What Happens to the Owner Whose Business Fails

Posted by Kevin on March 4, 2018 under Bankruptcy Blog | Be the First to Comment

In the prior blog, we learned that a corporation or LLC (business entity) can file bankruptcy under Chapter 7.  Are there any situations where the owner of the business would file bankruptcy when the business fails?  The answer is yes under the following circumstances:

– the business is being operated as a sole proprietorship; or

-the owner of the business has provided personal guarantees of the obligations of the business.

If the business entity is a sole proprietorship (for example, John Smith doing business as “The Hot Dog King”), the business and the owner are the same person for legal purposes.   All the assets and liabilities of the business are in the name of the owner.  If that business fails,  the creditors can bring a lawsuit against the owner.  Moreover, if the creditor obtains a judgment, that creditor can look to any of the assets of the owner to be made whole.  That includes both the business assets and personal assets of the owner.  To avoid this outcome and allow for an orderly liquidation of the assets of the sole proprietorship, the owner can file bankruptcy, and obtain a discharge of debt.

If the business is a corporation or LLC, the law considers the business to be an entity separate from its owners.  In many cases involving businesses, creditors (especially banks, inventory suppliers, and the like) will require the owner to guarantee business debt.  If the business defaults on the obligation, the creditor, which is the beneficiary of the guarantee, may sue the guarantor/owners, obtain a judgment, and attempt to levy on any assets of the owner including assets that have nothing to do with the business.  To avoid this outcome, the owner/guarantor can file bankruptcy, and obtain a discharge of debt.

Will the owner of the business, either as a sole proprietor or a guarantor of debt,  be able to file a Chapter 7 or will he or she be forced into a Chapter 13 where 3-5 years of payments to creditors are required.  While individuals are generally subject to the means test (which we spoke about a few blogs back) , the good news is that you do not have to pass the means test at all unless your “debts are primarily consumer debts.”  So if your debts are primarily business debts—more than 50%–you avoid the means test altogether.

Let’s be clear about the difference between these two types of debts.  A “consumer debt” is a “debt incurred by an individual primarily for a personal, family, or household purpose.”  So, business guarantees are not consumer debts.  It can be argued that cash advances on credit cards which are used by the business are not consumer debts.    If you had taken out a second mortgage on your home for the clear purpose of financing your business, that second mortgage would likely be considered a business debt.  It depends on the purpose for incurring the debt.

Certainly there are times when the line between a business and consumer debt is not clear. Given what may be riding on this—the ability to discharge all or most of your debts in about four month under Chapter 7 vs. paying on them for up to 5 years under Chapter 13—be sure to discuss this thoroughly with your attorney.