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.