Overview of Bankruptcy Reviewed by Momizat on . Procedures and Bankruptcy Code Changes for CPAs and Consultants A business or individual facing financial distress can utilize three types of federal bankruptci Procedures and Bankruptcy Code Changes for CPAs and Consultants A business or individual facing financial distress can utilize three types of federal bankruptci Rating: 0
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Overview of Bankruptcy

Procedures and Bankruptcy Code Changes for CPAs and Consultants

A business or individual facing financial distress can utilize three types of federal bankruptcies to attempt to resolve their financial difficulties. This article provides an overview of the differences and when each would be used. Keep in mind that bankruptcy is a legal proceeding and must be handled by an attorney. However, business and financial advisors need to have a good understanding of the process, when a bankruptcy is necessary, and which type is most applicable. Advisors need to be able to take a dispassionate view and assist in advising a client when to file or to avoid a bankruptcy altogether, as well as detecting warning signals when a customer of a client is heading toward or planning a bankruptcy.

A business or individual facing financial distress can utilize three types of federal bankruptcies to attempt to resolve their financial difficulties. This article provides an overview of the differences and when each would be used. Keep in mind that bankruptcy is a legal proceeding and must be handled by an attorney. However, business and financial advisors need to have a good understanding of the process, when a bankruptcy is necessary, and which type is most applicable. Advisors need to be able to take a dispassionate view and assist in advising a client when to file or to avoid a bankruptcy altogether, as well as detecting warning signals when a customer of a client is heading toward or planning a bankruptcy.

Types of Bankruptcy

The types of Federal Bankruptcies are as follows:

Chapter 7—Liquidation: for businesses and individuals

Chapter 11—Reorganization: primarily for businesses but can be for individuals who do not meet debt limits for other Chapters

Chapter 13—For individuals with regular income: provides for a reorganization and a plan to repay creditors over a period of three to five years

There are several other chapters available to specific debtors including Chapter 9 (Municipalities), Chapter 12 (Family Farmers and Fisherman), and Chapter 15 (International) that are not covered here.

Some states have their own versions of bankruptcy known as an Assignment for the Benefit of Creditors that is not covered here. Attorneys should be consulted to determine when the state laws could be an option to be considered. Bankruptcies are filed in federal bankruptcy courts. The Courts in each District have their own set of rules and procedures. Practitioners should, in particular, be attuned to the local rules related to retention and fee applications. The filing is done by the debtor with a form called a “petition” which is the legal document that starts the process. The petition includes an enumeration of the assets and liabilities of the debtor as well as various other financial information. The initial filing is usually done by the debtor, but there are circumstances when a group of creditors could initiate the process.

General Rules for All Bankruptcies

Upon filing of the bankruptcy petition, by operation of law, there is an immediate stop to most collection actions and lawsuits, known as the Automatic Stay. At the end of the process, the individual debtor receives a discharge and is able to attain a fresh start. Since not all debts can be discharged, a careful examination of debtor’s obligations is critical. It is essential that this be carefully done before any petition is filed.

Assets that can be retained by individuals are qualified pension assets and IRAs, a residence or homestead (state specific), and certain personal property. The exemption amounts vary by state. In addition, there is a Federal set of exemptions. The election as to which exemption (Federal or State) you will choose is made when the petition is filed. To determine what can be retained, especially where there are pensions or IRAs, the client should best consult with an attorney familiar with the bankruptcy laws.

Not all debts can be discharged, including secured loans such as car loans, real property and chattel mortgages, college loans, child support payments, and certain taxes and penalties.

Assets transferred by a debtor prior to filing a petition or because of the intended filing might have to be repaid to the trustee for distribution to creditors. The time limits vary based on circumstances and can be as long as six years prior to the filing for relief.

Tax Issues

Tax issues always ensue when debt is cancelled. In general, cancellation of debt under a bankruptcy proceeding does not result in taxable income, as it might if the same debts were cancelled without the bankruptcy filing. Individual debtors filing under Chapter 7 can elect to file a short year return.

