exceeded, then the business will have to file under Chapter 11. Under Chapter 13, reorganization and payment plans tend to be much shorter than those approved under Chapter 11 (generally extending about five years out).
It is sometimes advisable and necessary to file both a personal and business bankruptcy. This is not required if the business is operated as a sole proprietorship. However, if the business is operated through a formal corporate structure, sometimes full and complete debt relief requires this sort of dual bankruptcy. One common reason for a dual bankruptcy filing is the existence of personal guarantees for business financing. Often, lenders will require that, as a condition of extending financing, the owners of the business must provide a personal guarantee of payment. If a corporation obtains a bankruptcy discharge or reorganization, that has no impact on the personal guarantee. The lender can still seek payment from the owners personally. Under those circumstances, a dual filing may be necessary to protect personal and family assets.
As you can see, personal and small business bankruptcies are complicated. Whitcomb, Selinsky, PC has experienced and tested bankruptcy attorneys who can help you obtain the debt relief you need, help your business survive and help protect your personal and family assets. We can ensure that you are filing under the chapter that will best suit your personal and business needs. We can also review any personal guarantees and provide guidance on whether a dual filing is advisable. Our attorneys also help with all of the following:
If you need assistance with a personal or business bankruptcy, our aggressive and experienced attorneys can help. Whitcomb, Selinsky, PC has years of experience representing a wide variety of clients in a wide variety of legal matters. Contact Whitcomb, Selinsky, PC today. We can be reached online or by phone at 866-476-4558.