Monday, April 4, 2011

Why small business owners file personal bankruptcy

Owners of small businesses often ask if they can file a bankruptcy petition only in the name of their business or otherwise keep their consumer debts out of a business bankruptcy filing. In many cases, the owners themselves will need to file a personal bankruptcy and not a bankruptcy for their business entity. Here is why:

Most small businesses are not properly capitalized for the business owner to avoid giving personal guaranties on their loans and lines of credit. Although a business may be operating as a limited liability company or a corporation, these private entities only receive enough capital to operate and the owners can quickly and easily withdraw assets. Even though banks lending money might hold furniture, fixtures, and equipment as collateral, they will still want the personal responsibility of the business owners on the line.

So when the business runs into debt trouble, the owners are worried about lenders collecting from them personally. If they are shutting down the business, the debts of the business entity will not be a problem, but the personal liabilities will haunt them. Unfortunately, the bankruptcy system does not separate debts for a prospective bankruptcy filer. A legal person, whether an individual or a corporation or other entity, has the option of entering bankruptcy, but the debts of only a business operation cannot be separated from the debtor for bankruptcy treatment.

This is why business owners filing personally will need to report all their debts in a bankruptcy case, the business debts along with personal credit cards, car loans, and home mortgages. Furthermore, for many small businesses it does not make sense to file a petition for the business entity at all. Individuals usually file with the goal of receiving a discharge of debts, but corporations and limited liability companies are not eligible to receive a discharge. In fact, there is some risk for an attorney who represents an entity and files a bankruptcy petition where one is not warranted. There are some cases where the business entity needs a bankruptcy case to liquidate its assets and bring the resolution of lawsuits to a single forum, but small entities with negligible assets have no benefits from filing for bankruptcy.

The next challenge a business owner may face after filing a personal bankruptcy is starting over in order to continue in his or her line of work. This can usually be done with the proper planning. It is important to wind down the old business and distribute the assets properly without transferring liabilities to the new entity and without violating bankruptcy procedures. Business owners also need separate the old and new businesses to avoid any liability under legal theories (such as corporate veil piercing) for themselves personally or for the new business. Essential relationships may also need to be preserved, and sometimes this means that the new business may actually pay debts of the old business when another party recognizes the business owner personally as being the one in control.