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COLLAPSING CLOSELY HELD CORPORATIONS AND PUTTING
OWNERS INTO CHAPTER 7 OR CHAPTER 13 BANKTUPTCY
INTRODUCTION
A common situation presented to a bankruptcy attorney is the business client who is the
sole owner of his own business, but who owns and operates it in the form of a corporation
or limited liability company. The client comes into consult, thinking that the discussion
will revolve around getting debt relief for the "business", and is chagrinned to discover
that for numerous reasons (such as, personal guarantee of business debts, personal
liability for unpaid employment taxes, and incurrence of debts, such as credit cards, in his
individual name "for the business") that the discussion turns to him filing bankruptcy.
The discussion gets more difficult for the client who insists that he must keep the
business operating because that is his only means of livelihood. ('That's all I know how
to do. Besides, no one will hire me at this age.") After a frank discussion about the
profitability of the business, some clients do in fact establish that the business is or can be
profitable going forward. The business just needs to eliminate old debt Since chapter 7
for the corporation or LLC means it must shut down, and since chapter 11 's are timeconsuming, difficult, and expensive, the initial impression is that there is no effective
bankruptcy solution.
However, in many cases there is a solution. The solution is to "collapse" the corporation
or LLC, have the debtor begin (on in many cases, resume) operating as a proprietor, and
then file either a chapter 7 or chapter 13 for the individual debtor. The fact situations set
out below are designed to provide the springboard from which we will explore how this
is done. It is a strategy that has its perils, but a strategy that is usually worth the risk,
providing great benefit to the client and substantial fees to the attorney.
Fact Situation #1:
Joseph and Ruth Graves consult with you concerning their financial difficulties. Ruth is
employed as a research assistant in the Research Triangle Park and earns $3,000 per
month. Joe owns and operates a delicatessen called "Graves' Alimentari". The business
is owned by a corporation entitled "Graves Family, Inc.". Joe owns 100% of the
corporate stock. The corporation has two employees in addition to Joe. They are usually
paid every Friday for the hours they worked through the prior Saturday. The assets of the
corporation consist of $25,000 in equipment, inventory and supplies. Its debts consist of
a loan to Self Help Credit Union ("SHCU") in the amount of $36,500, which is secured
by a PMSI in the corporation's equipment, debts to suppliers and vendors in the amount
of $30,000, unpaid sales tax and payroll taxes to the State of $4,000, unpaid payroll taxes
to the IRS of $12,000 and a corporate credit card of $15,000. Neither the IRS or th State
have personally assessed Joe for the trust fund portion of the taxes, yet, but the period for
assessment has not yet expired. Payments on the SHCU debt are $325 per month and are
current Joe believes he has guaranteed most of the corporate debts, but is unclear on
which debts he has guaranteed. The lease for the restaurant is in the name of the
corporation, but is also guaranteed by the Graves. The lease payments are current The
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SHCU debt is also secured by the Graves' residence, which is worth $200,000 and
encumbered by a first mortgage of $160,000. The applicable homestead exemption is
$35,000 per person. The Graves are $9,000 behind on the mortgage. They have personal
consumer debts of $60,000. They have no non-exempt personal assets. Their nonexempt assets include $20,000 in IRA accounts.
An analysis of the business's income, expenses, and operations reveals that suppliers
have put the business on COD, but that the business is able to operate in this fashion. If
relieved of the unsecured debts, the business is profitable. Furthermore, if the Graves can
shed all of the unsecured debts, both personal and business, they have sufficient income
to keep the secured payments made, cure the arrears on the mortgage over the life of a
chapter 13 plan, and pay any personal liability Joe has on the sales and payroll taxes.
Proposed Solution:
You advice the Graves to "collapse the corporation" and file chapter 13 bankruptcy. The
steps to collapsing the corporation are as follows:
1. Create a new business entity by transferring all of the assets of the corporation to
Mr. Graves individually (see "Bill of Sale and Assignment") and have Mr.
Graves operate the business as a sole proprietorship.
