Harriet and Harry Homeowner, having taken an advance against the equity in their home, now face the payments that are due.  They financed a second on their home at 125% of equity, using all of the proceeds for remodeling, landscaping and paying off some credit cards used to get them into their home.  Harry Homeowner has his own computer consulting business and Harriet is a realtor.  Together they make just enough to service all of their monthly creditor obligations, but not enough to save.  Each uses a percent of their monthly business income for advertising and promotions, but with ends just being met, marketing is often the first thing to go.  They know they are just one month, one bad month, away from getting behind and in trouble on their home loans, auto leases, property taxes and income taxes.  They are on extensions to file their 2001 tax returns, but having not made any self employment tax deposits, they know they will be in trouble.  Even more troubling is the thought that Congress will resolve its differences on the pending Bankruptcy Reform Bill and send it to the President for his signature and its enactment into law.

The Bankruptcy Reform Bill is currently stuck in the House and Senate Conference Committee, to reconcile the differences between the House and Senate versions passed last year before September 11.  If the differences are worked out and the President signs it, the Bill provides a six month window before it is effective.  The President must sign it before the current term of the House of Representatives ends.

The Reform Bill will make it more difficult for consumers and small businesses to file for protection under Chapter 7 of the Bankruptcy Code.  Chapter 7, simply, allows individuals, partnerships, corporations, and other business entities, to seek protection from their creditors, while having their assets liquidated by a Court appointed Chapter 7 Trustee.  For individuals, a Chapter 7 is not necessarily a free ticket out of debt.  Debt arising from alimony, support, and maintenance are all excepted from a Chapter 7 discharge.  Also excluded, and therefore payable, notwithstanding the filing under Chapter 7, are judgment liabilities for criminal restitution, student loans (with minor exceptions), taxes (with some exceptions), and liabilities arising from intentional acts causing injury, fraud, and breach of fiduciary trust.  In total, there are 16 exceptions to a Chapter 7 discharge.  The Reform Bill intends to make it even more difficult to qualify for a Chapter 7 by imposing a Needs Test or a Means Test (depending upon which version of the Bill you read), that would compare the individual’s monthly living expenses to the IRS regional average, and compare the average annual income to the median income for the region.  If the actual monthly living expenses or average annual income exceed the regional statistics, there will be a presumption that the filing under Chapter 7 is in bad faith.  The Court will have the discretion to determine on a case by case basis whether the individual can get relief under Chapter 7 or must seek relief under Chapter 13.

A Chapter 13 Bankruptcy Case is only for individuals with a regular income who have sufficient disposable income on a monthly basis to propose and pay installments on a Chapter 13 Plan.  Also, their secured debt must not exceed $807,750, and unsecured debt does not exceed $269,000.  If the Reform Bill forces the Needs/Means Test analysis on individuals, and it is determined they should not be filing under Chapter 7, they will have the most difficult task of formulating a Chapter 13 Plan based upon statistical averages they must comply with, rather than actual dollar amounts.  So, an individual may be faced with the possibility they do not qualify under Chapter 7 because of statistical anomalies, yet unable to confirm a Chapter 13 Plan because they do not have the actual disposable income.  If the individuals secured debt or unsecured debt exceeds the limitations under Chapter 13, the individuals must file under Chapter 11.  If the debtor is not an individual, a Chapter 13 is not an option for consideration.

With this brief overview in mind, what should Harry and Harriet Homeowner do to protect the best financial interest of their family?  First, the Homeowners may want to consider doing some financial planning before considering filing for a bankruptcy case.  They should consult with an experienced set of professionals, including an accountant to assist them with their business financial plan, and an experienced bankruptcy attorney with a business background to work closely with them and the accountant to devise a long range plan and strategy.  Second, it may be recommended that the Homeowners incorporate, if they have not done so already, so that their business liabilities and assets are protected from their individual problems.  Also, generally speaking, Chapter 13 trustees prefer a bankruptcy filing by individual wage earners, over sole proprietorships, even if they own their own corporation.  On the other hand, a Chapter 7 trustee may consider the stock in the corporation an asset to be sold, and California state exemption laws do not provide the Homeowners with protection otherwise given to tools of the trade.  In essence, planning and careful consideration cannot be replaced or overlooked.