Cancellation of debt (COD) for business entities can be more complicated and require a knowledgeable professional to assist in navigating the rules. Partners in a partnership will have a unique set of issues as the COD will be passed through to them. They will then need to evaluate potential exclusions. The recently passed tax acts also provide for carrybacks of losses, which should be evaluated.

Taxes that are not more than three years old and certain penalties, regardless of when assessed, cannot be discharged.

Chapter 7

In a Chapter 7, the individual will generally walk away relieved of their pre-filing liabilities (with some exceptions) but also no assets (with some exceptions). A Trustee will be appointed to marshal the assets of the individual or business and pay the creditors based on a statutory priority. Both Individuals and businesses can avail themselves of Chapter 7. Regardless, each matter is unique, accordingly there always seems to be some exceptions so there are very few absolutes in this, or most every, litigation process.

Chapter 7 does not discharge secured liabilities, such as an auto loan or home mortgage, as the creditor can generally look to their collateral. In circumstances where the value of the collateral is less than the secured obligation, there may be an opportunity to address the shortfall in the Chapter 7 process. Other debts that cannot be discharged are college loans, child support payments, and certain taxes and penalties. These, too, must be discussed with an attorney before filing.

In order to file under Chapter 7, the individual debtor must pass a means test, which is designed to prevent high income earners from taking advantage of Chapter 7. The means test evaluates income and expenses and the amount, if any, of “excess income.”

Chapter 13

This is for individuals only, and not for a business. If there is sufficient excess income, only a Chapter 13 can be filed. Chapter 13 is subject to limitations on the amount of the secured and unsecured debt. Individuals can, as a result, occasionally file under Chapter 11, but it is not usual and not covered here.

Chapter 13 petitions are filed in instances where the debtor is unable to qualify for a Chapter 7, such as failing the means test or where they want to freeze a foreclosure proceeding with a secured creditor while retaining the asset, protect co-debtors on consumer obligations from collection actions while the plan is in place, get the ability to discharge obligations that cannot be discharged under Chapter 7, or where they have a regular source of income and wish to remain in control of their assets.

Under Chapter 13 the debtor enters into a plan to make creditor payments usually over a three- to five-year period.

Debts that cannot be discharged are similar to those in a Chapter 7, but there are some exceptions since the Chapter 13 process provides for a freeze and deferred payout on certain of those debts.

Chapter 11

Chapter 11 is also referred to as a reorganization. This permits a company to continue and operate with its existing management until a plan is arranged.

During the Chapter 11 period, the pre-11 unsecured debt does not have to be paid; and the company is under the supervision of the Bankruptcy Court and Office of the United States Trustee. The debtor will be required to file monthly reports with the court. A committee of unsecured creditors may be formed to oversee the proceeding on behalf of the unsecured creditors.

When existing management continues running the business, the company is referred to as a “debtor-in-possession” (DIP). During this period, the DIP tries to come up with a plan, subject to a vote of creditors, to continue the business and resolve creditor claims. It can take anywhere from two months to over a year before a Plan of Reorganization is approved.

During the period of time a plan is under development, regardless of good intentions, should the company continue to operate at a loss, making it likely that the creditors would get less than if the company were liquidated, the creditors or other parties in interest can move to convert the case to a Chapter 7. It is only in instances where there are allegations of mismanagement that a party in interest could move for the appointment of a trustee to take control of the business.

The current environment—given the cost of a Chapter 11—most debtors opt for a sale of the going concern (a 363 sale) where the assets can be sold free and clear of liens. Once the sale is complete, the remaining assets and legal actions of the debtor are typically transferred to a liquidating trust or the debtor entity is converted to a Chapter 7. In order to facilitate the process, some Chapter 11s are referred to as a pre-pack or  a “prepackaged” plan, which is based on an arrangement that has been worked out and is acceptable to the major creditors prior to filing for relief.

Operating Under Chapter 11

In many respects it could be business as usual, just that old payables do not have to be paid.