2. Provide proper notice under local law that the business is operating as a sole
- proprietor (see "Certificate of Assumed Name").
3. Obtain a new Employer Identification Number for the new business entity. To do
so have client go to irs.gov and click on "Apply for Employer Identification
Number (BIN) Online".
4. Have client open new bank accounts) for the business using the new BEST.
5. In the bankruptcy schedules list all of the debts of the corporation. Identify as
best you can, which ones are guaranteed, and which ones are not List the ones
that you do not believe to be guaranteed as "disputed", and note that the debt has
been listed as a precaution.
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Terms of Chapter 13 Plan:
Base amount of Plan: $27,000, paid in 60 payments of $450.00
Priority Claims:
Attorney's fees: $3,000 (Total fees are $4500 with $1500 paid pre-petion)
Taxes:
IRS: $8000l
State: $4000
Trustee: 10% of base amount of plan
Secured Claims:
SHCU: Paid directly
Mortgage arrearages: $9,000
Dividend to general unsecured creditors: 0
(Debtors have no DMI on Form B22C, and there would be no dividend to unsecured
creditors in a chapter 7 bankruptcy. An application of known or virtually certain changes
in income and expenses under Hamilton v. Lanrdng does not change the result (See
pages 7-8 for further discussion)
List all creditors of the corporation on schedule F.
With respect to the tax claims of the IRS and State be sure to list at paragraph 18 of
SOFA the debtor's operation of the corporation with its EIN, and schedule the debts on
schedule E as contingent, unliquidated debts with the consideration being "potential
liability for trust fund taxes owed by Graves Family, Inc.". If the taxing authorities fail
to file proofs of claim, be prepared to make a decision as whether to file claims for them.
This advisability of filing a proof of claim for trust fund taxes arises out of BAPCPA.
Prior to BAPCPA, trust fund taxes that were "provided for" in a plan were discharged if
the taxing authority failed to timely file a proof of claim. Section 1328(a)(2) now excepts
from discharge a debtor's liability for trust fund taxes as defined in § 507(a)(8)(C). So,
why then isn't it automatic to file the proof of claim? If in the absence of the priority
claim, the plan is still a zero percent plan to unsecured creditors, the debtors may prefer
to just "deal with the taxes" after the plan is completed. Furthermore, if the IRS has not
yet assessed the tax, it might let the time in which it has the right to do so expire.
Section, 362(b)(9)(D) does not stay the assessment of a tax, and presumably the
assessment period is not stayed.
1 The facts state the corporation owes the IRS $12,000 in payroll taxes, but amount listed here is only
$8,000. The debtor is not liable for all the payroll taxes, but only the trust fund portion. He is not liable for
the corporation's social security matching. If the employees are relatively low-wage employees, the trust
fund portion is usually 2/3 or less of the total payroll taxes owed.
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Fact Situation # 2
Same facts as Fact Situation # 1, except the debtors are current with their mortgage
payments.
Proposed Solutions:
Collapse the corporation as provided in Fact Situation # 1, but then file chapter 7. There
are no non-exempt assets. Tell the debtors that a) they will need to keep current with
their payments on the mortgage, and b) if the taxing authorities subsequently assess Mr.
Graves for the trust fund taxes, the taxes are not discharged.
Fact Situation # 3
Same situation as Fact Situation # 1, except that the debtors are current with their
mortgage payments and the loan from SHCU was an unsecured loan to the corporation,
but guaranteed by the debtors. The state law exemption that applies allows each debtor to
claim tools of the trade exemption of $2,000 and a "wildcard" exemption of $5,000.
