Business Sales Tax Dischargeability

One issue recently came up on the dischargeability of taxes in bankruptcy.  If you have studied bankruptcy much, you likely know that income taxes owed can be discharged so long as the tax return was filed at least three (3) years prior to the debtor filing a bankruptcy petition.  However, for many small businesses, an issue of sales taxes can come up in their bankruptcy filings.

A 1986 Ninth Circuit Court of Appeals case (In re Shank) reviewed whether sales taxes can be discharged.  In that case, Shank ran a business in the State of Washington.  For each of his sales, Shank was to collect sales tax and remit the funds to the State as sales tax.  Shank, in turn, failed to remit the funds and ultimately filed bankruptcy five (5) years after the business ceased operations.  He sought to discharge the debts in the bankruptcy.

The court reviewed the rule that certain tax debts can be discharged after three (3) years.  However, a law was enacted under the Bankruptcy Code in 1966 wherein certain tax liabilities would not be dischargeable, no matter how much time had passed.  One such tax was “trust-fund tax.”  The case went on to review the history of the legislation enactment through both the United State House of Representatives and the United State Senate. 

The court’s ruling presented two separate forms of sales tax liability: “[1] those owed personally by a retailer and [2] those incurred by a retailer’s customers which are collected by the retailer under the authority of the state, held in trust, and then remitted by the retailer to the state.”  To understand the difference between the two taxes, a Seventh Circuit Court of Appeals case determined that a 5% occupation tax on the gross receipts was not considered a “trust fund tax.”  However, Shank’s obligation to remit the sales tax he collected for his sales, did fall under the trust category, and could not be discharged.  Another court reasoned that if the tax is paid by the purchasers of goods or services, it is likely that the tax is part of a trust that will not be discharged.

If you own(ed) a small business an are considering bankruptcy to relieve yourself of debts, contact the Henshaw Law Office to determine whether your tax liabilities can be discharged.

Chapter 13 vs. Chapter 11 vs. Chapter 11 “Small Business”

In general, most people filing, or interested in filing, bankruptcy as a small business owner would likely choose between Chapter 13 and Chapter 11.  Chapter 7 bankruptcy is usually not a welcome option for the sole proprietor.  The main reason is that Chapter 7 bankruptcy would likely require that the business be shut down.  With that said, most business owners would prefer the relative simplicity and ease of a Chapter 13 case rather than the complexity of Chapter 11.  Additionally, the higher cost of Chapter 11 usually creates an additional incentive to utilize the benefits of Chapter 13.  However, for some business owners, particularly those looking to adjust secured debts, Chapter 11 may be the best option, even with the added cost.  Lastly, the creation of the “small business” Chapter 11 can help those business owners with limited liabilities with a streamlined process.

Eligibility for each Chapter

Chapter 13

To be eligible to file for bankruptcy under Chapter 13, the individual must have “regular income.”  This requirement means that the debtor maintains sufficient income to make payments under the Chapter 13 plan.  In addition, the Bankruptcy Code limits a Chapter 13 debtor to unsecured debts of $360,475 and secured debts of $1,081,400.  Should the individual’s debts fall outside this level, the debtor must file for Chapter 11.  This debt level limitation is equally applicable in cases of joint (married) debtors. 

Chapter 11

In general, any “person” who may be a debtor under Chapter 7 may also be a debtor under Chapter 11.  Although most people think of the various, large corporate cases, Chapter 11 can also be used for small businesses, sole proprietorships, and individuals.  A husband and wife may also be eligible to file a joint Chapter 11 petition.

Small Business Chapter 11

Recognizing that many small business owners do not qualify for Chapter 13, but want to be able to reorganize such small business debts, the Bankruptcy Code now allows for streamlined procedures in Chapter 11 for certain business entities.   A small business, for Chapter 11 purposes, is a person or business engaged in commercial or business activities whose total debts do not exceed $2,343,300.  This designation of a “small business” must be stated in the initial bankruptcy petition. 

