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.

2011 Tax Return Refund

I recently filed my 2010 tax return, and thought that a lot of people that are considering filing for bankruptcy may have questions about a potential refund on their own 2010 taxes.  For many, this refund is a huge part of the beginning of the year.  For some, it can be the difference between being able to survive the year (even after bankruptcy) and having to make even more drastic changes. 

Let’s look at one scenario.  It is late January and an individual is considering bankruptcy.  In the past three years the individual’s tax refunds has averaged approximately $4,000 (for both state and federal).  The individual’s income level and family situation has remained consistent throughout the past three years (and the tax year in question).  The individual estimates that a tax refund will equal the $4,000 level of the past three years.  What happens if the individual files for Chapter 7 bankruptcy before filing a 2010 tax refund?  Will that refund be confiscated by the trustee and distributed to creditors?  Does the individual have to claim anything on the bankruptcy petition?

The first question we have to look at is whether a tax refund can be considered “property of the estate.”  Only property of the estate is subject to turnover (delivery) to a bankruptcy trustee, and distribution to creditors.

Property of the estate is defined in the Bankruptcy Code as “all legal and equitable interests of the debtor in property as of the commencement of the case.”   The courts have held that this definition is broad and consists of virtually all of a debtor’s property.  The courts have also determined that a refund should be prorated to the percentage of the taxable year.  For example, if a debtor filed a bankruptcy petition on October 1, then only nine months (3/4) of a refund would qualify as “property of the estate.” 

The second question is what can be done to protect the refund should an individual file for bankruptcy.  Once the debtor’s interests or assets become property of the estate, the debtor may claim certain exemptions protecting that property.  One specific exemption that may apply in California is the “wild card” should a bankruptcy debtor choose the California (bankruptcy only) exemption statute.  In this case, a debtor can exempt any property in the amount of $1,100 plus any portion or a residence or burial plot (around $20,000). 

Thus, while in our situation (person filing for taxes in January 2011), the entire tax return for 2010 becomes property of the estate and subject to turnover to the trustee, it is possible, and potentially likely, that the property will remain with the individual through the use of statutory bankruptcy exemptions.  Bankruptcy planning comes into play again and the use of exemptions determines what someone can keep and what they cannot.

There is one more piece of tax information that should be briefly touched on.  Should an individual owe taxes from a previous period, it is possible that an individual may not be able to exempt a refund owed.  This would be a topic of another discussion…

OK, one more thing.  Always file a return, even if you owe money.  It starts the statute of limitations, and in many cases, your bankruptcy case will be dismissed if you have failed to file for the previous year.

For more questions, contact the Henshaw Law Office.

Common Scenario - Delinquent Home Mortgage Payments

Lately it seems as though individuals and couples filing for bankruptcy (especially Chapter 13) are doing so for one reason, to save their house from foreclosure.  Some people believe, based on what they have read, heard, or seen, that bankruptcy will prevent foreclosure.  To some extent, they are right.  Bankruptcy can permanently prevent foreclosure.  But, for most people, the protection is only temporary. 

All Too Common Scenario

Let’s take a look at a common situation.  In 2006, a couple buys a new house for $800,000 in a new development in South San Jose.  They are not required (and do not) to provide any down payment.  Their initial loan is a five year interest only loan at 4.5%.  Their monthly payment during the first five years is $3,000 (this does not include private mortgage insurance, taxes, homeowner’s insurance, etc.).  When the couple purchased the house nobody thought the market could decline, especially in the Bay Area.  The couple both had what they thought were stable jobs and an income that could sustain the loan and the existing payments.  However, as the months rolled on and all the house costs came in, the budget became tight, but still manageable.

Now, we fast forward to 2011.  In quick order, the loan payment alone has jumped over $1,200 per month, the house is worth $200,000 less than what the loan value is, the couple still has both jobs, but salary has slightly decreased, and their stability of employment has greatly declined.  Anything that can be paid with a credit card is.  The entirety of the debt becomes too much, and now the couple is late on their mortgage.  Default notices appear, and the bank has sent a note of a foreclosure sale.

The couple calls up a bankruptcy attorney, preferably one located in Los Gatos with Henshaw as part of his or her name, looking to save the house they have been in and created lasting memories in for the past five years.  They love the schools for their children, their neighbors, and all that the neighborhood provides. 

What Bankruptcy Can Do

Now we have to look at the realities of what bankruptcy can do for this couple.  First, the filing of a bankruptcy petition will immediately stop any foreclosure sale or other proceeding against the couple through the imposition of an automatic stay.  In general, this stay will last throughout the bankruptcy case.

The most important question an individual or couple in this situation must ask is whether the house is worth saving.  The second question is whether saving the house is feasible.  We have to look at a couple factors in determining this second question, including the bankruptcy chapter and the value of any first or second loans as compared to the value of the property.

In Chapter 7 (liquidation of non-exempt assets), the home lender will likely seek relief from the bankruptcy case’s automatic stay (which prohibits the foreclosure).  The grounds they mostly use in such situations is that their collateral (the house) is not adequately protected because the debtor (person that files for bankruptcy) has no equity in the property.  In the vast majority of cases, this is all that is necessary for a lender to show when the debtor is in default and has no equity in a property.

