There may come a time when one of your clients calls to say, “I’ve gotten myself into a financial mess and I think I need to file for bankruptcy.”
When that client is a business owner, the situation can get complicated. There are business consequences to consider when the owner files for personal protection from his creditors – even if the business is doing well.
There are two types of individual insolvency filings – a personal assignment in bankruptcy and a proposal to creditors. Proposals come in two forms: a consumer proposal for people with debts of up to $250,000 excluding mortgages on principle residences, or a Division One proposal for situations when debts are more than $250,000.
Personal assignment in bankruptcy
There are three common legal structures for a business: a sole proprietorship, a partnership, and an incorporated business. A bankruptcy filing by an owner impacts each business in a different way.
In a sole proprietorship, the business isn’t a legally separate entity from the owner. The owner is the business and the business’s assets are owned directly by the proprietor. If the owner files for bankruptcy protection, then the business assets may be subject to seizure and sale. Most provinces have an exemption for “tools of the trade,” which are assets used to generate income. In Ontario the exemption is $11,300. It’s common in sole proprietorships for the equipment to be worth less than this threshold, which means the equipment isn’t subject to seizure and sale. In cases where the value exceeds the exemption threshold, the owner may have the opportunity to buy the excess back from the bankrupt estate, so he can keep his equipment. It’s certainly worth investigating if your client wants to continue in the same line of work.
If one partner files for bankruptcy, bankruptcy law deems the entire partnership immediately dissolved. So it’s common practice for a partner to resign or withdraw before filing for bankruptcy protection. The partner who is withdrawing must receive the fair market value of his partnership interest. It may be difficult to value a business, but it must be done fairly to prevent the bankrupt person’s creditors from pursuing the business’s assets.
For an incorporated business, things are more complicated. When a shareholder files for bankruptcy, his shares vest in the bankrupt estate, but that doesn’t automatically give the bankrupt estate the right to do anything with the business. In closely held companies with a single shareholder who is also the corporate officer and director, the business will normally cease to operate as soon as the owner files for bankruptcy. A bankrupt person can’t serve as an officer or director, and a corporation can’t operate without an officer and director.
A possible solution is to appoint someone else as the corporation’s officer and director. The difficulty is the new director becomes liable for the corporation’s Crown debts and may expose themselves to the business’s other liabilities. Prospective buyers would be required to purchase the shares of the business from the bankrupt estate at their fair market value, again assuming existing corporate liabilities. For these reasons this solution is not normally considered.
A more common solution for closely held corporations is for a buyer to purchase the corporation’s assets. This would need to happen before the owner files, because once the owner has filed for bankruptcy, the corporation may no longer have any officers to facilitate the sale.
If a corporation has multiple shareholders and directors then only the bankrupt owner’s shares vest with the bankrupt estate. It may be possible for the business to keep operating. The bankrupt person will have to resign as an officer and director, but the other shareholders could carry on. The bankrupt estate would be required to sell the shares at fair market value to pay creditors. In most cases, the trustee would offer the shares to the existing shareholders before trying to sell them to a third party. Assuming the remaining shareholders are directors, they may already be exposed to the corporation’s liabilities, so unlike an outside buyer in the single shareholder scenario, they wouldn’t be assuming new risks.
Proposals to creditors
Under any business structure, when an individual files a proposal to creditors, their assets don’t vest with a trustee. The business owner is offering a plan for paying his debt — he isn’t signing over his assets. The value of the business will have an impact on the total amount the owner may have to offer his creditors in the proposal, but the owner doesn’t lose control or use of the business.
For many business owners in personal financial distress, a consumer proposal is the preferable solution, compared to personal bankruptcy.
Division One proposal
A word of warning – if a person files a Division One proposal to creditors and it’s rejected (or the person defaults) a deemed bankruptcy occurs. If your client is considering a Division One proposal, then the best advice is to assume the worst and prepare his affairs for a possible bankruptcy. That means reviewing how a bankruptcy filing may impact the business based on its legal structure.
It is possible for a business owner to apply for bankruptcy protection or to file a consumer proposal and for the business to carry on. A lot depends on the legal structure and the steps you help your client take before he files for bankruptcy. Like any legal procedure, the sequence of events is often critical to the success of the solution.
Ted Michalos, B.A., CPA, is a Licensed Insolvency Trustee and co-founder of Hoyes, Michalos & Associates Inc. in Ontario, Canada.