Most creditors will continue selling but might want to change terms to C.O.D. or C.B.D. Once a plan is confirmed and that the debtor receives new working capital as part of a plan to reorganize and can demonstrate a positive operating history, then some creditors will even extend limited amounts of credit. The major change for a DIP is the need to file a monthly operating report with the court, which discloses the financial results of the previous month.

Note to Accountants and Other Advisors and Consultants

Any money owed to you pre-petition becomes just another unsecured debt that probably will not be paid in full. If you are owed money, you likely will not be permitted to provide services in the bankruptcy. You can be retained should you choose to waive off the prepetition debt. You also need to be aware of funds received in the 90 days preceding the bankruptcy as they may be subject to disgorgement. To provide services in a bankruptcy matter, you must be approved by the court before you do any work– no matter how essential and imminent that work is, or you will not be paid. To receive payment, you must file a fee application which is subject to approval of the court.

Financial Advisors can receive retainers when they are retained in a matter. This will occur most often in a Chapter 11 filing. The retainer needs to be disclosed as part of the retention documentation.

Debtors usually file the petition but under certain circumstances, a group of creditors can file the petition to force the debtor into bankruptcy, known as an involuntary bankruptcy. The creditors do this to protect the assets that remain. The involuntary is subject to court approval.

Some Issues to be Aware Of

Many settlements only give the unsecured creditors “10 cents on the dollar” or a similar low value dividend. Occasionally, the settlement is a combination of items such as a small cash payment and a series of notes or potentially equity.

Legal, accounting, valuation, forensic accountants, and other professionals’ fees in the aggregate can be quite high and, in some cases, the 11 process can drag on indefinitely further adding to the fee total. The debtor entity will have its own advisors and will also pick up the cost for the creditor committee advisors as well, which drives up the costs.

Timing of Chapter 11

Planning the 11 well in advance can increase the chances for success. Understanding the assets, liabilities, contracts, and commitments of the debtor entity and strategizing with financial advisors and counsel can drive a positive result. A Chapter 11 can be used to shed leases, sell operating divisions, or excess assets in an expeditious manner. More importantly, a vision for the reorganized debtor and how they will go to market makes all the difference.

Chapter 11s New Subchapter V

This became effective February 2020 as a result of the Small Business Reform Act and is for small business debtors (those with less than $2,725,625 in debt). A provision in the CARES Act upped the debt limit to $7.5 million for a one-year period. A trustee is appointed in every case and their job is to facilitate negotiation with the creditor body and the development of a plan of reorganization. The trustee does not control the business as in a Chapter 7. There is no creditor committee. There will be a status conference 60 days after filing to review progress toward a plan. The debtor has the sole ability to file a plan and a plan must be filed within 90 days of relief.

Possible modification of a mortgage if the proceeds were used solely for the business (not a house) are permitted.

The payment plan can use “disposable income” for a three- to five-year period.

Informal Arrangements

Rather than a company filing for Chapter 11, occasionally an informal arrangement can be made with major creditors. This requires:

1)      Having a plan that will show profitability.

2)      Contacting major creditors and getting some buy-in from them. An example could be a freeze on past due debt and a COD type of arrangement where payments of past due debt is made equivalent to the amount of new shipments. Occasionally this is accepted but with a 10 percent add on. This means that an order of new merchandise of $40,000 will be accompanied by a $44,000 payment to be applied to older accounts receivable. This way, the supplier still has a customer and the prior debt is frozen but also is being reduced somewhat.

3)      Key customers agreeing to remain as a customer. This is important since some companies have a requirement that suppliers cannot be operating under Chapter 11 or be noticeably insolvent.

4)      Key customers can be asked to still place orders and to keep their account current.

5)      Employees agreeing to maintain their status and perhaps forgo raises and bonuses.

6)      The landlord agreeing to a partial rent reduction.

7)      The bank agreeing to accept interest only for a period without principal reductions.

8)      Company management able to increase sales.

9)      A great set of advisors that know what they are doing and can keep the plan intact and negotiate on the company’s behalf.

10)  Hard focused work by everyone in the company.