First Alternative:
Collapse the corporation, and transfer the assets to both husband and wife in connection
with the "collapsing". Then file chapter 13. Since the debtors own the business assets
free and clear of any liens, they now have more assets than they can exempt in a chapter
7. However, there is still no dividend to general, unsecured creditors because the
potential priority claims owed to the IRS and the State exceed the amount of non-exempt
assets. The analysis is as follows:
Value of business assets:
$25,000
Tools of Trade Exemption:
Wildcard Exemption:
$ 4,000
10,000
Total Exemption:
$14,000
Non-exempt assets
Distribution in Chapter 7:
Priority Claims:
Estimated Administrative
Claims:
Priority Tax Claims:
$4,000
12,000
Total Priority Claims:
$16,000
$16,000
Available for General,
Unsecured Creditors
($5,000)
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In the event the taxing authorities forfeit their allowable claims by failir to timely file a
proof of claim, then the trustee may have the authority to require the am sndment of the
plan to provide a dividend to unsecured creditor in the amount of $6,00(. Therefore, you
must file proofs of claim on behalf of the taxing authorities within the 30 days following
the claims bar date. Otherwise, funds will be distributed on dischargeable debts to the
exclusion of the nondischargeable trust fund tax debts.
Second Alternative:
File chapter 7 and be prepared to negotiate the purchase of the non-exempt assets from
the trustee. Your clients' source of funds for the purchase could be early withdrawals
from their IRA. accounts.
Potential Risks Under Fact Situation #3:
Pursuant to § 1325(a)(3) a plan must be proposed in good faith and not by any means
forbidden by law. In the first fact situation, the assets transferred by the corporation were
fully encumbered by the security interest of SHCU, and the plan provided to maintain
contractual payments to SHCU. SHCU had no reason to object to the plan, and the
creditors of the corporation had no real basis to claim bad faith. In this scenario, if the
corporation were liquidated, the creditors of the corporation might recover some small
dividend. The debtors did not pay adequate consideration to the corporation for the
assets they received. The bill of sale does recite the assumption of the corporation's
debts, but this provision is a bit hollow when the debtor files bankruptcy immediately
thereafter. Here are potential responses:
1. Just take the risk.
2. Pay adequate consideration to the corporation for the assets. This consideration
can take the form of cash (perhaps from the IRA accounts) or in the form of a
promissory note. If cash is paid, the corporation could distribute some of the
funds to the IRS for its payroll taxes.
3. Delay, if possible, the period between the collapsing of the corporation, and the
filing of the bankruptcy.
Fact Situation #4
Same facts as Fact Situation #1, with the following changes:
" a) SHCU's debts is secured only by the equipment, and payments are $5,000 in
arrears.
b) SHCU has been "working with" the debtors and has shown little interest in
:
repossessing the equipment
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c) The debtor accepts his homework assignment of determining the replacement
value of the equipment, and provides solid evidence that he could replace all of
the equipment for $18,000.
Proposed Solution:
In this case we push the envelope a little more. The debtors propose a plan in which
SHCU's debt is crammed down to the value of the collateral at paid at the Till rate
over the life of the plan. The plan look like this:
Base amount of Plan: $49,500, paid in 60 payments of $825.00
Priority Claims:
Attorney's fees: $3,000 (Total fees are $4500 with $1500 paid pre-petition)
Taxes:
IRS: $8000
State: $4000
Trustee: 10% of base amount of plan
Secured Claims:
V
SHCU: Monthly payments through the plan of $340.25, amortizing a debt of
$18,000 at 5.25%
Mortgage arrearages: $9,000
The plan will provide for preconfirmation adequate protection payments to SHCU in the
amount of $340.25 to be applied to reduction of the debt To comply precisely with the
most restrictive interpretation of the Code, we would proactively file a motion to use cash
collateral pursuant to § 363(e).2
The primary risk of a challenge to this proposed plan is obviously an objection from
SHCU along the lines of "Judge, the debtors can't just take a debt to the corporation,
transfer the assets securing that debt to themselves, file a chapter 13 bankruptcyimmediately thereafter, and cram down the debt as part of its plan. That just isn't right
That's bad faith." There are a number of responses to the objections including the
following:
1. Substantively, what is happening to SHCU is not wrong. Without some type of
reorganization, this business is going to fail, and if it fails, SHCU is going to have
to repossess its collateral, and it will receive substantially less than $$18,000. The
corporation could file a chapter 11 and accomplish the same cram down of
My experience is that § 363(e) is essentially ignored in chapter 13 cases. For example, in a case in which
our client is a track driver and owns an encumbered truck, the court can prohibit or condition the use of the
track as is necessary to provide adequate protection, but only upon the request of the creditor. This rarely
happens., and the standard adequate protection provisions imposed by §1326(a)(l)(C) essentially provides
the adequate protection that a court might impose under § 363(e).