Chapter 13 bankruptcy provides a more realistic option for our couple.  Chapter 13 cases required the debtor to provide a plan of reorganization of debt.  While in most cases Chapter 7 debtors are not required to either sell property or pay creditors after the close of a bankruptcy case, the Chapter 13 debtor has a required payment plan of three to five year years.  One large benefit of Chapter 13 is that through the plan, the debtor can make up for delinquent mortgage payments.  This can be done in a number of situations because other debts are reduced or even wiped out completely. 

Another benefit of Chapter 13 is the ability to strip a second mortgage off.  This lienstripping ability is only available in situations as described above, where the first loan is at a higher value than the market value of the property, with the second completely outside of the value.  In our situation, because the value of the home is now $600,000, and the first loan is for $650,000, the second loan amount of $150,000 can be stripped off, leaving the debtor with only a loan for $650,000 to pay off for the property.  This can be of a huge benefit, but only if the debtor is able to make payments on that first loan.  Chapter 13 bankruptcy cannot reduce interest rates or values of a loan that is based on a debtor’s principal residence.

What this means is that if the couple can afford to do both (a) pay off the delinquent payments owed on the first loan, and (b) pay the regular payments of the loan, they can keep the house.  What they would need to do to show the bankruptcy court this is to either start or continue to pay the lender while the bankruptcy case is ongoing.  If the lender is receiving no payment during the time the case is pending, it is likely they will seek and receive relief from the automatic stay.

Keeping a house in bankruptcy in this economy is possible for some.  Bankruptcy can be of a substantial benefit in keeping that property.  However, knowing what is required is necessary before the process is initiated.

Call the Henshaw Law Office today if you are in a similar circumstance.

Auto Repossession Before Bankruptcy

The other day I received a call where an individual asked me whether filing bankruptcy would allow for a car that has been repossessed to be returned.  Although my response probably failed to satisfy the caller (the usual attorney response of it depends), here is what is required in California (at least how the courts have viewed the law).

Background

In most vehicle contracts the lender retains a right to repossess a vehicle if the borrower fails to make the scheduled payments.  With many contracts, this repossession can be done outside of any court proceedings.

However, once an individual files for bankruptcy many of the rules change.  For one, an automatic stay is implemented.  This stay prevents most actions against the debtor (individual that files for bankruptcy).  Specifically, the automatic stay strictly prohibits any lawsuit or repossession against a debtor that is delinquent on car loan payments.  Any repossession after a bankruptcy petition is filed constitutes a violation of the automatic stay, with the repossession void and of no effect.  In that case, the lender would be immediately required to return the vehicle to the debtor.

Effect of Bankruptcy on Prepetition Repossession


Section 542 of the Bankruptcy Code requires that entities in possession of "property of the bankruptcy estate" are generally required to turn the property over to either the trustee (in Chapter 7) or the debtor (in Chapter 13).  This big sticking point then for this turnover requirement is determining what is "property of the estate."

Section 541 of the Bankruptcy Code defines property of the estate.  This definition includes "all legal or equitable interests of the debtor in possession as of the commencement of the case."  Basically this definition states that whatever rights the debtor has at the commencement of the case continue in bankruptcy.  As for the vehicle that has been repossessed, the court has to discover what rights a debtor had when the bankruptcy case was filed.

These rights are determine by state law (California State law).  Under the California Civil Code (section 2983.2), a debtor has the right to redeem a repossessed vehicle up until the date the car is sold by the repossessing lender.

Two recent cases have come to different conclusions as to whether turnover of the vehicle is required upon the filing of the bankruptcy petition.  First, in a case from the Southern District of California (In re: Fitch, 1998), the bankruptcy court held that while a repossessed car is property of the estate, the right to possess the car was transferred to the lender prior to the filing of the bankruptcy petition.  The court interpreted the statutes to mean that the automatic stay freezes the positions of the debtor and creditors.  Thus, the lender had the right to maintain possession.  The court did state that a vehicle could be returned to a debtor upon the debtor's giving of adequate protection.  In most cases adequate protection means the establishing of proof of insurance and proof that the debtor will be able to make the regular payments on the car.

In the Northern District of California (In re: Cortez, 2010), the Bankruptcy Court interpreted the Bankruptcy Code, and specifically the section on the automatic stay, to mean that a "knowing retention of estate property violates . . . the automatic stay."  Because a debtor has the right to redeem until the date of a sale by the lender, the vehicle remains part of the estate, and subject to turnover.  In this case, the debtor provided adequate protection to the secured creditor.  However, the court seemed to say that it was not necessary for turnover.


What to do?

If your car has been repossessed, and you want to make sure you retain possession, bankruptcy may be a solution if you are not able to pay the balance before a lender's sale.  However, while the Northern District seemed to state that adequate assurance is not necessary for turnover, it will ultimately be necessary to avoid a lender's motion for relief from the automatic stay.  Be prepared to show (a) insurance, (b) regular and sufficient income, and (c) an ability to pay for the vehicle.

If you have any questions on the matter contact the Henshaw Law Office.