The Mortgage and the Business Bankruptcy

When a business fails the owners frequently find themselves facing their own personal bankruptcy. Owners considering bankruptcy want to discharge business obligations they’ve guarantied but still retain their home. This home is almost always subject to a significant mortgage. Because the mortgage is considered consumer debt, the mortgage may become an obstacle to the former owner discharging the business debt in a Chapter 7, especially if the owner is a high income earner due to their main employment or a new job that arises after the business goes under.

The rule for high income earners is that if their gross income exceeds the state’s median income for the debtor’s family size the debtor will need to fill out the “long form” to determine if the debtor qualifies for Chapter 7. If the resulting monthly net disposable income x 60 exceeds $10,000 or 25% of the debtor’s unsecured claims, the debtor fails the means test and will be forced into a Chapter 13 case. This prospect can be daunting due to the Bankruptcy Code’s rigid interpretation of allowed deductions against provable income.

Issues of median income, the means test and the “long form” only apply to debtors whose liabilities are primarily consumer debts. Upon learning of this limitation, business owners are frequently relieved because they only want to discharge business debts, which dominate their general unsecured liabilities.

Unfortunately, the Bankruptcy Code does not distinguish between debts to be discharged and debts to be paid in determining whether a debtor owes primarily consumer debts. As a result, the business debts the owner has guarantied may be substantially less than the owner’s home mortgage. If so, the owner will not qualify for Chapter 7 and may have difficult choices to make because of the amount of the projected Chapter 13 payment.

The challenge then is to find business debt that can be used to turn the imbalance into the debtor’s favor. If the business was wholly owned the debtor may argue that all the business debt represents a contingent obligation of the debtor, depending upon whether creditors argue that the debtor and his company were merely alter egos of each other. The Bankruptcy Code does not distinguish between contingent, unliquidated, and/or disputed claims and other debts owed. This technique may be sufficient if the defunct company has incurred substantial debt.

Similarly, debts arising from long term leases, franchise agreements and other extended royalty arrangements may give rise to ballooning obligations that, when included in the debtor’s bankruptcy schedules, cause the scales to tip in favor of the debtor being considered other than a person owing primarily consumer debts.

The home mortgage presents special problems for a business owner that is trying to discharge debt from a company gone bad, but that business may have enough hidden liabilities to overcome the consumer debt that would bar the debtor from Chapter 7.

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