There are two common scenarios which involve businesses in chapter 7 bankruptcy. First, you technically own a small business that earns insufficient or no income, and you wish to dissolve the business or you recently dissolved it. Secondly, you own a small business which is your sole source or part source of income.
For either of the above scenarios, you must remember the job of the chapter 7 trustee. He or she is looking for assets to sell, in order to make payment to your personal creditors. Secondarily, it is the chapter 7 trustee’s job to make sure that you are not hiding or disguising income which would otherwise disqualify you from chapter 7 and force you into chapter 13.
1. A business or corporation that is NOT an ongoing concern and may even have been dissolved recently. Who owns the business, the membership shares, the corporate shares? Has the business filed its tax returns or is the tax reporting properly reflected on your personal income tax returns? Did or does the business have assets? What happened to those assets? Were the assets encumbered by liens? If the assets were sold, to whom were they sold and where did the sales proceeds go? Again, all these things must be accounted for to the trustee, and even if you have nothing to hide, if these issues are not properly accounted for with documentation, the chapter 7 trustee may pursue litigation against you and cause you legal fees and distress.
2. A business that is an ongoing concern and provides you with all or part of your income. How much of the business, the membership shares, the corporate shares do you own? Has the business filed its tax returns or is the tax reporting properly reflected on your personal income tax returns? Does the business have assets? Are the assets encumbered by liens? Has the business ever sold or transferred any of its assets, other than inventory in the ordinary course? If the assets were sold, to whom were they sold and where did the sales proceeds go? Again, all these things must be accounted for to the trustee, and even if you have nothing to hide, if these issues are not properly accounted for with documentation, the chapter 7 trustee may pursue litigation against you and cause you legal fees and distress.
3. Personal Guarantees. If you intend to file a chapter 7 bankruptcy petition, then you potentially can discharge or rid yourself of the obligations you have under any personal guarantees. However, as with real estate and a mortgage, you can be discharged of the personal liability, but the secured party still has recourse under state law to repossess the property of the business.
4. Recently transferred business interests. Supposing that, in contemplation of a possible bankruptcy filing, you transferred part or all of your corporate shares or membership interests to your spouse, relative or friend for no consideration or below market value. Please don’t think that you have outsmarted anybody. The chapter 7 trustee has the power to retroactively undo such transfers if the trustee believes there may be value in those shares or interests. Additionally, it could be argued by the trustee that a transfer was not legitimate if the transfer was done in name only. In other words, you still own or control the business, but not on paper.
The pitfalls are numerous when a small business is involved, even tangentially, in a bankruptcy case. It is strongly advised that you get all your accounting ducks in a row before submitting to the jurisdiction of the bankruptcy court.