COVID 19 Losses on Businesses, Chapter 7 Bankruptcy and the Business Loophole

The Covid 19 pandemic has caused many businesses to halt their activities and now they find themselves either barely surviving or deciding to close for good. 2020 has brought business challenges that were completely unforeseen by small business owners. Through no fault of their own, business owners now find themselves unable to generate income sufficient to meet even their basic expenses for rent, utilities, supplies, insurance, etc., let alone the costs of employees and benefits. This is especially true in businesses that provide goods and services to the public that require in person meetings, like restaurants, bars, salons and similarly situated businesses. In the past few months, I have be fielding telephone calls from small businesses relative to the availability of bankruptcy proceeding to wind up business operations and eliminate liabilities for business and personal obligations from the losses during the pandemic.

Many people have come to know that in 2005, Congress re-wrote the Bankruptcy Rules to include a “Means Test” which limits the availability of a “Chapter 7 Bankruptcy” based on a debtor’s income. A Chapter 7 Bankruptcy, allows debtors to receive a discharge of their debt without requiring any repayment, so long as they do not exceed the means test for their annual income. In Massachusetts the current means test for a a single person is just over $67,000.00 and a family of 4 is just over $134,000.00. However, the means test only applies to individuals whose debts are “primarily consumer debts”, as opposed to business debts. Congress in Section 707 of the Bankruptcy Code did not define the word “primarily”. Most courts have determined that word to mean more than half. If the debtor’s debts are more than 50% non-consumer, the debtor is automatically eligible to file a Chapter 7 Bankruptcy. This is important because the means test is a lengthy calculation which decides whether or not you are eligible to receive a Chapter 7 discharge. If your debts are not “primarily consumer debts “ then the debtor can simply check the box and does not have to complete the means test and there is no presumption of abuse of the bankruptcy procedure. This will ultimately lead to a full discharge of the debtor’s personal and business debt without any repayment required.

The question then remains, is it business or consumer debt? The best way to determine the difference is to look at what you used the money for, rather than where you got it or the technical name placed on the type of transaction. Section 101(8) of the Bankruptcy Code defines a consumer debt as “debt incurred by an individual primarily for a personal, family, or household purpose.” Many Bankruptcy Courts across the country have developed a “profit motive” test in determining the type of debt. If the debt or obligation was taken on with the purpose of producing a profit, then in all likelihood the debt would be deemed to be a business debt. Even if the individual guaranteed the business debt personally, the debt would still be deemed to be a business debt and the personal guarantee would be a business debt. Similarly, if there was a loss as a result of the investment, it would be a business loss. The Bankruptcy Court generally will make the determination on whether it is a business debt or personal consumer debt at the time the debt or obligation was incurred, not on the date of the bankruptcy filing. The determination of the type of debt really will look beyond the title of the transaction. For example, one Bankruptcy Court allowed one of three mortgages on a debtor’s home to be treated as a business debt even though it was against the debtor’s personal home, because the funds at the time they were acquired were for the funding of a business venture. In another instance most credit cards are used for personal household goods and services. However, if a debtor used a credit card expressly for business purposes then the debtor could most likely successfully argue that the debt is a business debt. Other types of business debt usually include purchases of inventory, equipment, vehicles purchased for the business and cash advances deposited into the business account to pay business expenses. It should be noted that if the issue is close and the Bankruptcy Trustee raises an objection, then the burden of proof is on the debtor to show the purpose of the debt at the time it was incurred.

The business debt exception to the means test does have some limitations. The Bankruptcy Code still requires the debtor to exercise good faith. A Michigan Bankruptcy Court in the case of In re Rahim and Abdulhussain, No.1 10-57557 (Bankr.E.D.Mich 12/10/16), took up the issue of whether the business debt exception to the means test had any limitations. In that case the debtors, a husband and wife, had over six million dollars in unsecured business debts from failed real estate investments. Although the Court found that the debtors did not fail the means test as their debt was primarily business debt, the debtors must still act with good faith. The facts in the case were that both debtors were doctors and their budget contained in the bankruptcy schedules showed $42,000.00 per month of budgeted household expenses. The Court found they had an extravagant and lavish lifestyle. Both had expensive Mercedes automobiles they drove regularly and an additional BMW in the garage. The Bankruptcy Court found that debtors failed to exercise good faith because they could have reduced their expenses and still had a very good lifestyle, while paying a significant dividend to their creditors through a Chapter 11 Plan. This case does illustrate that the business debt exception to the means test does have some limitations. However, in most instances local struggling business owners that I am in contact with, are not lucky enough to have an income which affords them the ability to spend $42,000.00 a month on living expenses.

In review, as a result of the current covid 19 pandemic and the business losses incurred from it, many individuals with primarily business debt are eligible to file a Chapter 7 bankruptcy and get a full discharge of their business and personal debt, without the need to comply with the means test requirements or make any repayment on the debt.