Sonoma County Bankruptcy Lawyer Blog

When your small business can no longer hack it and it's time to close up shop, there is an alternative to bankruptcy.

Assignment for the Benefit of Creditors is a way for certain companies to quickly and quietly dissolve without submitting to the control of the bankruptcy court, as the LA Times explains in this article.

Instead of a U.S. Bankruptcy Court appointing a trustee to liquidate the company, the business owner hires an assignee -- often an insolvency lawyer or specialist with experience in ABCs -- to sell the company's assets and distribute the proceeds to creditors. The assignee has a fiduciary duty to try to get the highest price for the assets.

"We signed the assignment and right away [the assignee] took over everything," said Gurmeet Singh, who used an ABC to close his formerly 40-person business, Precision Gear of Corona, two years ago. "He had a locksmith right there and he got the locks switched and we were out of business. Then he got some people in to take inventory of things."

An ABC sell-off distributes the company's assets at pennies on the dollar, and gets the owners off the hook for liabilities. Thus, ABCs are only available to corporations and LLCs, and only make sense if the owners have not signed personal guarantees, which many creditors require for small business credit.

"I don't want to mislead people, because one thing is, to the extent they have made personal guarantees, whether it be for a product or on their loans, they are not released from those" in a general assignment or a bankruptcy filing, said attorney Robert L. Cohen, who runs Alternative Bankruptcy Concepts Inc. in Buena Park.

It's clear that it's a good idea to create a business entity for most small businesses. But which is better: LLC or an S corporation?

1. Why not a sole proprietorship? It's dirt cheap to run your business as a sole proprietorship. There's no filing fees, no minimum taxes, no paperwork, other than the city business taxes and the like that every business must pay. And you get the deductions for business use of home, business expenses, etc. But despite these savings, running a sole prop comes with one huge risk: You are personally guaranteeing every obligation your business enters into. If your business signs a lease for a store front and you wind up breaching the lease, the landlord is entitled to the remaining rent on the lease at the time of breach. If that's $100,000 and you have that much in equity in your home, guess where that's going to come from?

2. Limited liability entities

Yup, you just lost all the equity in your house, if not the house itself, or you've been forced into bankruptcy. Viewed from that perspective the $800 minimum tax bill for an LLC or S corporation is pretty freaking cheap. When your LLC or S corp enters into that store front lease, the landlord is left trying to get the money out of the business entity -- not you personally. If your breached the lease because your business is bust and the company has no assets, the landlord will get a judgment against the company but won't be able to collect from you. OK, that sounds better!

3. The LLC

The LLC is quite flexible and friendly entity. In California there can be single-member LLCs as well as several member LLCs. There are member-managed LLCs (most common in smaller companies) and manager-managed. The key benefits of an LLC: fewer rules in terms of formalities like boards, meetings; and greater flexibility. In an LLC the members can allocate profits however they like, however seems fair. For instance, if one person is going to put in all the work and someone else the money, they might want to structure the profits in a particular way. You can do that with an LLC.

4. The S Corp and the employment tax

If you're self-employed, you have a special relationship with the alluring Form SE. Yup, the self-employment tax: 15.3 percent of net income goes straight to Uncle Sam and despite the thousands you have in deductions for home mortgage interest, SEP-IRA contributions, HSA contributions, you can't get away from that tax. An LLC doesn't solve that problem. But an S corporation does. As a corporate employee, you pay yourself a salary and you pay self employment taxes on just that amount. You can take more money as a distribution, and you don't have to pay taxes on the distribution amount. Thus you can save thousands a year in taxes by paying yourself a reasonable salary - but it must be reasonable - and taking the remainder as a distribution. If taxes are a concern, the S corp may be an attractive way to go. But there are many more restrictions on S corps, so seek a business lawyer's counsel to make sure the trade off is worth it.