Benefits of Each Chapter

Chapter 13

Overall, Chapter 13 gives the individual debtors, including small business owners, the same opportunity to reorganize their debts that large business have under Chapter 11.  However, this reorganization is completed through a less complex and expensive procedure.   As with Chapters 7 and 11, all debtors that file for Chapter 13 bankruptcy are afforded the benefit of the automatic stay.  This stay prevents any collection, foreclosure, lawsuit, or garnishment activity against the Chapter 13 debtor.   While the Chapter 13 debtor must file a reorganization plan, it is only the debtor that may propose and create the debt repayment plan.

Also, in Chapter 13, like Chapter 11, the individual debtor maintains possession and control of any business interests.  As such, the debtor has the exclusive right to sell, lease or otherwise use business assets, as long as such actions are in the normal course of business operations. 

Unlike Chapter 11, in Chapter 13 a creditors’ committee is not appointed.  Also, the plan does not require that any creditor consent to the reorganization plan in Chapter 13.

Many individuals are attracted to Chapter 13, if not forced out of a Chapter 7 because of a failed means test, because of the ability to alter secured debt.  For example, a car loan can be altered if the borrower is behind on the car payments to allow for (1) repayment of past payments owed and (2) restructuring the loan to conform to market value even when the loan balance far exceeds the true value of the car.  Similarly, on home loans, Chapter 13 allows the debtor to make up past due payments over the term of the plan (3-5 years).  However, in Chapter 13, like Chapter 11, a debtor cannot adjust the terms of a loan secured by the debtor’s principal residence.  As to non-primary-residence property, the Chapter 13 plan can restructure the debt so long as full payment is made within the plan period (3-5 years).

As to claims, unlike Chapter 11, a Chapter 13 debtor does not have to obtain approval from its creditors to approve a plan.  The debtor simply has to provide a plan that the court approves.

Chapter 11

In Chapter 11, a sole proprietor is able to continue business operations, and run the business as previously done.  The debtor is able to obtain financing, sell assets, lease property, and do all that the business normally would do, but for the bankruptcy.  While Chapter 11 can be quite expensive due to the extensive reporting, filings, and other procedural matters involved, one real benefit unavailable to Chapters 7 and 13 debtors is that secured debt can be adjusted extensively.  For example, a rental property that that has a principal balance far below the current market value (quite common in this economy) can be adjusted to conform to that market value.  The payment terms do not have to fall within a 3-5 year plan window.  Again, while Chapter 11 can be expensive, this simple ability to adjust non-primary-residence secured debt may be worth the additional expense.

Small Business Chapter 11

The benefits of the “small business” Chapter 11 is strictly procedural.  Congress has simplified the procedure to allow for companies that are not Blockbuster or GM to partake in all the benefits of Chapter 11.  The advantages include a simplified plan form for most courts, not requiring a committee of creditors in most cases, a shortened monthly operating report, and an extended exclusivity period to file a plan (180 days vs. 120 days).

Conclusion

In most bankruptcy cases where an individual business owner is considering whether to file a Chapter 13 or Chapter 11, the decision is clear.  Chapter 13 will be most beneficial due to the increased costs and procedures of Chapter 11.  However, in cases of a qualified “small business” with real property outside of a principal residence, the small business Chapter 11 may be a benefit that can save the business owner substantial money over the course of the bankruptcy and in the future.

If you have any further questions in small business bankruptcy, contact the Henshaw Law Office today at (408) 599-1305.

Bankruptcy Options for the Sole Proprietor

When a person decides to start a business, the potential owner has to make a lot of decisions such as where to locate the business, how to market, and deciding on a business strategy.  The legal aspects of starting a business, especially if it is the owner’s first time out, can seem less important than making money and managing the company. 

The first legal principle to recognize with sole proprietorships is that the business is not separate from its owner.  If you are in such a situation, you are probably all too aware of this fact.  This means that the business owner is individually and personally liable for any debts the business incurs.

This personal liability of a sole proprietorship has serious implications should the company enter bankruptcy protection.  First, a business established as a sole proprietorship cannot file for bankruptcy without the business owner (one good reason to set up a business as LLC or corporation).  Second, the individual owner’s assets may become available to both the company’s and the individual’s creditors.