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Harriet and Harry Homeowner have much to think about, given their financial condition and their entrepreneurship. Harry Homeowner has his own computer consulting business and Harriet is a realtor. Having reviewed the bankruptcy issues facing them, they are now concerned about preserving the businesses they have built up over the years. Harry is well known in the Valley for the truthful and honest manner in which he consults with clients. He takes the time to explain the computer systems and software his clients may need, and has even developed a slide presentation and training manual for his clients. Harry’s main competition is the big box electronic stores that sell computers and software, but leave the customers on hold with their 800 numbers or with kids who may know computers, but know little about customer loyalty and satisfaction. Harriet is also well known around town for her quick recognition of her client’s taste, needs, and standard of living in which they seek to be accustomed in a home to be shown by Harriet. She is attentive and responsive, often sacrificing her family time for her client’s demanding weekend schedules. Both are concerned that a pending bankruptcy may bring ruin to their goodwill and reputation around town.

Harry and Harriet have some information they gathered about corporations, limited liability companies, partnerships, and limited partnerships from the California Secretary of State’s Website at www.ss.ca.gov/business/business.htm, but are still confused about which they should choose, when may be best time to elect a new business entity, and the cost associated with it. The Homeowners realize their decision is one of the most important they will make, and do not want to make a mistake.

Harry and Harriet both seem to understand that a corporation is a fiction of the state, through which shareholders own stock, a board of directors is elected to make decisions about policy and business direction, and management follows through by implementing the decisions of the board. In California, a corporation may have as few as one shareholder and up to 35 shareholders before the incorporation process is made more complex by state securities laws. Harriet understands that a corporation will give the shareholders protection from liabilities incurred by the corporation, but she is concerned about whether creditors can get to them personally, notwithstanding.

In order for the corporation to maintain its identity and protect shareholders, the shareholders and the board must maintain all of the corporate formalities of minutes, resolutions, meetings, taxes, accounting records and segregation of personal and corporate affairs. Even though it may seem simple, and typing services or paralegal services offer to perform incorporations, Harry understands that the ongoing business of maintaining the corporation goes beyond his expertise or that of a paralegal, and he is considering paying the attorneys’ fee for an incorporation and first year’s maintenance. Luckily, his attorney has a fixed fee he charges that includes the state’s fees. Harry understands very well from his own clients who were sued personally that the “corporate veil” can be “pierced” if all of the “i’s” are not dotted and “t’s” crossed. Harry remembers how much trouble his landscaper, Larry, got in by not having workers’ compensation insurance, and how Larry, even though he was incorporated, was held personally liable his worker’s injury.

Before deciding on a corporation as a form of doing business, Harriet asks about partnerships, limited partnerships and limited liability companies. Her understanding is that a partnership is two or more people coming together for the purpose of making a profit. That is the definition given under the Uniform General Partnership Act as adopted in California. A limited partnership is governed by the Uniform Limited Partnership Act. Under California law, professional limited liability companies are not allowed, but in other states, a professional limited liability company will protect its members from all liability, including professional liability. In all states, a limited liability company gives the members the tax benefits of partners. A general partnership, as opposed to a limited partnership, has a managing general partner who may not have a financial stake in the partnership, but who has pulled together the investors, who are given limited partnership interests. Partnerships are best governed by written agreements, and not merely handshakes. Because neither Harry nor Harriet work with others or have other investors, they understand that a general or limited partnership is not for them. As of January 1, 2000, however, a single member limited liability company may be formed in California. As with a corporation, a limited liability company operates through an Operating Agreement, whereas a corporation operates with bylaws.

With the information about the different business entities in mind, Harry and Harriet return to their attorney advising them in the course of their financial planning. As the Homeowners discussed with him last month, their interest in the new business entity is an asset of their bankruptcy estate. In a Chapter 13, with their receiving regular pay checks from the business entity, the Chapter 13 Trustee will be able to evaluate the financial ability of the Homeowners to reorganize with regular income. Sole proprietorships, with the individuals often taking income and expenses as they may without regard to corporate/business formalities, are particularly troublesome for a Chapter 13 Trustee. Should they decide to liquidate all of their credit card debt through a Chapter 7, the Chapter 7 Trustee may look more closely at the value of the interest in the business entity, but cannot take possession of it directly and liquidate it for the benefit of the Homeowners’ creditors in preference to the business entity’s creditors. So, the Chapter 7 Trustee will be more interested in the transaction by which the assets of the individuals were transferred to the new business entity as the capital contribution in formation.

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