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SHCU's debt The main difference is that the costs of a chapter 11 bankruptcy,
especially attorneys' fees, are greatly higher. The chances of success, and
therefore the chances of SHCU getting paid are much greater with this chapter 13.
When SHCU made this loan, it required the debtors to guarantee the loan. In
reality it relied on three things to get paid: a) the value of its collateral 2) the
profits of the business and 3) the personal liability of the debtors. What the
debtors have done here is consistent with that reliance.
2. You negotiate with SHCU. In essence, you persuade SHCU that you might lose,
but SHCU can't win. Either the court confirms your plan, and SHCU loses, or it
denies confirmation, and the debtors just surrender the collateral. SHCU then sell
the collateral for $9,000 and its financial losses are even greater. Perhaps, the
issue is resolved by increasing the amount of SHCU's secured claim from
$18,000 to $22,500.
3. You do some pre-bankruptcy planning by having the debtors inform SHCU a
month or two prior to filing that the corporation has ceased operations due to
financial reasons, and has transferred its assets to the debtors. They indicate in
written communication that they realize that they are personally liable for the debt
to SHCU, and that they intend to continue to operate the business as individual
and make payments on the debt A payment on the debt accompanies the
communication.
In reality, from my experience, lenders in the position of SHCU do not file objections
in these cases. The absence of objections might arise from the lack of focus on the
part of the creditor or from the determination that the debtor's plan is actually in its
financial best interest. The role of the attorney for the debtor is to fully inform his or
her client of the issues that could arise, plan for them, and proceed with the
bankruptcy if the client assents.
HOW DOES ALL THIS WORK IN LIGHT OF LANNING?
Section 1325(a)(6)'s feasibility requirement mandates that a debtor "be able to make all
payments under the plan and comply with the plan." In establishing feasibility in these
corporation-collapsing cases, debtors will point to the decrease in business expenses
arising from the elimination of the requirement to pay some of the business's debts. They
will often point to a projected increase in income, as well. When confronted with a
objection to confirmation for lack of feasibility, a successful strategy employed by
debtors is to: a) postpone any hearing as long as possible; b) make all the payments
required under the plan; and c) argue at the hearing that the debtor is making the
payments and that the "proof is in the pudding". Hamilton v. Lanning permits a court to
account for "changes in the debtor's income and expenses that are known or virtually
certain at the time of confirmation." In light of Lanning, will the normal manner in
defending against objections to confirmation due to lack of feasibility automatically
result in the increase in DMI? Potential escapes from this trap follow.
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1. Feasibility Standard versus Lanning Standard
There is little case law applying Lanning's known or virtually certain changes in income
and expenses. The uncertainty of the continued profitability of businesses is well-known
and understood by the bankruptcy courts. Feasibility under § 1325(a)(6) does not require
certainty. The following quote is representative of the feasibility standard
"A debtor proposing a Chapter 13 plan need not prove that the plan is guaranteed
to be successful. Virtually every plan that requires some performance in the future
will be subject to a risk factor affecting its successful completion. This Court's
judicial discretion is to be exercised, then, to determine at the time of confirmation
whether the risk of failure of the proposed plan is impermissible." In re Anderson, 18
B.R. 763,765 (Bankr.S.D.Ohio 1982). affd 28 B.R. 628 (S.D.Qhio 1982).
In re Comvton, 88 B.R. 166,167 (Bankr.S.D.Ohio 1988).
