Is Chapter 13 An Option For A Small Corporation Or A Limited Liability Corporation (LLC)?

29 Sep Is Chapter 13 An Option For A Small Corporation Or A Limited Liability Corporation (LLC)?

A small business may need to file a bankruptcy to protect its owner and its assets while continuing to operate. The sole proprietor (an individual “doing business as”) can file a Chapter 13.and include his business. One exception to this rule is if the small business is operating as a corporation. Corporations are not permitted to file Chapter 13 pursuant to Section 11 USC 109 e. This section clearly states that only an individual with regular income can file a Chapter 13; however, there may be a way around this.

The statute provides that only individuals may file Chapter 13. This means that a corporation, whether it is a Sub-Chapter S Corporation, a Limited Liability Corporation ( LLC) or a C Corporation is not permitted to file Chapter 13. Many small businesses operate as sole proprietorship (i.e. the individual operating the business files a schedule C on their individual tax returns) when actually the business is an LLC. Their accountant or business lawyer advised them to become a corporation for tax purposes and to avoid or limit the amount of tax they would have to pay or to limit the liability of the owners. Therein lies the problem.

Many individuals believe the corporation protects them from liability and from the creditors of the business. This is often a mistake. Corporate owners, officers, and stockholders of a closely held corporation often have to either sign as a guarantor for the loan, the lease, or the accounts payable for the corporation. This results in personal liability for the business debt. By signing the guarantee or by signing the loan documents, they make themselves personally liable. As an example, the president of IBM does not sign a guarantee on IBM’s debts. IBM has its own ability to borrow money. I am an IBM stockholder. I am not liable for IBM’s debt. If IBM goes out of business I can only lose the money I have invested in IBM’s stock. In the alternative, with closely held corporations, the stockholders, the corporate officers, the members or the owners are usually all required to sign various guarantees. The newly formed corporation has no credit history. It has limited collateral. There is a limited business history for the banks to base their credit decisions on. This often holds true even if the small corporation has been around for a while. The lenders are in the driver’s seat and can demand personal guarantees. The parties to the corporation often take out business credit cards in their own name rather than the corporate name. Often times the lenders will even take mortgages on the stockholder’s or members’ homes. This protects the lenders because they have another party to collect from should the business not be able to pay the debt.

A corporation can file a Chapter 7 bankruptcy and shut down the business. This will still leave the members liable for much of the business debts. A corporation can file a Chapter 11 bankruptcy. Many times they find that after consulting with a Chapter 11 attorney, the business cannot afford to file Chapter 11 and it is too complicated for their operations. It also may not protect the individuals associated with the business thereby requiring a second bankruptcy for the guarantors’ of the corporate debt.

An idea has recently evolved, which under the right circumstances, could allow the small business corporation to continue to operate under the protection of the bankruptcy code. This protection will allow the business to operate and protect the individual under a Chapter 13. The process can be complicated and, like a Chapter 11 will involve several professionals to make it work. The premise is simple: the owner of the small business offers to buy the business assets in exchange for assuming the debts of the business. These are usually debts that the owner is already personally responsible for. The corporation then collapses and the owner (stockholder) who has taken over the corporation can now operate as a sole proprietorship. Once the business is no longer operating as a corporation, it can file a Chapter 13. This will allow the small business to continue to operate while reorganizing.

Accomplishing this will require coordination between a business lawyer to handle the buy/sell agreements, an accountant to review and discuss the tax implications of the change of ownership and a very experienced and highly qualified bankruptcy attorney. The business lawyer and the accountant can work closely on the corporation while the bankruptcy lawyer puts the new business into a Chapter 13.

There are advantages to filing Chapter 13 over Chapter 11. The Chapter 13 will protect the business and the owner/operator as one entity within the bankruptcy. The cost of the Chapter 13 is usually less than the cost of a Chapter 11. The US Trustee’s office is not usually as deeply involved in a Chapter 13 as they are in a Chapter 11. The business does not need to get the votes of the creditors for its plan of reorganization. The debtor just has to meet the confirmation standards set forth by the bankruptcy code. There is less paperwork involved in a business Chapter 13 than there is in a business Chapter 11. It is important to note that for some businesses there are advantages to being in a Chapter 11 instead of a Chapter 13. Those are not discussed here.

This option gives the debtor and the business one more way to protect themselves while operating during an economic crisis.

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