Monday, February 28, 2011

How Chapter 7 Affects Sole Proprietors

Most businesses are legal entities separate from the individual owners. Microsoft, for instance, is not the same as Bill Gates. Corporations, LLCs and the like are recognized as operating independent from the business’s owners. When an incorporated business files bankruptcy, the owners are not in bankruptcy, and vice-versa.

On the other hand, when the business is a sole proprietor, the owner is the same as the business. The business is not a legal entity that is separate from the individual. In fact, the business is not recognized as existing apart from its owner. The business income, expenses, property, and debts all belong to the owner. Therefore, when a sole proprietor files bankruptcy, the business is also bankrupt.

The Chapter 7 trustee who administers your bankruptcy case is under a mandate to seize control and cease operations of your business. The main reason for this is that the business assets are considered personal assets and part of the bankruptcy estate. Fortunately, in most cases personal exemptions are able to protect tools and equipment used in the sole proprietor’s business.

Accounts receivable are also part of the bankruptcy estate, so it is important to provide accurate business records to assist your attorney before your bankruptcy is filed. The trustee will want to see all gross income received by the business, and all business expenses. Since this gross income is included in your personal gross income, business income can sometimes push the total family income over the qualifying ceiling for Chapter 7 bankruptcy. Additionally, business debt is considered personal debt, so it is generally included in the bankruptcy discharge.

Every sole proprietor bankruptcy case is different. For instance, in a case where the debtor runs a day care from her home, there may be little or no business inventory or assets. In bankruptcy terms, there are no business assets for the debtor’s estate. However, where the sole proprietor runs a restaurant, there may be significant assets for the bankruptcy estate. It is important for you to speak candidly with your attorney and discuss your sole proprietor business thoroughly. Your attorney can effectively advise you on the best future action including whether it is permissible to continue business operations, whether you should form a corporation or LLC, or taking some other action to best protect your interests. If you are dealing with a personal financial difficulty, speak with an experienced bankruptcy attorney before making any decisions regarding your sole proprietor business.

Discharging Family Debt in Bankruptcy

Consider the following example:

Tom and Becky Sawyer get a divorce. They have no children and Tom and Becky each have identical incomes (Tom is an aspiring riverboat captain and Becky owns a seamstress business). Tom and Becky are joint owners of a 2008 Pontiac GTO which they own outright, and they have $20,000 in joint credit card debt. Becky agrees to sign over the GTO to Tom in exchange for Tom paying the credit cards. The family court judge (Judge Thatcher, of course), orders that Tom will hold Becky harmless for any nonpayment on the credit cards. Later Tom is fired from his riverboat captain job (it wasn't his fault – honest!) and is unable to pay the credit cards. Poor Tom sold the GTO and is now considering bankruptcy to discharge his debts.

Tom and Becky's situation is fairly common and causes quite a bit of confusion in real life. First, Becky is still obligated to the credit card companies despite Judge Thatcher's decree. Briefly, this is because the credit card companies were not parties to Tom and Becky's divorce, so the legal relationship between Becky and the card companies did not change.

Second, Tom is able to discharge his debt to the card companies through either Chapter 7 or Chapter 13, but he cannot discharge Becky's obligation to pay this debt because Becky did not file bankruptcy.

Finally, while Tom can discharge his obligation to the credit card companies, there is a second obligation: Judge Thatcher's order that he hold Becky harmless if he fails to pay the credit card debt. When Tom does not pay the credit card companies, Becky can ask Judge Thatcher to enforce the hold harmless order against Tom.

Whether Tom can discharge the hold harmless order in bankruptcy depends on whether the debt and the hold harmless clause constitute a "Domestic Support Obligation" that is in the nature of “alimony, maintenance, and support.” A Domestic Support Obligation cannot be discharged, but the bankruptcy filing may stop collection actions such as wage garnishment, bank seizure, or even jail for contempt of court; and a Chapter 13 may provide time to repay support money owed to a spouse, former spouse, or child.

A debt not in the nature of “alimony, maintenance, and support” is commonly referred to as a "property settlement." If Tom's obligation to pay the credit card companies is a property settlement, then the hold harmless clause can be discharged at the end of a Chapter 13 bankruptcy, but cannot be discharged in Chapter 7.

Determining whether the debt is a "Domestic Support Obligation" or a "property settlement" depends on specific facts and requires the careful consideration of an experienced bankruptcy attorney. Call today for assistance and learn how the Federal Bankruptcy Code can help your debt problem.

Short Sales

A short sale is the sale of real estate for less than the balance owed on the property. Short sales are common in today's real estate market, where home prices have fallen and the home owner is no longer able to pay the mortgage loan. A short sale takes cooperation between the home owner and the lender to sell the property at a loss. Both parties must consent to the sale. A short sale can avoid a foreclosure, which can be mutually beneficial to the parties. The lender avoids the expense of a foreclosure and the home owner avoids the negative impact on personal credit.

Short sales were seldom used by homeowners prior to the mortgage crisis because a short sale results in a deficiency balance obligation to the homeowner. The home owner was sometimes sued for the difference between the amount owed on the home and the short sale price, or, more commonly was taxed by the IRS on the amount "forgiven" by the lender. Either way, a short sale created another heavy burden on the home owner.

In response to the mortgage crisis, the Mortgage Forgiveness Debt Relief Act was signed into law in 2007 which excludes from income a discharge of debt on a principle residence. Debt forgiven by a lender in connection with a foreclosure, refinance, or short sale in calendar years 2007 through 2012 is eligible for this relief. Up to $2 million is excluded ($1 million if married filing separately). This relief only applies to a principal residence, and does not include a second home, credit cards, or a car loan.

A forgiven debt is generally taxed as income to the tax payer, but that is not always the case. The most common exclusions of this tax are: (1) if the tax payer was insolvent immediately before the debt was forgiven; (2) if the debt was discharged in bankruptcy; or (3) if the debt is a qualified principal residence indebtedness until 2012.

If you are struggling with a home mortgage and need to walk away, consult with an experienced bankruptcy attorney and learn how the law can work for you. Your attorney can explain your options and together you can make the decisions for a better financial future.