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Everyone associated with a failing business can expect to suffer some negative effects. Lenders,
suppliers and employees may not receive payment in full. Customers may not receive goods
which have been paid for and may not receive warranty service as promised. Generally however, it is
the owner of a failed business who bears the heaviest burden both from the standpoint of emotional
turmoil and potential financial ruin.
The purpose of this article is not to aid unscrupulous business owners
in avoiding their obligations, but is instead intended to alert
current and future business owners as to certain steps that
they may legitimately take to try and minimize the adverse financial
consequences which will result from the failure of a business.
Few people want to consider the possibility of failure when they are starting out in a new
venture, but that is a time when decisions are made which can have a significant effect on the personal
liability of the owner in the event of a future business failure. A properly formed and maintained
corporation offers its shareholders a high degree of protection from personal liability on ordinary
business obligations. A new entity known as a limited liability company also offers the owners
immunity from regular business liabilities. However, neither a corporation nor a limited liability
company offers any protection against obligations which have been personally guaranteed by the
owner. Also, neither entity offers protection to an owner whose personal conduct causes injury or
property damage to a third party. For this reason, appropriate liability insurance is always advisable
even if a corporation or limited liability company is utilized.
If the failing business is a proprietorship or general partnership, the individual owners are
personally liable for all of the debts of the business, regardless of the type of debt involved. This will
include regular trade creditors, banks, taxing authorities, landlords, etc. In this case, if the owner lacks
sufficient personal assets to pay the debts and obligations of the failing business, the owner will need
to evaluate the possibility of filing personal bankruptcy. There are various types of bankruptcy, and
the proper choice of bankruptcy vehicle is beyond the scope of this article. In general however, by
filing personal bankruptcy, the owner will be able to discharge in whole or in part his or her regular
business debts and obligations. The owner will not, as a general rule, be able to discharge current
taxes, governmental penalties or similar obligations, since those types of debts are non-dischargeable
in a personal bankruptcy regardless of the reason why such debts were incurred in the first place.
Unfortunately, questions regarding personal liability for business obligations usually arise well
after the business is formed and after it is too late to choose a form of business entity which might
serve to limit the owner's personal liability. Therefore, it is necessary to consider other alternatives
which might serve to protect the owner's remaining assets.
Before discussing strategies which may help the owner of a failing business, it might be
appropriate to mention certain devices which probably will not work to protect the owner's personal
assets. When trouble strikes, many people consider transferring personal assets to some third party,
perhaps a family member, in the hope that such assets will then be beyond the reach of business
creditors. This will not work. Under the laws of virtually every state, the gratuitous transfer of assets
by an insolvent person or business for the purpose of avoiding payment of debts is defined as a
"fraudulent transfer". Such transfers can be reversed or otherwise successfully attacked by creditors
or by a subsequently appointed bankruptcy trustee. Furthermore, the failure to disclose such transfers
on a bankruptcy petition constitutes a serious federal crime.
Another device which is occasionally considered by the owner of a troubled or failing business is
the transfer of assets to a "trust" for the purpose of placing those assets beyond the reach of creditors.
While the use of certain types of trusts prior to incurring debts may place assets beyond the reach of
creditors, it seems fairly clear that the transfer of assets to a trust after debts already exist is just
another form of fraudulent transfer which is likely to be reversed or overturned in the event of a
bankruptcy filing or creditor's lawsuit.
In many business failures, the owner has some degree of control over how the remaining cash
flow is used. It is in this area that owners of failing businesses may be able to help themselves avoid or
reduce personal financial hardships while at the same time complying with existing laws.
Where a creditor holds collateral or security for repayment of a particular
obligation, it is important that the proceeds from that collateral
actually be used to pay the creditor in question unless the
creditor consents in writing to some other arrangement. On occasion,
a secured creditor will consent to the use of some portion of
the proceeds from its collateral to pay certain defined debts,
such as rent, taxes and salaries during the period while inventory
collateral is being liquidated. If proceeds from collateral
are improperly diverted to pay other creditors, the business
owner is committing a type of fraud known as conversion of collateral.
In the event of subsequent litigation or bankruptcy by the owner,
the owner who has converted collateral may find that the debt
which was left unpaid due to such conversion is declared to
be "non-dischargeable". This is an extremely negative result
and one which can be avoided by refraining from conversion of
the proceeds of collateral. Of course, once a secured loan is
paid in full, any remaining collateral may be liquidated by
the business owner and the proceeds used for any legitimate
purpose.
In the event that the business owner is considering the surrender of
collateral to a secured lender as part of an agreement to reduce
or cancel the debt, prior consultation with a tax advisor is
recommended. If a lender "forgives" a debt in exchange for the
surrender of collateral worth significantly less than the balance
due, substantial tax liability may result. It is hard to imagine
a more painful result than to lose a business and at the same
time become indebted for taxes on "phantom income" created by
the surrender of collateral.
If there is some cash flow available to the owner of the failing business which does not include
proceeds of collateral, there are certain types of debts that should be given priority for payment. First,
debts that have been personally guaranteed by the owners can be paid, thereby reducing the owner's
personal exposure. At the same time, debts owing to governmental authorities for certain types of
taxes should be paid. It is critical to note that even where a business is incorporated, the owners are
personally liable for various forms of taxes which are not paid by the business. The most common
types of taxes which would fall into this category are "employee withholding" taxes (commonly called
940 / 941 taxes), and in Washington, sales taxes which have been collected from customers but not
yet remitted to the State. Other forms of business debt which may be paid on a priority basis are
wages and salaries due to employees and perhaps money owed to a landlord for back rent,
particularly if the landlord may be in a position to assert a landlord's lien on the remaining equipment
and inventory of the failing business.
Where the money available to pay business debts is less than the total amount of debt, every
business owner has a natural tendency to use the available money to pay certain creditors to the
exclusion of others. It may feel better to pay the trade creditor who is a fellow member of the Rotary
Club and ignore a creditor located on the east coast. However, such "favoring" of creditors may be
subject to reversal by a bankruptcy trustee if bankruptcy is later filed by or against the failing business
or business owner. In general, substantial payments made to "preferred" creditors within 90 days
prior to a bankruptcy will be recovered by the bankruptcy trustee and redistributed (after deducting
the trustee's fees and costs) to all creditors on a more equitable basis. In some cases, payments made
up to one year prior to a bankruptcy filing can be recovered by the bankruptcy trustee. This longer
period applies to so-called "insiders" or persons who have some personal or close business
relationship with the failing business owner. Note that these "preference" rules apply equally to debt
which has been guaranteed by the owner, so any attempt to "prefer" creditors holding guaranteed
debts must be timed in such a manner as to avoid the 90 day preference problem.
Even if business failure appears unavoidable, it is not unlawful or improper for business owners
to pay reasonable salaries and fringe benefits to all bona fide employees including themselves. Many
owners of failing businesses fail to pay themselves, which may be a significant mistake, since the
owner may be able to protect a reasonable salary by using it to increase the value of "exempt assets"
such as home equity or qualified retirement plan or pension funds. Exempt assets are those which the
owner will be able to protect and preserve even if a personal bankruptcy filing becomes necessary at
a later date.
While business failure is always painful, with planning and proper allocation of remaining
resources, the owner may at least avoid complete financial ruin, thereby preserving the hope of a new
endeavor with a happier and more profitable result.
©Copyright 2003, Landerholm, Memovich, Lansverk & Whitesides,
P.S. |
