Incorporation saves business in Chapter 7 bankruptcy

by Cathy Moran, Esq.

October 5, 2007

Spending a small amount on incorporating a sole proprietorship can mean the difference between the debtor’s ability to file a relatively inexpensive Chapter 7 or a vastly more expensive Chapter 11.

This came up when a couple with several investment houses in big trouble and a small business that was doing fine wanted an assessment of their bankruptcy options. They expected to lose the real estate, but needed the business to support themselves going forward.

They could file a Chapter 11 in order to reorganize and thus keep running the business. Chapter 11 costs tens of thousands of dollars, and the business wasn’t in trouble, it was the investment real estate that had to go.

When we met, their business was a sole proprietorship. If we filed Chapter 7 now, Chapter 7 trustee’s first reaction to a going business is to shut it down. The trustee is concerned about his liability for regular business debts the operation may incur and the possibility that a customer may be hurt on the premises. The trustee wants to preserve the status quo by shutting the doors, even if there is nothing in the business that he can sell for the benefit of creditors.

Different story if the business is incorporated. The corporation is a separate legal entity. It is the corporation that owns the business, not the debtors. The debtors own the shares of the corporation, but not the business itself. It is the shares in the corporation that is property of the bankruptcy estate.

Most trustees have no problem letting a business with no net value to the shareholder’s creditors continue to operate. Incorporation shields the trustee and the bankruptcy estate from liability.

Thus my clients expect to be able to file Chapter 7, and get relief from the overwhelming debts they now face without endangering the small business that puts food on their table. All possible because the business will be incorporated.

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Cathy Moran, Esq.

I'm a certified specialist in bankruptcy law (California State Bar Board of Legal Specialization) practicing in the San Francisco Bay Area for more than 30 years. In addition to practicing bankruptcy law, I train new practitioners at Bankruptcy Mastery.

Last modified: November 28, 2012