Does a personal bankruptcy affect ownership interest in a small business?

A personal bankruptcy affects an ownership interest in a small business and must be considered—though the way it may affect that interest depends on how the business is set up and the type of bankruptcy filed.

The two types of personal bankruptcy are Chapter 7 and Chapter 13. In a Chapter 7 filing, the bankrupt debtor’s assets are liquidated, or sold, and the proceeds are distributed to the creditors, subject to certain exemptions (types or exempt amounts of property are listed and the debtor does not have to liquidate these assets). That’s the law, though, as usual, practical issues can surface—i.e., can a given asset (such as an illiquid one or ownership in a closely-held company) be sold, and, if so, for what amount?

Ownership Interest in a Chapter 13

In a Chapter 13, the debtor will be a given a repayment plan—a fairly strict, court-ordered budget—which he or she must live by for several years, while paying as much as practicable from monthly income to creditors. Business assets (and income) may be affected, since some amount of power over them moves from the hands of the titled owner to the bankruptcy trustee.

Small businesses are most commonly either: sole proprietorship, corporations (either S-corps or C-corps) or limited liability companies (LLCs). If a corporation or an LLC, the business usually has a legal existence independent of the owner. That independent existence means that just as the owner is not personally liable for the business’s obligations, so is the business not liable for the owner’s personal obligations. Some closely-held corporations, however, do not get this protection, so it’s important to discuss your and your business’s situation with a bankruptcy attorney.

However, a sole proprietorship is also the individual—there is generally no legal distinction between the two, though state-by-state differences can influence specific exemptions. This general rule means that the individual’s bankruptcy is also the business’s bankruptcy. What this in turn means is that if a sole proprietor declares bankruptcy, their business is affected just as much as their house, car, or cash—the business is just another asset.

If the owner of a corporation or LLC declares bankruptcy, only the owner’s ownership interest is typically affected. That is, the business can run as per normal; but if the owner’s ownership interest is worth, say, $250,000, that represents an asset in the bankruptcy.

• Caveat: Seven states allow unlimited homestead exemptions. Many entrepreneurs live in these states, and channel much of their assets into their homes.New Jersey and Pennsylvania, to the contrary, have no homestead exemption at all. (Click for your state’s rules regarding the homestead exemption.)

Ownership Interest in a Chapter 7

If filing a Chapter 7 bankruptcy, the net value of the ownership interest will be assessed with the other assets of the owner, to determine what creditors might receive from a liquidation (or sale) of assets.

For example: someone owns an LLC worth $500,000. If he also owns another $500,000 of nonexempt assets (cash, stock, cars, property, etc.) in theory, there are $1m of assets that could be sold and the proceeds split up among creditors. However, we stress “in theory,” because regardless of the “book” or other theoretical value of a small business, it may be an illiquid asset—something for which no buyer can be found. Also, many small business, regardless of their gross revenue, have little, no, or even negative value, often because so much debt has been accumulated to fund or finance them. In these cases, while the ownership interest is an asset that could, in principal, be liquidated for creditors, it may have no value.

• Caveat: Bankruptcy law allows a “fresh start exception.” This applies to future earnings, and under some circumstances, allows a business to be conducted without being burdened to repay pre-bankruptcy debts.

Case Studies: How Personal Bankruptcy Affects Ownership Interest in Small Businesses

Case Study 1: John’s Sole Proprietorship

John is the owner of a sole proprietorship that operates a small restaurant. Unfortunately, he recently filed for personal bankruptcy due to overwhelming debts. In this case, John’s personal bankruptcy directly affects his ownership interest in the restaurant.

The business is considered just another asset, similar to his house, car, or cash. Consequently, the restaurant may be subject to liquidation, and the proceeds will be distributed to creditors.

Case Study 2: Sarah’s LLC

Sarah owns a limited liability company (LLC) that provides graphic design services. She finds herself in a situation where personal bankruptcy becomes necessary. Unlike a sole proprietorship, an LLC is a separate legal entity from its owner.

Therefore, only Sarah’s ownership interest in the LLC will be affected by the Chapter 7 bankruptcy filing. If her ownership interest holds value, it can be sold as an asset to repay creditors. However, it’s important to note that this scenario is relatively rare, as many small businesses have little to no value or are illiquid assets.

Case Study 3: Mark’s Corporation

Mark is the owner of a small corporation that manufactures and sells handmade furniture. Similar to an LLC, a corporation has its own legal existence separate from its owner.

In the event of Mark’s personal bankruptcy, only his ownership interest in the corporation will typically be affected. The corporation can continue to operate normally, but Mark’s ownership interest will be considered an asset in the bankruptcy proceedings.

In Summary:

A sole proprietorship is an asset and part of its owner’s bankruptcy. A corporation or LLC may be affected by a Chapter 7 filing, if the business has a net positive value and can be sold as an asset of the debtor. This is somewhat rare, however; so in practice, while the owner will need to account for the business, most often, nothing will happen.

Finally, in a Chapter 13 filing, the owner’s ownership interest in an LLC or corporation is likely to be virtually unaffected, though the owner’s income from the business will be part of his or her overall income, considered in determining the plan.