Small business owners are, by nature, risk-takers. For every business that succeeds, there are several that never get off the ground, and wind up with more debt than they can repay.
For those who are self-employed and need bankruptcy protection, a unique problem arises. Under the Chapter 7 bankruptcy rules, only the trustee may operate an “estate business,” which often includes a self-employed debtor’s livelihood. This applies to handymen, attorneys, shops, and restaurants. In other words, the moment the bankruptcy petition is filed, the business must stop operating, even if it is profitable.
Fortunately, there are several way to fix this problem for self-employed debtors.
First, before filing the petition, the business owner can convert the self-employment into a business entity. In California, we tend to prefer LLCs for small businesses. They are relatively inexpensive to form, flexible in their rules, and most importantly, they can continue to operate even if the owner files for bankruptcy.
Second, the owner can file a motion with the bankruptcy court to “compel abandonment” of the business. Essentially, this takes the business out of the bankruptcy estate, allowing the owner to resume operations. The down-side is that, depending on the court’s local rules, it may take several weeks to obtain this relief, and in the meantime, the business cannot operate. In the Sacramento region, these motions can be set on 14-days notice.
Third, the owner can close the business prior to filing, and after filing can start a new business. The new business can be in the same line of work, as long as it does not make use of the old business’ property. This can be a tricky analysis, since many business owners rely on certain assets, such as bank accounts, customer lists, and equipment. However, for small businesses in the service industry, this can sometimes be a viable option.
For any of these three approaches, you should consult with a bankruptcy attorney to discuss the pros and cons, and which solution is best suited to your particular circumstances. What you should NOT do is break the rules by continuing to operate your business while in bankruptcy without taking the appropriate steps to ensure you are complying with the law.