If confronted with the feasibility-versns-Lanning adjustment issue, make this point to the
court,
2. Lanning Adjustment is not Mandatory
The Supreme Court in Lanning held that "when a bankruptcy court calculates a debtor's
projected disposable income, the court may account for changes in the debtor's income
and expenses that are known or virtually certain at the time of confirmation." The
adjustment is not mandatory. In business cases it is not appropriate to make any
adjustments. BAPCPA's means test provisions are primarily aimed at consumer debts.
The means test in chapter 7 doesn't apply to a debtor whose debts are not primarily
consumer debts. When faced with the application of Lanning in connection with a
business debtor, urge the court to exercise the discretion explicitly granted to it by the
Supreme Court to decline to account for changes in income and expenses.
3. Below Median Debtors
The Supreme Court in Lanning affirmed the holding of the Tenth Circuit that in
calculating projected disposable income, the bankruptcy court must begin the analysis
with the mechanical approach provided in § 1325(b). The applicable commitment
period (ACP) clearly derives form the debtors current monthly income (CMI), not his
"projected disposable income". Therefore if the debtor's CMI is below median, the ACP
is 36 months. Even though the ACP is 36 months, a debtor may propose a plan that is 60
months. This "extra" 34 months provides a bridge between the dual obligations of
proposing a feasible plan and accounting for changes in income and expenses. An
example follows:
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PROJECTED DISPOSABLE INCOME UNDER LANNING
Future Income
Joseph Graves (Gross Revenue)
$9,000
Ruth Graves
3,000
Total Income
$12,000
Future Expenses
Schedule I Expenses
(Taxes and Insurance)
Schedule J Expenses
Curing Arrearage
($9,000/36)
Business Expenses
$12,000
$750
4,025
$ 11,525
Total Expenses
Projected Disposable Income
Available for Unsecured Creditors
(3:6 x $475)
$17,100
Distribution to Unsecured Creditors
Chapter 13 Trustee
Debtors' Attorney
Priority Tax Claims
$2,700
3,000
12.000
Total Priority Claims
$17,700
$17,100
Available for General Unsecured Creditors
WHAT ABOUT THAT NINTH CIRCUIT BAP WIEGAND OPINION
In the Ninth Circuit and the Central District of Illinois this strategy of collapsing a
cprporation and operating a business as a proprietorship could have negative
consequences in determining the applicable commitment period (ACP). The Ninth
Circuit BAP in In re Wiegand, 386 B.R. 238 (9th Cir. BAP 2008), in a case from
Montana, held that in calculating whether a debtor's CMI, when annualized, was above
or below median income, income means the gross revenue or receipts of the business
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with no reduction for business expenses. The Bankruptcy Court for the Central District
of Illinois followed Wiegand, in In re Sharp, 394 B.R. 207 (Bankr. C.D.I11. 2008). If the
"business owned and operated by the debtor is a bona fide corporation, then presumably
the gross revenue received during the CMI period is not received by the debtor, but by
the corporation. The debtor receives only the salary the corporation pays him, if any, and
the profits of the corporation, if any, after paying its debts and expenses.3 However, if
the debtor is a sole proprietor, the gross revenue is received by the debtor. Depending
upon where you practice, you may need to factor this peculiar determination of ACP into
developing your bankruptcy strategy for your client
If you are in one of these jurisdictions, what do you do? First, run the numbers, as best
you can, to see how significant an impact collapsing the corporation will have upon the
dividend to unsecured creditors, and weigh this impact against the positive aspects of
utilizing this strategy. Most importantly, file the bankruptcy as quickly after collapsing
the corporation as practical. If a debtor is operating his business in the corporate form
until the end of the month preceding the filing of the bankruptcy, then Wiegand and
Sharp will not impact the calculation of CMI and ACP.
3 The
ruling in Wiegand is suspect due to the BAP's failure to take note of the fact that Mr. Wiegand
operated his tracking business as an LLC. The bankraptcy court's opinion make mention of this fact, but
since that court held that the business expenses were deductible in determining CMI, that fact was not
relevant in its final determination.
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