Like most things in the law, the issue of how individuals and their businesses relate is multifaceted. It comes up when individuals have a small business that provides a living, but the owners have accumulated crushing debt. I wrote earlier about how incorporation could create a separate legal entity that could continue to operate during the bankruptcy of its shareholders.

My good friend Doug Jacobs pointed out that under some circumstances, incorporation could be seen as a fraudulent transfer.

A fraudulent transfer is one where the entity conveying property either intends to put it beyond the reach of his creditors, or, receives less than the asset was worth in exchange, leaving the transferor less able to pay his debts. The bankruptcy code allows the bankruptcy trustee to recapture assets transfered in fraud of creditors.

My counter argument to Doug’s point is that incorporation hardly conveys away the value of the business, as the debtor simply exchanges his outright ownership of the business for outright ownership of the stock in the corporation that owns the business. If there is real value there, a bankruptcy trustee can reach it by dissolving the corporation.

My second argument is that before incorporation, the business was indistinguishable from the individual. The idea of “transferring” debts to the newly created corporation is facially pleasing, but cannot relieve the individual of any liability he had before incorporation.

It is an axiom of law that no agreement between two entities can bind a third: that is, the individual and his corporation cannot by agreement cut off the right of the individual’s creditor to look to the individual for repayment, even though the new corporation and the individual might agree that the corporation will be henceforth liable.

This analysis is probably more theoretical than real, since the small businesses my clients usually operate are little more than personal services businesses. Incorporation simply provides cover for the trustee who, because of incorporation, doesn’t have to shut the business down as part of his duties to preserve the assets of the estate.

But it does draw attention to the fact that the legal culture does vary from place to place. I practice in Silicon Valley; Doug practices in the Central Valley. Like it or not, even though the law is the same in both places, judges often bring a slightly different perspective to the bench, depending on where they practice.

For that reason, when you select a bankruptcy lawyer, you want one who knows the judges before whom your case will be heard and understands the legal culture in that community.

When politicians talk about credit cards, they conjure up images of consumer purchases, and often, of consumer spending run amok. However, the facts that I see in my bankruptcy clients show that credit cards are increasingly used to finance small businesses.

Entrepreneurs use credit cards in two ways: one is to buy goods and services for the business or cash advances to make payroll. The second way is more subtle: the business owner uses his personal credit to support himself in lieu of the salary he isn’t getting from the new business.

Too little attention is paid to the impact on business plans of funding at credit card interest rates. My sense is that it takes a dynamite business operation to retire a business loan carrying interest at 18-24%. Yet small business types resort to their credit cards because that is often the only money available. It further seems to mandate that if the business fails, the entrepreneur is personally exposed.

A small business owner finds it hard to separate themselves from the business, even when that business is incorporated. After all, the owner’s financial livelihood rises and falls with the success of the corporation’s business.

Twice in the past two days, I had occasion to point out to clients who own small corporations that when the bankruptcy trustee says “you”, the trustee is talking about you, the individual, not the business that you have been immersed in.

But the important legal distinction is that the corporation that owns the business is a separate legal “person” from the flesh and blood human being who owns the stock in the corporation and serves as its officer and director. The debts of the corporation are not necessarily the debts of the shareholder. The corporation can file bankruptcy without the shareholder, and conversely, the shareholder can file bankruptcy without impacting the day to day operations of the corporation.

In analyzing a bankruptcy filing or answering questions from a bankruptcy lawyer or bankruptcy trustee, make sure you know who you are.

More on business bankruptcy.

Chip Parker and I have been writing about bankruptcy issues for the self employed over on the BankruptcyLawNetwork.
Chip pointed out that the bankruptcy of the shareholder does not protect the operations of a corporation that the debtor owns, since the corporation is not in bankruptcy, the shareholder is.
The flip side of that proposition is that since the incorporated business is not in bankruptcy, it can usually proceed to operate through the bankruptcy of its shareholder. After all, it is a separate entity, distinct from the owner of the stock.
When a small business is a proprietorship, the assets belong to the owner and are part of the owner’s bankruptcy estate when the owner files for debt relief. The trustee may want the business to stop operating 1) so it does not incur more operating debts; 2) so that the trustee is not liable for any tort claims that arise after the commencement of the bankruptcy; and 3) so the assets can be preserved and accounted for.
I have frequently advised clients with an operating business or professional practice that they want to continue to run post bankruptcy to incorporate before filing. In that manner, they draw a circle around the business assets and create a separate legal “person” who is not in bankruptcy. It shields the trustee from the concerns set out above and allows the debtor to continue to work.
If the stock in the corporation has non exempt value on the open market, the debtor may buy the stock from the trustee. Most small businesses however have little value if the owner were to stop working in the business. Trustees frequently abandon such assets as having insignificant value for creditors.

The Bankruptcy Code attempts to exclude from its shelter those who “abuse” the system. Chapter 7 has a provision in Section 707(b) that allows a challenge to the entitlement of a debtor to get a dishcarge under that chapter. However, only a debtor whose debts are “primarily consumer” debts is subject to this scrutiny. One whose debts result from business failure or failure to pay their taxes are not subject to review for “abuse”, regardless of their ability to pay.

That came home to me as I interviewed a single man with a fine salary, yesterday. He is exempt from the means test because his debt was incurred in business. There is certainly a policy argument for making the consequences of business failure tolerable. That is, I think, a hallmark of the American business ethic, the acceptance of failure and the encouragement of trying again.

The exclusion from the “can-pay” scrutiny for those who haven’t paid taxes seems to me to be harder to justify. Our society isn’t stronger for a policy protecting those who haven’t paid their fair share of maintaining our infrastructure.

Which leads you back to the unstated premise underlying the means test, that all consumers who can’t pay their bills are to some degree dishonest. My learned opinion is HOGWASH.