Why A Trustee May Want To Close A Sole Proprietorship
Let’s say that you have a sole proprietorship, and you are thinking of filing for bankruptcy. Will the trustee take your business and close it? It may seem silly to imagine a trustee would want to do that. After all, you need the business to make a living, and since it’s a sole proprietorship, the business really doesn’t have value without you running it.
But the problem is that when the trustee takes ownership of the business, the trustee is liable for the business. Let’s look at some common scenarios.
Chapter 11 and Sole Proprietorships
In a Chapter 11 bankruptcy there is a continuing estate. That means that the case is open, and there is a bankruptcy estate that is run either by the trustee or the debtor in possession. The debtor owns a sole proprietorship—say, an art studio that is run from the debtor’s home.
While someone comes into the debtor’s home to look at some art, the visitor/customer slips and falls. The claim—that is, the value of the lawsuit, or the amount of the verdict or the settlement—is now an expense of the bankruptcy estate. Additionally, it is a priority claim—the claimant gets paid before most of the creditors do from the debtor’s assets.
Some of this can be minimized by the existence of insurance, which may pay claims, but nonetheless, the exposure, and cost to defend the claim, are expenses that the trustee doesn’t want and ethically cannot voluntarily incur, due to the trustee’s obligations to protect assets for creditors.
Chapter 7 and Sole Proprietorships
A Chapter 7 bankruptcy is quicker—there is no long-lasting estate. But there is still the same concern. Even though the trustee is just an owner in “name only,” and only temporarily, if someone is injured by the business, or on the property of the business, the trustee is a potential defendant in the lawsuit.
That claim—even if it isn’t resolved until after the Chapter 7 bankruptcy is over—takes priority over other creditors.
Protecting Sole Proprietorships
Many of these problems come from sole proprietorships—essentially, single individuals that run businesses without legally incorporating. With legal incorporation there are more protections (a good reason to incorporate, even if you aren’t considering bankruptcy), and thus, it is less likely that a trustee simply closes a business that was owned by the debtors.
That means that people with sole proprietorships may want to incorporate before filing for bankruptcy.
Chapter 13 Protections
These problems don’t happen with a Chapter 13 bankruptcy, where the law specifically allows someone to continue to operate a business, even though the plan may be 5 years long. Debtors with businesses may want to consider a Chapter 13, to ensure the ability to run, own and operate their business.