Filing bankruptcy while self-employed

Do you own your own business and are your own boss? Congratulations! You're living the American dream! Of course, if you're finding yourself in financial difficulties, the American dream of being self employed can feel a little bit like a nightmare. This article will explore the two most typical ways individuals own businesses, and how it impacts your options when it comes to getting lasting debt relief through a personal Chapter 7 bankruptcy.

To be or not to be - an entity!

Small business owners at some point need to decide whether to form a separate business entity in order to conduct their business. The only alternative to forming an entity to run your own business is being a sole proprietor.

When you're the heart and soul of your business, it can certainly feel like you're a sole proprietor no matter what, but that's not what matters. When you're dealing with the bankruptcy court, facts matter most, so it's important to know how your business is set up.

Limited Liability Company vs. Corporation vs. S-Corp

 The most common legal entity that small business owners form are limited liability companies, or LLCs. A corporation is another form of business, though it’s typically more common for larger businesses. To keep it all as confusing as possible, you can have an LLC and elect to be taxed as a corporation (specifically, a so-called S-Corp).

Why what your tax returns says doesn't matter

Just because your limited liability company has elected to be taxed as an S-Corp does not make it an S-Corp. It's still a limited liability company, or LLC. Similarly, just because your LLC's profit passes through to your personal tax return does not make you a sole proprietor. You're still an owner of a limited liability company.

What's does "separate legal entity" even mean?

A separate legal entity is a different kind of "person" that can be sued in court, in addition to the human being that runs the business. If you're a sole proprietor, on the other hand, no separate "person" exists. If someone wants to sue John Smith in court, the action is brought against John Smith, the individual. But what if their issue is not with John, the person, but with John's business, Smithy LLC?

Say Smithy LLC broke a promise it made to you in a contract and didn't deliver the goods you ordered and paid for. Smithy LLC is holding your goods and took your money. In that case, your claim is against Smithy LLC, not John personally. The legal fiction that Smithy LLC is its own separate person in the eyes of the law makes it possible for you to file a complaint against Smithy, LLC. 

Why does this matter in bankruptcy?

There are a few areas of the bankruptcy forms where the distinction between being a sole proprietor and having an LLC or corporation is important. Let's go through the most important one first, your property. Remember, if you file an individual bankruptcy case, everything you own is considered an asset, even if it has little or no value.

In John's case, his Schedule A/B would show a 100% ownership interest in Smithy LLC in response to Question 19. The value of this asset is determined by Smithy LLC's balance sheet. Say Smithy LLC has $100 in the bank account and tools of the trade with a value of $1,500 but it also has a line of credit with a $2,000 balance. In that case, Smithy LLC has a value of $0. That's because its liabilities (debts) are higher than the value of the property the LLC owns. If Smithy LLC doesn't have a line of credit because John has been using his own personal credit card to pay for stuff, then Smithy LLC has a value of $1,600.

On the other hand, if John Smith is merely doing business as "Smithy's Plumbing" and doesn't have a separate legal entity, both the $100 in the bank account and the tools of the trade are John's personal property. He personally owns everything, and it’s listed that way on his Schedule A/B.

What about exemptions?

You may think, "well, looks like John Smith owns the inventory and tools no matter what, since he owns 100% of Smithy LLC" and you would be right, generally speaking. But, whether John owns Smithy LLC, or simply owns all the tools and inventory that Smithy's Plumbing needs to operate, makes a big difference in John's personal bankruptcy case.

Why? Because most, if not all, state exemptions and the federal bankruptcy exemptions protect a person's tools of the trade. That's because the Bankruptcy Code recognizes that it wouldn't be giving folks much of a fresh start if their only means of making an income (their tools) are getting sold for the benefit of their creditors. In other words, John Smith, who makes a living doing business as Smithy's Plumbing, is able to keep his tools of the trade even after filing bankruptcy by claiming the appropriate exemption.

On the other hand, there are no exemptions, other than the occasional wildcard exemption, that protect a filer's ownership interest in a business entity. So, while it's $1,600 worth of assets either way, John can keep all of it without issue by claiming an exemption only in only one of these situations.

Conclusion

We've explained how the different ways of operating a business impact a filer's ability to protect certain aspects of that business. What's important is that you don't forget that "it is what it is" when you fill out your bankruptcy forms. If you have an LLC or other legal entity, that's the asset you list on your Schedule B, protected or not.

If you have an interest in a business with significant assets such as inventory, accounts receivables or equipment, you'll be best served by speaking to a knowledgeable bankruptcy lawyer in your area about how to best protect yourself in the event a bankruptcy filing becomes necessary. At that point, it becomes about protecting your livelihood, after all, so it makes sense to get all the help you can get. And since most law firms provide free consultations to discuss bankruptcy options, all it'll cost you is some time. This is especially true if you're not 100% sure about how to calculate your monthly income for purposes of the means test, what your disposable income actually is, or how to provide actual proof of income based on your profit and loss statements.