Persons considering Chapter 7 bankruptcy must qualify for Chapter 7 under the “means test.” The means tests evaluates your disposable income after expenses. This week a caller asked me if a self-employed person could successfully manipulate income for purposes of the means test. After I explained median income and the means test, this caller stated that he could make his income whatever it needed to be for purposes of filing bankruptcy.
The caller was self employed. If a self employed person wants to file Chapter 7 bankruptcy the means test considers the amount of income the self employed person was paid from his business during the prior six months including salary and profit distributions. The means test does not look at the business’s gross income or business expenses.
The caller proposed that he could retain money in the business rather than pay it to himself as profit distributions in order to lower his personal income prior to filing bankruptcy. He wanted to know if his plan would work.
Business profits not distributed to the owner would increase the business’s cash deposits and the business value. If the business ends up with equity because of retained cash the Chapter 7 trustee could claim the business’s net equity as part of the owner’s bankruptcy estate. However, in most cases where self employed business owners consider Chapter 7 the business’s debt is greater than business assets. Retaining extra cash inside the business usually does not make the business solvent nor create equity in the owner’s interest.
There arguments a trustee or creditor could make to counter this type of pre-bankruptcy planning. For example, a creditor may argue that the debtor is “fraudulently transferring” money he is entitled to receive back into the business, or that the debtor is using the business as an “alter ego” to hold his personal salary and profits. These are academic arguments which I believe would not be pursued except in an egregious case. In practice, some self employed business owners probably can manipulate personal income within the scope of legitimate pre-bankruptcy planning in order to pass the means test.
Interesting post. The greater problem with this is that whether you make a profit or not has nothing to do with whether your entity (LLC or corp) keeps the money or distributes it as distributions to the owners. Profit is profit. So if I take in $15,000 and have $5000 of expenses, I made a $10,000 profit. It doesn’t matter whether I distribute that to myself not. The means test would count income from wages (if, for example, my corporation pays me wages) as well as the profit attributable to that owner.
But an owner could, of course, make less profit. If the owner is killing himself and working 80 hours a week to make more money to pay personal debt (credit cards, large car payments, mortgage(s) on upside down houses, etc.) he could slow down, work only normal hours–let’s say 40 or so and thereby pass the means test and the more important “totality of circumstances” test, providing he waited long enough to get that average down.
Nice post as always, Jonathan. Keep them coming!
great post