Sole Proprietors Face New Challenges if Their Businesses Become Insolvent

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Upcoming changes in the bankruptcy law may have the unintended consequence of making it harder for consultants, contractors and other small businesses to discharge their debts.


Many sole proprietors who operate unincorporated businesses have used the same bankruptcy protections as individuals after their companies fail. The changes, which take effect Oct. 17, could significantly increase the risk involved in starting a business.


“Many businesses run by perfectly ordinary people taking perfectly ordinary business risks just cannot make a go of it,” writes Eric Brunstad, chair of the business bankruptcy committee at the American Bar Association, in a USA Today op-ed piece.


“For the vast majority of these businesses, insolvency is an accident brought about by such diverse events as a tragic hurricane, unforeseen market shifts, or changes in the law that alters how the company must conduct its business.”


Sole proprietors encompass a wide range of businesses, such as catering services, restaurants, independent contractors, consultants or lawyers who work out of their home. They often do not incorporate to avoid the high costs in state fees, and if their businesses fail they generally prefer to clear their debts as soon as possible so they can start over. That may change once the bankruptcy changes become effective.


“If you’re a sole proprietor, not incorporated, you can’t file for just the business alone,” said Howard Ehrenberg, a partner at Sulmeyer Kupetz. “You have to file for yourself, and because of the much stricter rules for qualification, entrepreneurs who aren’t necessarily destitute but whose business has failed may not get the relief.”


Under the new bankruptcy law, individuals seeking to file Chapter 7 must meet several new requirements outlined in a “means test,” which calculates salaries, assets and liabilities. As part of the means test, an individual may not file for Chapter 7 if his or her household income is above the state’s median, which in California is about $50,000 for a family.


Most sole proprietors would not meet the means test and would have to file under Chapter 13, which forces them into an individual repayment plan, or Chapter 11, which reorganizes the business by having it pay off most of its debts.


Not all small business owners appear concerned about the new rules. The National Federation of Independent Business, which represents small business, did not take a position on the bill because its members don’t consider it a priority.


In a 2004 survey of its members, small business owners ranked bad debts and bankruptcy as their 52nd biggest concern among a list of 75 business issues. At the top of the list were the costs of insurance, fuel and property taxes.


The Independent Community Bankers of America, which represents banks that finance small businesses, lobbied in favor of the bill. “It’s a balance,” said Bill Grassano, a spokesman for the organization. “People who can afford to pay back their debts will have to, and we believe that the new law brings reasonableness to the bankruptcy business.”

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