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Sole Proprietor During Chapter 7 Bankruptcy

May 28, 2013

An incorporated business is separate and distinct from its owner. “The law” recognizes Microsoft as distinct from Bill Gates, just as Mary Smith’s Onion Buns, LLC is separate and distinct from it’s owner, Mary Smith. During an individual debtor’s bankruptcy, an incorporated business is not included in the bankruptcy (however the value of the debtor’s ownership interest in the company may be at issue). The business continues despite the business owner’s personal bankruptcy.

On the other hand, when a sole proprietor files bankruptcy all of the assets belong to the owner and are part of the owner’s bankruptcy estate. Even worse for the debtor, the bankruptcy trustee may direct the debtor to discontinue operating the business to avoid incurring debt; so that the trustee is not liable for any tort claims that arise after the commencement of the bankruptcy; and so the trustee can account for the assets of the business. This can be devastating for a sole proprietor who derives his income from the business.

What can be done? Well, one obvious answer is to incorporate your business before filing bankruptcy. Many small businesses can benefit from forming an LLC (limited liability company). As a general rule it is important to have more than one member in your LLC in order to protect your company from personal creditors. Be cautioned that you may lose your ability to property with personal exemptions if you transfer personal assets (e.g. sole proprietor property) to a company just before filing bankruptcy. Speak with an experienced bankruptcy attorney before transferring assets to a new business.

A sole proprietor’s business may not matter to the trustee. For instance, if Mary Smith’s Onion Buns is unincorporated, and has no business property, the only real asset is debtor Mary Smith herself (and maybe her recipes which may or may not be worth anything). The trustee cannot force a Mary to work for someone else, or force Mary’s customers to purchase their onion buns from another retailer. There is really nothing to sell, and the business has little value if Mary stops working in the business. The same is generally true for any number of small businesses where the business owner is providing a “personal” service like lawn care, painting, plumbing, etc. In these cases, the trustee abandons any interest in the business and the debtor is allowed to continue providing service to his customers.

Many small business owners file bankruptcy each year. If you are struggling with personal debt, speak with an experienced attorney and review how a bankruptcy will affect your business.



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