Incorporating A Troubled Business: Work-around Or Worse?

Facets on a gem bend light and change how we see things.

The same thing happens when bankruptcy law encounters a small business owner and the business itself.

Seen from one angle of the law, the business is a valuable asset.

Seen from another, it is nothing more than a job for the owner, having no real value without the owner.

It depends on where you stand and where the light hits.

What’s the danger in incorporating?

The question comes up when individuals do business as a proprietorship. The business may provide a living to the proprietor who works there day to day, but the accumulating debt is debt of the individual.

I wrote earlier about how incorporation could create a separate legal entity that could continue to operate during the bankruptcy of its shareholders.

My good friend attorney Doug Jacobs pointed out that under some circumstances, incorporation could be seen as a fraudulent transfer.  And that’s not good.

A fraudulent transfer is one where the entity conveying property either intends to put it beyond the reach of his creditors, or, receives less than the asset was worth in exchange, leaving the transferor less able to pay his debts.

The bankruptcy code allows the bankruptcy trustee to recapture assets transferred in fraud of creditors.

My counter argument to Doug’s point is that incorporation hardly conveys away the value of the business, as the debtor simply exchanges his outright ownership of the business for outright ownership of the stock in the corporation that owns the business.

If there is real value there, a bankruptcy trustee can reach it by dissolving the corporation.

My second argument is that before incorporation, the business was indistinguishable from the individual. The idea of “transferring” debts to the newly created corporation is facially pleasing, but incorporation cannot relieve the individual of any liability he had before incorporation.

It is an axiom of law that no agreement between two entities can bind a third: that is, the individual and his corporation cannot by agreement cut off the right of the individual’s creditor to look to the individual for repayment, even though the new corporation and the individual might agree that the corporation will be henceforth liable.

This analysis is probably more theoretical than real.

The small businesses my clients usually operate are little more than personal services businesses. Incorporation simply provides cover for the trustee who, because of incorporation, doesn’t have to shut the business down as part of his duties to preserve the assets of the estate.

Law colored by local culture

But whether you see incorporation representing a meaningful transfer or not, the issue highlights the fact that the legal culture does vary from place to place.

I practice in Silicon Valley; Doug practices in the Central Valley. Like it or not, even though the law is the same in both places, judges often bring a slightly different perspective to the bench, depending on where they practice.

For that reason, when you select a bankruptcy lawyer, you want one who knows the judges before whom your case will be heard and understands the legal culture in that community.

Image:  Nemo & Pixabay