Protecting Your Clients

You can provide guidance to your clients on how they can spot potential Chapter 11s from their customers advising your clients to watch for some of the following:

1)      An awareness of changes in buying patterns—have order sizes and order frequency been accelerated.

2)      Notice whether payment patterns changed or slowed up. Comment: A customer that is billed on net 30 terms then typically pays in 10 days and now has slowed to 25 days are still paying early, but this is a change in the pattern for that customer. Your client should find out why there was a change.

3)      Be aware whether accounts receivable are creeping up.

4)      Is customer ordering something new?

5)      Is ordering by customer being done by a different person?

6)      Are orders missing full authorization or paperwork?

7)      Are shipments requested on a rush basis?

8)      Is customer substituting items for backorders or waiting as usual?

9)      Have pattern of sales returns changed?

10)  Try the “smell” test. If something does not seem right, check it out further.

11)  Review for public filings including UCCs, tax liens, eviction notices, or judgments.

12)  Have lawsuits started against your customer?

13)  Does customer have new banking relationships?

14)  Has a major customer of your client filed bankruptcy?

15)  Is a major customer of your client involved in litigation or warranty claims that could affect its continuance?

16)  Has customer downsized?

17)  Are union or employee problems evident?

18)  Has management or ownership changed?

19)  Have accountants changed?

20)  Did company engage a bankruptcy attorney?

21)  Are items that your clients sell being resold at lower prices?

22)  Has customer stopped price bargaining?

23)  Has customer’s “housekeeping” deteriorated?

24)  Did customer relocate in a manner that indicates it was not planned or thought out thoroughly?

25)  Has customer’s marketing and advertising expenses been drastically reduced?

Some protective measures are to have your clients consider selling on consignment so title remains with them until paid for; client can file UCCs on items shipped to clients; client can get paid COD or cash before delivery (CBD); can get a third party guarantee; or get a personal guarantee from owner (this might not protect the client too much, but it can have a psychological effect on customer and your client can assess the reaction to this request).

Timing of Tax Write Off

When a client’s customer files for Chapter 7 or 11 there might be an opportunity to write off all or some of the debt—the write off is not automatic and the circumstances and potential for recovery needs to be examined.

When a matter is placed for collection by your client, at a minimum, the percentage fee that would be paid could be deducted immediately.

How to Get Public Information

D&B reports: www.dandb.com There is a fee for this. These reports usually provide basic information but include UCC filings and bank information.

Legal filing search at county clerk where client is located or with the Secretary of State of the state where they do business or have their main office.

Here are some websites that can be reviewed.

www.bankruptcydata.com

www.pacer.gov

www.abiworld.org

www.njb.uscourts.gov

Conclusion

Understand the basics. Look for danger points. Advise your clients to be alert and what to look for. Do not neglect bringing in an attorney, one admitted to the bankruptcy court where the case is being filed.

This article is a brief primer of the issues involved with a bankruptcy filing. The accountant or advisor should be knowledgeable enough to understand the issues and advise their client on danger signs and how to protect themselves. However, clients, individuals, and businesses, considering a bankruptcy should be advised to consult with an attorney to determine how it will affect them and the ramifications of such filing.


Edward Mendlowitz, CPA, PFS, ABV, CFF, is emeritus partner with WithumSmith+Brown, PC, in East Brunswick, New Jersey. He has over 40 years of public accounting experience, is a licensed Certified Public Accountant in the states of New Jersey and New York and is one of Accounting Today’s 100 Most Influential People. The author of 28 books, Mr. Mendlowitz has written hundreds of articles for business and professional journals and newsletters and presented over 350 CPE programs. He writes a twice a week blog at www.withum.com/partners-network-blog.

Mr. Mendlowitz can be contacted at (732) 743-4582 or by e-mail to emendlowitz@withum.com.

Kenneth DeGraw, CPA, CFP, CFE, CFF, is a partner with WithumSmith+Brown, PC in Whippany, New Jersey. He specializes in bankruptcy and insolvency consulting, financial forensics, and tax controversy.

Mr. DeGraw can be contacted at (973) 898-9494 or by e-mail to kdegraw@withum.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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