The question that many people have with their own personal business is whether the bankruptcy trustee or court will close the business completely.  The answer to this question will depend on a number of factors.  However, the main factor is which Chapter of bankruptcy the business owner chooses to file under in the bankruptcy court.

Chapter 7 is also known as liquidation.  The Chapter 7 trustee will sell all “non-exempt” assets to pay off creditors.  A business that is not able to exempt much of its assets will be required to close based on the inability to function as required as compared to its business needs.  There is also a growing trend with sole proprietorships of trustees simply closing the business to prevent the business from incurring further liabilities. 

If the owner of the company has significant assets and wants to continue operating the business, Chapter 13 may be the better alternative.  In Chapter 13 the owner’s debts are reorganized and a payment plan is created to pay part or all of the debts over a three or five year period.   The owner can keep all of the business property through this repayment process. 

Ultimately, if you are considering bankruptcy for sole practitioner debts, consider all of your alternatives, including setting up a separate business identity.  If bankruptcy is needed, contact the Henshaw Law Office today at (408) 599-1305.

Super Bowl Trouble

As it is Super Bowl week, I thought it would be appropriate to add a little football spice to the blog.  The other day I was reading an article that detailed some of the financial struggles of NFL players.  According to a separate Sports Illustrated article, approximately 78% of NFL players are seriously struggling financially after two years of retirement (whether voluntarily or not).  That same article compares the life and lifestyle of professional athletes to lottery winners.  For the most part athletes have short careers that provide them with a significant sum of money in a short period of time.  Most athletes have gone from high school to scholarship-funded college athletics to the pros.  Most do not have any budgeting or accounting background.  I think we can all look back and think what we would do if at age 20 someone suddenly gave us all the money, notoriety, and possessions we could want.  The problem is that, for the most part, all three generally last only a few years.

I am not saying that we should take pity on those that are able to squander upwards of $100 million.  But, again, lessons can be learned from their tales.  I heard once from a man in Brazil, “it is not what you make, it is what you spend.”  For many, this recent recession has caused a hard look at what are really necessities.

Many athletes ultimately have used bankruptcy to curb their losses.  Some of these include Deuce McAllister (failed car business), Lawrence Taylor (drug habit), Jose Canseco (houses/cars), and Michael Vick (investments…).  When an individual has a lot of money, the investments, the assets, and the falls just seem to be bigger.  However, for the average American, the stakes can be a matter of being able to make a $1,000 rent payment or being able to keep a car that is threatened with repossession. 

I keep thinking to myself, how are these guys squandering this money away so quickly.  Don’t they have someone helping them to know that their money will run out?  Doesn’t anyone let them know that their careers in athletics is a finite and somewhat defined period?  Doesn’t anyone advise them that buying 13 Ferraris is not part of a strong investment portfolio?  The answer is not that they don’t have the advice.  It is that they are surrounded by other people and ideas that make them believe in a world without spending limits and where money will easily fall from the sky (broadcasting, music production, car washes). 

After high school, while attending De Anza College I worked part time for a company where each executive had a very nice car.  Part of my job was to take the cars to get washed, fill them up with gas, and take them to the repair shop if needed.  After driving a brand new $100,000 Mercedes it was difficult to climb into my 1983 Nissan 200SX with screeching brakes.  I wanted to live the executive life so I bought a car I simply could not afford.  It took me four solid years to make up for that mistake.  To this day, I still drive the car I traded for after the mistake car (my wife always seems to get the nicer cars). 

The main lesson I take away from the financial plight of the professional athlete is that the old saying is still true.  Keep costs below pay.  Save for a rainy day because the weather can change quickly.  Lastly, although it is sometimes difficult, try to keep up with the Joneses.  Just because someone has the new 60 inch 3D HDTV doesn’t mean it is the best use of money.  Financial freedom starts with responsible decisions. 

Also, find a good, responsible person that you can discuss your financial situation and goals with on a regular basis.  A financial advisor or accountant can help make sure you are on the right path.  In case you do find yourself in a sinking path, bankruptcy may be the way to keep you afloat.  Don’t look at it as your last option.  Take the time to consider all options before they are chosen for you. 

If you are having financial struggles currently, contact the Henshaw Law Office today to see what options you may have.